Thursday, March 26, 2009

Venture Capital Becomes Vulture Capital?

As I suppose might be expected, there are early signs that the venture funding model here in the Valley is starting to morph in order to take into account the new market realities.

Up until now, VCs have focused almost exclusively on identifying and nurturing young companies. Firms would have their own preferred markets - everything from green tech to software - and in many cases would also have a preferred stage from series A investments through to late-stage C or D round companies. However, the old order is in turmoil, roiled up by a fundamental shift in the business landscape.

Quick recap of the golden years. VC firms raise money from limited partners. These funding sources drawn from a range of different directions including pension funds, investment banks, endowments & wealthy individuals, to name but four. In the agreements drawn up between the LPs and the VCs, things denoting the funds investment thesis, such as market and stage preference, are codified, as are other terms like the maximum amount of cash permissible into any single deal. After a life-cycle of about 5 to 7 years, some percentage of those firms get a decent exit with enough money being made to square away the losers and leave a healthy profit for all concerned.

Fast forward to 2009. Oh dear. It seems that now things aren't likely to go quite so well.

Firstly, the available exits are dwindling fast as the big acquirers have all their attention, not to mention cash, committed elsewhere just now. Furthermore, where they do have a need then why not buy a public company? Dollar-for-dollar, with the Dow at record lows, you likely get more bang for the buck by acquiring larger businesses and taking the strategy in a different direction more quickly, than would be possible buying smaller, riskier private companies. Net result is that existing portfolio companies will need more cash in order to wait for the right dance partner to tap on their shoulder and take them off the sidelines.

Secondly, raising additional VC funds is going to be a challenge, too. Even if the usual suspects in the LP class are still making investments, their typical approach of allocating a percentage of assets to the VC class automatically means that they have a fraction of the real dollars now available to pledge to new funds.

Thirdly, existing portfolio companies will now consume more of their attention and, as we saw above, money as new ways have to be found to ride out the current conservatism on the part of the early adopter communities. Suppose you are selling a new technology for enabling better real-time data analysis for firms on Wall Street? Yeah, it can easily be that tough.

Fourthly, private companies that are looking good will not be willing to take the same fire-sale pricing that others will, meaning that the best companies will simply hunker down and stay out of reach until valuations start to climb upwards again.

Lastly, in the midst of all of this, VC firms still have to find a way to make investments and deliver returns to their LPs. Just collecting management fees and pleading force majeure simply won't cut it.

What, then, to do? Here's a leading-edge example of how VCs are starting to change their business mode. In summary:
- requiring far more flexibility about where they invest. Follow the mantra of "trust us to do good things" and allow the partners to invest wherever they think looks good;
- removing the limits on how much can be invested into a single property;
- blending together of the VC, PE and buy-out models, significantly downplaying the role classic VC investing plays in the outcome of any given fund;
- changing the mix of skills necessary in order to excel in these markets and to follow the new maths to find those happier, bigger results.

This of course begs the BIG question: will it work?

My own view is that it will, but only for the very few "alpha-dog" firms. As always, they get to see the good stuff before anyone else, combined with having the necessary access to sufficient funds to move fast and move first. Plus, timing is all. Buying into this thesis now, when the market is so low, dramatically increases the chance of success regardless how how good you are.

To use an analogy, the first vultures who can push their way onto a fresh carcass get all the good bits, and there are a lot of very weak looking animals ranging around the Valley just now so dead meat is going to be in good supply, at least for a while. Expect, therefore, the scavenger population to increase, but far too quickly and far too broadly. The vast majority will get too little, too late, and meanwhile will have abandoned their traditional hunting grounds.

Before you know it, the world will have turned again and it's unhappiness all round, especially as the economy ticks up and now the herd suddenly looks healthier.

VCs have spent a very long time honing their teams, skill-sets and fund-raising activities in order to do one thing but do it very well: find, build and sell great new companies. Doing PIPE deals, buying distressed assets and generally straying from that path isn't a case of wearing the same coat but now of a different color, it's fundamentally a different business. A few will adapt and make it work, but I have to predict that most won't.

Stick to your guns, guys. Do what you are best at and what you have been in business for years to do. The "V" in VC is for "Venture", not "Vulture".

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