Barbell or Lollipop?

A great barometer as to the health of the venture capital industry is the quarterly fundraising data which the National Venture Capital Association, in conjunction with Thomson Reuters, released recently. The 3Q14 data suggest that the annualized fundraising pace should come in around $32 billion for the year; this past quarter 60 funds were raised totaling $6.1 billion. The amount raised through three quarters of 2014 ($23.8 billion) already surpasses the amount raised in all of 2013 and will edge right up to the mark set in 2006, the last year the industry raised more than $30 billion. Great sign, right? Closer scrutiny of the data raises some troublesome trends.

In aggregate the VC industry manages $193 billion per the 2014 National Venture Capital Association Yearbook across 874 firms employing 5,891 people (that seems light to me). Interestingly California-based firms manage $94 billion of that amount (or 49%) while Massachusetts firms account for $33 billion (or 17%). The top five states (CA, MA, NY, CT, IL) manage 72% of all venture capital dollars; interestingly those same five states captured 76% of venture dollars invested in 3Q14. Some other notable data points:

  • The dollars raised in 3Q14 was a 21% decrease from the amount raised in the prior quarter. The number of funds declined by a larger amount – 26%. Maybe because it was the summer months?
  • Of the 60 funds raised in 3Q14, 36 were follow-on funds and 24 were from first-time fund managers – quite an important dynamic as it suggests new managers are able to raise capital and that the VC industry can “innovate” with new talent and/or investment strategies.
  • Unfortunately those new funds tended to be quite small; the largest new fund raised was $150 million (congrats, Providence Ventures). In fact 88% of capital committed in 3Q14 went to existing managers leaving the 24 first-time funds to fight over the remaining 12%, implying the new funds were ~$30 million in size on average.
  • Overall the average fund size was $102 million, while the median was only $24.5 million – ouch.
  •  The largest fund raised this past quarter was ~$1.0 billion – J.P Morgan’s Digital Growth Fund II.
  • The top five funds raised 48% of the capital. The top ten raised $4.3 billion or 71% of the capital.
  • Only 16 of the 60 funds raised were larger than $100 million.
  • There were 32 funds raised that were less than $25 million in size, 23 of those were less than $10 million.
  • One poor soul raised a $0.01 million fund.

According to Prequin’s “Fund Manager Profiles 2014 Q1” analysis, 9% of venture firms have raised at least 6 funds, 11% have raised between

Funding Gap Slide 3Q14

– 5 funds, 36% have raised between 2 – 3 funds, while 44% of the industry is still with just one fund. This underscores the ability of the industry to rejuvenate itself with many new small funds but it is also really hard to break through and create an enduring venture franchise. Many industry observers have taken to calling this a “barbell” industry structure suggesting stability on either end of the continuum but that may actually be quite elusive. Maybe it looks more like a lollipop – scratch and crawl up the stick to get to the fat and sweet part of the market?

It also continues to be notable that the VC industry is raising capital at a pace well below the amounts invested (see chart below). This fascinates me and probably is explained away by the non-VC investors who have piled into the market (hedge funds, mutual funds, really rich people). We are staring at the seventh consecutive  year that these lines have failed to converge.

Funding Gap Slide 3Q14

Ultimately the real barometer of the industry’s health is measured in returns, which are very complicated to assess. Arguably conditions have conspired to make this a tremendous time for venture capitalists. Powerful new platforms have emerged – such as Amazon Web Services – which can drive innovation in low-cost ways unlike ever before. There are numerous “on ramps” for entrepreneurs with incubators and platforms like Kickstarter. Corporates continue to pursue outsourcing and partnering strategies like never before. The rise and creativity of “super angels” and micro-VC’s contribute enormously to ecosystem. And start-up’s can now address global markets versus just smaller domestic markets.

One of the hallmarks of an inefficient marketplace arguably is a dispersion of returns. Thomson Reuters recently published an analysis which concluded that over the past 30 plus years the top quartile venture returns outperformed by 22.3% the bottom quartile. While returns data are problematic, and if one tortures the numbers long enough, you can get them to say anything, it does seem apparent that small funds struggle relative to peers. In February 2014 Thomson Reuters presented aggregated fund performance data by vintage year which looked at returns by fund size: after three years, funds between $0- $100 million generated 0.6% IRR versus funds $200- $350 million in size with 4.9% IRR; after 10 years it was 1.3% vs 5.3%, 15 years was 13.1% vs 27.4% and after 20 years, the difference was 18.9% vs 34.3% consistently in favor of the larger funds. Returns for funds over $500 million in size tended to outperform on an IRR basis in the near-term (probably due to later stage investments turning over more quickly which helps reported IRR’s, not necessarily return as a multiple of invested capital) but meaningfully underperformed over the long-term.

What does all this mean? The truism that the (historic) venture model really sings with ~$50 million per partner per fund across relatively small partnerships of 4 – 6 general partners may actually be the most productive model. Of course there are outliers on either side of that argument but it is nearly irrefutable that the VC industry structure is changing in profound and not yet fully understood ways.

So barbell or lollipop? Or maybe you have a different shape in mind?