Is the Venture Model broken?

February 18, 2009 at 5:17 pm

The traditional venture capital (VC) model is either broken or on its way to being broken. The meltdown of the financial markets has had a severe adverse effect on venture capital (VC) and private equity (PE) funds, and it is useful for those of us inhabiting the high technology ecosystem to appreciate these forces at work. This post expands on my February 6 San Jose Business Journal interview regarding the need for a new or at least modified venture capital model.

Limited Partners are under pressure
First and foremost, many long standing, quality VC and PE funds are concerned about whether their Limited Partners (LP’s) will be in a position to fulfill capital calls in the coming months or years. Limited partners in the leading VC funds are dominated by pension funds, university endowment funds or similar trust funds. Typically, these sources of capital have internal guidelines about balancing their portfolio between various investments, such as public securities, debt, government instruments, international, etc. Private equity and venture capital have long been part of their investment mix.

Now these LP’s are facing a several major issues that adversely affect VC’s:

(1) The value of their other investment sectors, such as public securities, has significantly eroded over the past year (the DJIA is down 33% over the last six months). As a result, the absolute amount allocated by LP’s to the VC and PE sector is out of balance and will probably be curtailed in order to balance their portfolios;
(2) Investments in venture capital funds have had returns hovering at or below zero for the past decade. Notwithstanding historically low interest rates, the portfolio managers are probably evaluating whether the VC sector can or will return to higher yields, which are demanded by the higher risk inherent in venture investments; and
(3) The management fees charged by VC funds are typically based on capital committed, not actually invested. So, many of the funds are still drawing large management fees without being able to call capital. This fact might further upset the LP’s who watch their capital being drawn out as fees by VC fund managers, while the new investments have slowed down.

Therefore, many VC’s, including many of the Tier 1 firms, are not making capital calls at this time, because if the calls are not met, they would have to admit that the traditional model is broken. They also are trying not to upset the apple-cart of their ability to draw the management fees, even while returns have been unacceptably low for the LP’s.

Need a robust public market
So, as the reader ponders these issues, probably the biggest question is how can we fix the venture capital model, or what will it be replaced with? The answers are not yet clear.

One obvious possibility is to gain momentum for positive exits for portfolio companies through IPO’s or M&A. But when this can occur is very unclear. The re-emergence of a viable US IPO market is probably at least 8 to 10 quarters away, unless something dramatic shakes our world and stimulates an economic recovery. The first signs of market recovery, which may spark renewed IPO or M&A activities, may include a positive consensus developing among analysts and other market watchers regarding a recovery, and/or strong growth within specific high profile technology segments.

M&A exits will help, but when?
As for M&A, the temperament among corporate development officers is similar to that of a schizophrenic…on the one hand they are salivating at the availability of relatively cheap deals, but on the other their better judgment forces them to horde cash except where a deal is strategically compelling beyond anyone’s doubt. While there will be plenty of interesting potential sellers, the strategic buyers will only cherry pick those deals that are strategically critical or those they can “steal”. Until the economy shows signs of resurgence, whether through profits or market caps increasing (probably both), cash will be horded by typical acquirers like Intel, Cisco, Oracle, and Microsoft.

Recent financial market dynamics have exacerbated the pressure on the traditional venture capital model by imposing further constraints on capital availability and decreased exit options. At a minimum these forces will be with us for the next few years, creating greater stress on all participants in the venture community. Ideally these dynamics will provide the impetus for a new and improved venture capital model, but in any event, it is unlikely to be business as usual.

Rich Brenner is Founder and CEO of The Brenner Group, one of Silicon Valley’s premier professional services firms. Rich is a veteran executive, entrepreneur, investor, board member, and philanthropist.

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