Shrinkage—Expanded Upon….

Opinion

Poor investment returns have had a similar effect to cold water – the VC industry is shrinking. As a follow-up to comments I posted this past weekend, I wanted to look deeper into recent fundraising data and see what other implications one might draw.

Since 1980 the VC industry has raised $495 billion across 4,333 funds or 1,670 firms (firms typically raise more than one fund). Today the industry is thought to actively manage right around $200 billion of capital and industry analysts estimate that there are about 770 active firms in the US today. There are 415 firms which are members of the National Venture Capital Association (where I am a board member).

VC funds tend to be fully committed within the first three to four years of being raised, although it may actually take quite a few years—upwards of eight to 10 years to be fully invested (because of reserves for follow-on investments in existing companies) and at least that long to be fully liquidated. Most VC funds have a contractual 10-year life. Firms are deemed active if they have raised a new fund in the prior eight years, per the NVCA.

In 2010 nearly $21.8 billion was invested in 3,277 deals but only approximately $12.3 billion was thought to have been raised by VC’s to invest—thus the shrinkage issue. Between 2007 and 2009 roughly 100 venture firms left the industry each year—in 2007 there were just over 1,000 firms—-not terribly surprising given the global economic meltdown. Perhaps a more interesting metric, though, is the number of funds raised; the high water mark in 2000 saw 635 new funds raised (six hundred and thirty five—over two per day not counting weekends), which declined to 157 in 2010. In 2000 all those funds invested in 7,970 deals – simply staggering.

More stats. Since 2004 more than $166 billion was raised by VC’s and $168 billion was invested (since 2005, $149 billion raised, $147 billion invested) so things seem to be in reasonable balance. The analysis is tricky because how long it takes to actually invest a fund once raised, but the industry has a nice ability to recalibrate itself quite quickly.

So as the economy recovers we would naturally expect to see the amount raised and the amount invested to converge – but we did not see that in 2010. In fact – other than for 2001 – we have never seen such divergence. What happened?

The venture industry this year reported for the first time 10 year returns data—which was quite negative—while expected, sent shockwaves through the LP community. As of September 30, 2010 the 10-year aggregated VC return, according to Cambridge Associates, was -4.6 percent (the 1, 3, 5 and 15 year returns were 8.5 percent, -2.1 percent, 4.3 percent, and 36.9 percent, respectively). Of course LP’s do not and can not invest in a VC index—they get to carefully select specific VC managers—but the message that the VC industry is now structurally challenged and/or unattractive took hold with many large institutional LP’s this past year.

Some other interesting implications and insights when one stares hard at the data…

Average Fund Size: Since 2000 the average VC fund raised was between $130 – $150 million, even throughout the “billion dollar fund” craze. In 2010 the average fund size was $80 million—an incredible decline—which may reflect the “micro VC” or “Super Angel” phenomenon or it may preview that a structural shift is upon us.

Average Deal Size: The average deal size has interestingly remained consistently between $6.25 and $7.5 million over the last five years or so. In 2000 it was $12.4 million, which clearly reflected all the capital that flooded into the VC marketplace ($107 billion was raised that year and just under $100 billion was invested). My guess is we should expect to see average deal size drop significantly over the next 18 months.

Total Number of Deals: In 2008 there were 4,025 deals—in 2009 there were 2,927. Interestingly there were 3,277 deals in 2010 which reflected the activity of the “Super Angel” as well as the profound waves of exciting innovation across all sectors including cloud computing, cleantech, consumer internet, personalized health, etc. My guess is the pace will remain around 3,000 new deals—maybe down slightly—per year in the near to medium term; deals will just be smaller on average.

This is not just a VC problem—entrepreneurs will have fewer sources of capital to access, there will be fewer cool companies offering great jobs, and new medicines/games/applications/devices will not be created. As we collectively witness this recalibration, maybe it is time to get out of the cold water and stop shrinking.

What do you think?

Michael Greeley is a General Partner at Flare Capital Partners, a healthcare technology venture firm. Follow @greels1

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