Much has been written of late about the demise of venture capital.
I have picked up on two principal themes:
1) Hedge funds are bringing more competition, depressing returns and paying their portfolio managers better
2) Start-ups need less capital, eliminating the need for large venture funds
Both of these concerns are fundamentally wrong and, I predict, will be proven so no later than at the end of the next recession, whenever that may be.
First, with respect to competition from hedge funds, let's note that most hedge funds were launched to invest in liquid investments. Even though most hedge fund charters allow for investment in private equities, the limited partners did not invest expecting to have their funds tied up indefinitely or to be subject to the relatively opaque valuation process of private companies. Hence, I predict that hedge fund participation in the venture markets will be short lived as a result of pressure from the LPs.
Separately, the economics of venture investing and investing in liquid investments of any sort, are remarkably different. On one hand, a venture partner can manage only a handful of portfolio companies at one time and, on the other, the hedge fund manager may be able to handle dozens or even hundreds of positions with the right software. Fundamentally, hedge fund managers can be leveraged better and therefore stand to make more money. That said, hedge fund companies can't economically pay anyone more than VCs make to manage venture investments because the economics of the business don't allow it. Ultimately, hedge fund managers can't draw away the best venture guys by offering them more money because there simply isn't more money in the venture game to pay them.
Finally, to the extent that hedge fund managers create funds designed for investment in early stage growth equities, this isn't really competition from hedge funds so much as hedge fund managers joining the club.
As regards the second problem, lower costs for start-ups such that large funds have no opportunity to play, there is no long term problem. We are seeing a blip in the economy in a period of extraordinary shifts in the economy as huge swaths of our traditional economy are moving to the web. At the same time, fundamental technologies have facilitated an unprecedented fragmentation of media.
Basically, the only costs for building businesses that have been eliminated or reduced, are those associated with creating core technologies to provide competitive advantages. The web economy is so large that when someone creates a new product that attracts any genuine interest, scaling can be almost instantaneous.
What some commentators are forgetting is that in most companies, later rounds of venture capital have relatively little to do with the core kernels of technology and everything to do with scaling the technology and the business. The costs of growing a business--adding people, equipment, marketing spend, etc.,--really haven't changed. As a result, all of the businesses emerging quickly today without serious A rounds, may still need capital--lots of it--if they are to really achieve huge scale.
Furthermore, the range of deals to which current web 2.0 economics apply is small. Most companies developing high tech applications from medical devices, proteomics, nanotechnology and even enterprise software will require varyingly significant amounts of capital to reach first revenues.
So, with a nod to Bobby McFerrin, to all of my friends in the venture capital arena, let me just say, don't worry, be happy!
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