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BW Businessworld

No Easy Exits Ahead

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The story is familiar to people in all industries. Times get tough, revenues decline, and the company managers begin deep introspection. They discover serious flaws in the way the company conducts its business. They cut costs, restructure the corporation, and often downsize as well. What emerges is a leaner and healthier company. This story repeats itself with such regularity that it is usually considered not worth mentioning. Except that this time the industry involved is the venture capital (VC) industry, which is often thought to be immune to the vicissitudes of ordinary mortals.

About a month ago, the National Venture Capital Association (NVCA) in the US released  statistics about the industry that got passing mention in the US media. It said that 10-year returns of venture capitalists have dropped in the last quarter, from 26.2 per cent to 14.3 per cent. The association also issued a warning with the statistics: if the conditions do not improve quickly in the exit market, the returns will continue to deteriorate for the next few years. The VC industry is known to be cyclical, and thus neither the statistics nor the warning received wider public attention. However, a few industry veterans started pointing out some fundamental faults in the industry structure, which have become so serious that it is about to lead to a consolidation and shrinking of the sector.

 The problem, as they see it, is this. In the past two decades, the VC industry has had some exceptionally good years interspersed with some poor years. When it had a bumper crop, like in 1999-2000, a lot of money flowed into the industry (see ‘Weakening Commitment'). As the amount of innovation in the US remained steady compared to the previous decades, VC firms began to invest in ideas that were not truly innovative. Such investments never gave expected returns. Now that the bumper years of the end-1990s are going off the 10-year period, the returns over the decade are beginning to look poor, and would look even poorer over the next few years.

The ‘Size' Of The Matter
Industry insiders and observers differ in their assessment of the situation. While some feel that special conditions like the recession created this situation, and that things will improve soon, others feel that the current size of the VC industry is unsustainable. "If your fund size is too large," says Paul Kedrosky, senior fellow of the Kauffman Foundation, "you end up investing by the wrong metrics." Kedrosky had published an analysis of the sector a few months ago, concluding that the VC industry needed to shrink to be sustainable. However, Kedrosky and others feel that it is not just a matter of size, and that there may be other factors as well that are impacting the returns.

Even industry insiders agree that less capital may be a good thing. "The VC model is broken," says Daniel Perez, a venture partner at Bay City Capital near the Silicon Valley. "Companies have deviated from what VCs should be doing. Earlier, the industry had a small number of groups focusing on innovation that makes a difference. Now, majority of the investments are on commercialisation of products." Perez points out that his remarks mainly pertain to life sciences and healthcare investments by VC firms — a sector that he specialises in.

Shrinkage of the industry could make some venture capitalists think harder about their portfolios, and go back to funding only true innovation. It could also force them to focus more on commercialisation of products, to make sure that their existing portfolio companies do not go out of business. In either case, it would have a significant impact on the amount of VC money available for investment in the next five years, on the nature of their investments and, by implication, on entrepreneurship as well.

Consider the declining returns of the industry more deeply. VC performance had improved steadily throughout the 1990s. It peaked at 48 per cent in the year 1999, remained steady for a year, and then began to drop. Returns went to negative levels in 2004, improved slightly for three years subsequently, and is now moving southward once again (see ‘Venture Capital Vs Stockmarkets' on page 42). Interestingly, these were the years when maximum capital was committed to the VC firms as well, as the high returns of the end-1990s led to a dramatic spurt in the size of VC funds.

According to data from Thomson Reuters, analysed by market research firm Industry Ventures, the average fund size was $53.7 million in the 1980s, $94.7 million in the 1990s and $179.7 million in this decade. In the 1980s, only three funds were higher than $1 billion. In this decade, 30 funds were over $1 billion. The number of funds also went up from 653 in the 1980s to 1,622 in this decade. In the 1980s, small funds accounted for 75 per cent of the VC funds. Now, they account for 33 per cent. The size of funds had been increasing relentlessly, even as the performance of these funds kept dropping.

One cannot directly conclude from these statistics that excessive fund size is the cause of the decline in performance, but there is enough reason to suspect a correlation. As Kedrosky argues in his paper, although the returns declined after the year 2000, the investments never slowed. Amazingly, this pace of investment has lasted a decade and continues even now, after a short blip during the recession, at approximately $28 billion a year. Till the dot-com boom, the VC investments were around $10 billion a year.

Click here to view enlarged imageUnfriendly IPO Market
This situation is going to continue, at least for a few years. According to data from NVCA, the second quarter of this year was the weakest quarter in terms of fund raising since 1994 (see ‘Building Up Confidence', BW, 3 August 2009). Industry Ventures thinks that fundraising will decline 40 per cent this year. And also that 50 per cent of small fund managers will be unable to raise money in the next few years and will shut down. The Silicon Valley, for example, is already full of such ghost VC firms who have existing investments but cannot raise more money.

Such a situation may be a natural correction for the presence of excessive capital. However, some industry observers believe that the problem is not too much capital, but its concentration in a few large funds. They think that a series of smaller funds, with the total industry capital remaining the same, would improve the returns over the long term. However, as is obvious to even the casual observer, large fund size is only part of the problem. The most obvious of the other problems is the declining IPO (initial public offering) market and, to a lesser extent, of mergers and acquisitions (M&As). The changing nature of a few key industries has also contributed to VC firms' troubles.

In the 1980s, IPOs accounted for 94 per cent of all the exits of VC firms from their portfolio companies. This figure had fallen to 59 per cent in the 1990s. This decade, IPOs have accounted for only 17 per cent of the exits. More stringent regulations are part of the reason for declining IPOs. However, there is another more important reason. The public is less supportive of companies with untested technology and low revenues. Says Ravi Mhatre, managing director of Lightspeed Venture Partners: "Companies had gone to IPO prematurely." The Silicon Valley is still full of companies with high VC investments and poor or no revenues. There is little reason to suppose that the public will support companies with high valuations and low revenues.

The prime exhibit in this case would be Twitter, but even the highly knowledge-intensive biotech sector has several such companies. For example, the Seattle-based Omeros had its IPO on 8 October at $10 a share, but within a month this value had dipped to $6.06 a share. It is of course the worst performer of all the 42 IPOs the US has had this year. Omeros has six products in various stages of development, but no revenues. The poor performance of Omeros is not deterring other biotech companies — again with no immediate revenues in sight — from filing for IPOs. On 6 November, San Diego-based Trius Pharmaceuticals filed for an IPO. Trius is preparing to do Phase III clinical trials on its anti-infective. Other life sciences companies in the IPO pipeline include Anthera Pharmaceuticals and Aldagen. These IPOs in the next few months are critical for opening up — or shutting — the IPO window for life sciences companies. "The IT  (information technology) venture capitalists regrouped after the dot-com bust. A similar phenomenon is going to happen in life sciences now. Those who are trying to make a quick buck will disappear," says Perez.

The recent fate of the biotech industry has raised questions about the viability of VCs investing in this sector. At first sight, the life sciences sector does not seem to be a good investment opportunity at all. VCs typically require returns in five years, and it takes about 10 years — and $1 billion — to make a drug. If a company's first drug makes it to the market, it could expect revenues in 10-12 years after inception. It is clear that VC firms need to exit such companies before they start making money. Says Bruce Jenett, head of life sciences practice at DLA Piper, a law firm that has orchestrated several biotech M&As: "The VC model is not suited to the life sciences sector. We need to find another way of nurturing life sciences innovation."

As the public appetite drops for investing prematurely in biotech companies, M&A becomes the only exit route. M&As in the life sciences sector have declined 21 per cent in the past two years, but this sector has actually performed better than other sectors. However, VCs are still investing as ever in the life sciences sector, but lack of true innovation could affect their returns here. On the other hand, small biotech companies remain the best way of bringing new drugs to the market. A small biotech company could bring a drug to Phase-II clinical trials with just $50 million, while a large pharma company could use up twice this much. "There are still opportunities in the life sciences sector, says Brian Atwood, co-founder of Versant Ventures, a VC firm that specialises in life sciences: "Investors are worried about healthcare reform. They will come back once this is sorted out."

*From Jan-Nov; mn: million Source: PWC/NVCA MoneyTree ReportWhile the life sciences sector could challenge the VC firms in the long run, there are problems in the other two sectors as well. There is a feeling among observers that the IT sector has matured, and cannot sustain new billion-dollar companies any more. The share of IT in VC investment has declined steadily after 2000, from over 80 per cent to 50 per cent now. IT has also become less capital intensive over the years. "I would expect a sharp decline in the amount of money invested in IT," says Kedrosky. If that happens, one of the most lucrative areas for VCs would shrink.

However, not everyone agrees with this situation. "People had said that there would be no big companies after Google," says Mhatre. "But then came the social media and Facebook." Of course, areas like mobile software, gaming, and internet advertising are all very active at the moment. And of course, cleantech has arrived to make up for IT. Cleantech looks set to continue as the biggest investment sector for the VC firms in the US, but it remains to be seen how much returns it would provide to the venture capitalists over the next five years. The sector already has had a spectacular IPO on 24 September, of the Boston-based energy storage company A123 Systems. Though the firm's market cap has fallen lately, investor confidence remains high in the cleantech sector — and thus exit opportunities for VC firms. Says Dallas Kachan, managing director of the Cleantech Group, a research, events and advisory services company in San Francisco: "Exit opportunities in the cleantech sector will continue to be good for a while."

The NVCA, the VC industry's main lobby group, recently published a study on the value of venture capital to the US economy. In the year 2008, VC-backed companies employed 12 million people and generated $3 trillion in revenue. This represented 11 per cent of US employment and 21 per cent of US gross domestic product. The implication is clear, but these statistics do not tell the whole story. The US sees about 600,000 start-ups every year, of which only 1 per cent receives VC money. As the VC industry shrinks, other kinds of private equity and angel funding could take its place. In any case, an efficient and healthy VC industry could probably do better for entrepreneurship in the long run.