TCS Daily

After the Hangover

By Dominic Basulto - March 10, 2004 12:00 AM

After three years of disappointing returns due to staggering losses on Internet-related portfolio investments, the venture capital industry is in the midst of a comeback. The long Internet-induced hangover seems to be fading, thanks to the greatest hangover remedy ever created: money -- and lots of it.

After a period in which venture capitalists were shutting down companies, selling off equity stakes in the secondary market, and administering IV needles to start-ups on life support, the VC industry is once again attracting tens of millions of dollars from institutional investors hungry for outsized returns. In what seems like a flashback to the late 1990s, VC firm New Enterprise Associates recently announced the formation of a blow-out-the-doors $1.1 billion VC fund.

But is this first glimmer of optimism emanating from the VC industry just the prelude to another drunken binge -- or a sign of significant changes to the structure and function of the VC industry? It's too easy to explain the sudden giddy surge within the VC industry on the rising fortunes of the public equity markets or the hype and irrational exuberance surrounding the upcoming Google IPO. True, investors are more optimistic (and in fear of losing out on the next tech boom) -- but there would be appear to be a number of reasons to suspect that the VC industry is undergoing a transformation.

Firstly, the largest institutional money managers (e.g. pension funds, endowments) are now allocating a greater percentage of their portfolios to VC investments. Venture capital, just like real estate and hedge funds, is now a respected 'alternative asset' -- an asset class that institutional money managers turn to when they want to juice up portfolio returns. For example, one of the largest institutional investors, CalPERS, allocates approximately 4% of its $164 billion in assets to its private equity portfolio, and in mid-February, announced plans to invest an additional $3 billion in private equity in 2004.

The latest survey figures from JP Morgan Fleming Asset Management seem to bear out this story. More than one-third of pension plans are planning to shift their asset allocations this year and are more inclined to use alternative investments (such as venture capital) to enhance returns or reduce overall portfolio risk. This is an important point, since even a relatively minor shift in allocations by billion-dollar institutional investors can lead to a massive inflow into the VC industry. Consider a rough back-of-the-envelope calculation: if CalPERS were to increase its private equity allocation from 4% to 4.6%, it would translate into an additional $1 billion that could be invested in venture capital funds.

Perhaps this fact explains why, despite the presence of a potential $85 billion capital overhang (the difference between the amount raised by VC firms during the Bubble Era and the amount actually invested in portfolio companies), VC funds are finding it surprisingly easy to tap deep-pocketed investors for more cash. There's suddenly a wave of money ready to gush through the tech sector like a tsunami. In addition to NEA, other VC firms in the process of raising money include Technology Crossover Ventures ($900 million), Venrock Associates ($550 million), Battery Ventures ($450 million), Kleiner Perkins ($400 million), Kodiak Venture Partners ($316 million), General Catalyst Partners ($300 million) and Charles River Ventures ($250 million).

The VC industry is also moving into an era of massive professionalization. The funds raising additional capital from investors are not the Johnny-come-lately VC funds set up during the peak of the Internet boom -- they are professional money managers with an increasing ability to diversify their portfolio investments in a dizzying number of ways. In other words, they are funds that don't have to bet the whole house on tech. Some private equity firms, for example, are setting up different operating divisions to offer banking and corporate finance services, behaving more and more like hedge funds and blurring the distinction between different forms of private equity (e.g. buyouts, venture capital).

For example, consider Warburg Pincus, which Forbes magazine ranked as the #1 VC investor of 2003. In 2003 alone, Warburg Pincus invested more than $237 million in VC deals. The firm may not generate the same kind of hype as Kleiner Perkins or Benchmark Capital, but the company is at the forefront of creating a "new professional approach to VC." The firm boasts a truly global network (including offices in Beijing and Mumbai), has a 21-member executive management group, invests in 11 different industries, and provides a number of value-added services related to capital markets, technology strategy, and strategic marketing. Quite simply, the firm has the capital and strategic heft to fund start-up companies from start to finish -- what the company is calling the "fully-funded "model of VC investment. When VC firms are prepared to supply capital on a continual basis, start-ups can avoid the problem of round-by-round funding and focus on becoming cash flow positive.

It all adds up to good news for innovative start-ups. As long as institutional investors continue to consider venture capital a respected alternative asset, the VC industry becomes increasingly professionalized, and VC investors find new ways to diversify tech-laded portfolios, the tech sector -- fueled by a massive influx of freshly minted VC money -- could be poised for an impressive bounce-back.

Dominic Basulto last wrote for TCS about innovation in Silicon Valley.


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