When people ask me about the likely development of the venture capital industry I always answer that it is governed by two somewhat independent cycles.
The first is the macro-economic cycle. When the overall economy is performing poorly it is harder for startups to grow their businesses and create value and those that make it as far as exit find their companies attract lower valuations both at IPO and in M&A. These factors depress returns across the industry which reduces the attractiveness of venture capital as an asset class and hence the size of the venture industry as measured by investment into venture capital funds is driven in part by the macroeconomic cycle.
In my 11 years in this industry venture industry suffered significantly in the downturns from 2001-04 and 2008-2009.
The second cycle is the asset cycle. The other big driver of returns in the venture industry is the weight of money in the market. When there are fewer funds investing the balance between the supply and demand of capital shifts in favour of investors resulting in lower valuations and higher returns. Capital then floods into the market chasing the higher returns driving valuations up and returns back down again, and so the cycle goes.
William Quigley (who I’ve now referenced twice in two days) is quoted on Business Insider giving a great description of how and why we are at the bottom of the asset cycle now and why things will improve going forward:
1. Venture capital is no longer be considered a “necessary asset class” to invest in by many limited partners given the sectors insignificant size relative to the financial assets LPs have under management
2. Limited partners, who generally look retrospectively to determine their portfolio allocations, not progressively, have shunned the asset class.
3. But, as a result of this shaking out of the venture capital sector (in terms of #’s of firms and amount of capital raised by those firms) conditions are now actually favorable for sustained long term returns
The asset cycle has played out somewhat differently in the US and Europe. Here in Europe there was very little money invested in venture funds prior to 1999 and then the industry grew extremely rapidly through to the tech bubble bursting in March 2000. At that point we were at the top of the asset cycle and we have been coming down ever since (albeit with a brief up-tick in 2007-2008). There are relatively few funds in the market right now and I’m hopeful that the crop of venture funds raised in the last couple of years will generate good returns and bring the LPs back to Europe.
In the US the venture industry stayed at the top of the asset cycle from 2000-2008 before crashing precipitously, and as Quigley argues I think they are at the bottom now.
The final driver of returns to venture are tech bubbles. Bubbles have more effect on the performance of venture funds and the attractiveness of the industry than the macro-economic or asset cycles, but they are not cyclical. Rather they emerge periodically and are hard enough to identify when you are in them and almost impossible to predict in advance. An interesting dynamic of the market right now is that despite the asset cycle being at or near the bottom investors who presumably believe we are at the beginning of a bull run are pushing valuations upwards.