Nathan C. Werner, CFA
Vice President
“Though the current environment for venture capital appears bleak, the long-term nature of the investment strategy transcends multiple market cycles.”
PRIVATE EQUITY: Venture
The turmoil in the public equity markets presents numerous challenges to venture capital funds as their portfolio companies face the possibility of a slowing economy and a virtually non-existent initial public offering (IPO) market. Venture capitalists who were around when the technology bubble burst are applying one of the most important lessons learned, which is to conserve cash and operate as efficiently as possible with limited amounts of capital. The long time horizon to an IPO further complicates the current environment, as the average age of a venture-backed company going public more than doubled in the last 10 years from 4.2 years in 1999 to 9.6 years in 2008. Public investors today expect larger and more mature companies to list on a stock exchange and venture funds are trying to build them with as little capital invested as possible.
Though the current environment for venture capital appears bleak, the long-term nature of the investment strategy transcends multiple market cycles. A typical venture fund will have a life of 10 years or more. The investment period usually lasts for the first three to four years followed by three to four years of company building. Meaningful realizations generally do not occur until late in the life of a fund. Patience for returns will be tested as these funds progress through their life cycle while the public markets fluctuate. Venture capital continues to offer potential for high returns due to opportunities of investing in companies when they are early in their life.
Fundraising and Investing Environment
The aggregate amount of capital raised by venture funds through the first nine months of 2008 continued at a consistent rate compared to the last several years, though the average fund size grew in 2008. Commitments fell slightly in the third quarter, though the timing of when a venture fund closes can cause fluctuations in the aggregate fundraising levels. For example, the three largest venture funds raised in the third quarter accounted for over 25% of the entire amount raised by the aggregate 55 funds during the quarter.
According to PriceWaterhouseCoopers MoneyTree report, venture capital funds invested $22.6 billion through the third quarter of 2008, virtually unchanged from the $22.6 billion during the same timeframe in 2007. The biotechnology and software industries attracted the most investment capital for both the year, $7.2 billion (approximately $3.6 billion each), and the quarter, $2.6 billion (approximately $1.3 billion each). The telecommunications industry, down 25%, and the networking/equipment industry, down 49%, fell significantly through the first three months compared to year-ago levels. Venture investing in semiconductors, another traditional area of venture capital investing, fell 13% in 2008 compared to year-ago levels.1
An area of increasing attention is in the clean technology sector, which has some crossover with traditional industry classifications. Investments in clean technology companies rose 14% in the third quarter, as venture capitalists placed $1.0 billion in 73 companies.2 The clean technology sector continues to attract significant capital and attention as an emerging industry for venture capital funds. New entrants are raising clean technology focused funds while an increasing number of established venture funds are exploring the area.
Exit Environment
Venture capitalists will struggle to achieve attractive returns until the exit market improves for both IPOs and acquisitions. 2008 will likely be the worst IPO market for venture-backed companies in 30 years. Only six venture-backed companies have gone public so far this year, levels not seen since 1977.3 Venture capital funds rely on a robust IPO market to generate high returns on their investments. Returns will likely not improve until the IPO window opens again. According to the National Venture Capital Association, the number of venture-backed companies that filed for an IPO with the SEC fell from 42 to 38 in the third quarter.4 A total of 28 venture-backed companies have withdrawn their registration to go public through September 2008.
The number of acquisitions of venture backed companies through the first three quarters of 2008 fell to 199 from 271 in 2007, a decline of nearly 20%.5 Public companies will likely slow down their acquisition pace as they conserve cash in the current environment. There were a few bright spots so far in 2008 as Dell acquired Equal Logic for $1.4 billion in January and GlaxoSmithKline acquired Sirtis Pharmaceuticals for $715 million in June. More recently, eBay acquired Bill Me Later for $945 million in October.
Performance
Venture capital fund performance reports on a quarter-lag basis. Short-term performance can be misleading given the long-term nature of the strategy. As highlighted in the chart, performance for most trailing time periods remained positive. One and three year performance through June 30, 2008 was lower than the March 31, 2008 and June 30, 2007 periods, reflecting the lack of meaningful exits over the last twelve months. Meaningful performance assessment during weak exit markets remains challenging due to the lack of realized returns. Keep in mind that most of the declines in the public markets occurred in the second half of 2008. The combination of lower public markets and the implementation of FAS 157 will likely push valuations lower in the third and fourth quarters of 2008.
Conclusion
The weak exit environment and slowing economy make for challenging times in the venture capital industry. The valuation at the time of investment and valuation at the time of exit ultimately drive the performance of venture capital funds, as the interim values do not necessarily represent what the venture companies will be worth when the general partners are ready to sell. Patience is needed today more than ever due to the extended time to an exit and current environment. Despite the challenges, venture capital offers return potential unlike any other strategy due to the opportunity of investing early in a company’s life and building the company to a profitable exit.
1-2 PriceWaterhouseCoopers MoneyTree Q3 2008 Report. PriceWaterhouseCoopers. (October 2008).
3-5 “Venture-backed IPO Drought Continues in the Third Quarter of 2008.” National Venture Capital Association. 1 October 2008.
