Why All That VC Cash Is Causing Jitters

A surfeit of money could drive up the costs of startups -- and depress returns

Five years after the internet bubble burst, institutional investors are once more lining up to put money into venture-capital funds. Last year pension funds, foundations, and endowments shoveled $17 billion into the coffers of North American venture firms -- up 67% from 2003, according to researcher Thomson Venture Economics (TOC ). Experts predict the number will surpass $20 billion this year.

But this rising optimism is making some institutions skittish. The staff of the California State Teachers' Retirement System (CalSTRS) is recommending that its board cut venture capital to 15% of its private-equity investments, from 25% now. Staff analysts worry that too much money is chasing too few promising startups. Plus, as the teachers' fund has ballooned to $116 billion in assets, it has outgrown the number of venture firms the managers believe can deliver a decent payback. A vote on the staff recommendation is expected in July.

CalSTRS isn't alone. Harvard, Yale, and Stanford have shrunk the amount of their endowments allocated to private equity, which includes venture, for three straight years. And last November, the Ohio Public Employees Retirement System slashed its venture target to 15% of private-equity investments from 25%. Its shifting money into leveraged buyouts and restructuring deals. "The venture capital market has contracted while the supply of capital remains high, causing some concern that future returns may not meet expectations," wrote Greg Uebele, assistant investment officer for private equity for the Ohio pension fund, in a memo to its board.

Do these institutions know something their peers don't? After all, venture capital turned in 19% returns last year, according to Thomson. That's above the historical average of 15%. But now a number of experts argue that the days ahead will be much tougher. "My guess is for [VC funds raised from] 2000 to 2009, the median returns are unlikely to get out of the single digits," says Fred Giuffrida, managing director at Horsley Bridge Partners, a San Francisco firm that advises institutions on venture investments.

The bears' argument warrants a close look. It starts with the sluggish corporate demand for information technology. While double-digit increases in tech spending helped drive roaring venture returns in the 1990s, Forrester Research Inc. (FORR ) predicts that tech demand will rise by only 6% a year through 2008. Furthermore, the weak initial public offering and merger markets mean that venture firms won't see many premium paydays. Most of all, a ton of capital is chasing after startups these days, in tech and elsewhere. Venture firms still have $53.6 billion in investor commitments since 1999 that they haven't put to work, more than twice the size of the industry before the late 1990s boom. Too much venture money can drive up the price of promising startups, depressing returns.

Investors may have poured money into venture for the outsize returns, but in truth, relatively few firms deliver such results. The number of venture firms has more than tripled over the past 20 years, to roughly 1,200. Yet only 4% of those firms accounted for 66% of the market value from IPOs between 1997 and 2001. In other words, the top 50 firms are delivering the vast majority of the investment returns. "The disparity between the top and bottom is becoming pretty incredible," says Erik R. Hirsch, chief investment officer at Hamilton Lane, a Philadelphia firm that manages funds of private-equity funds.


Studies like this explain why institutions are pushing hard to get into funds raised by the VC firms with the best track records. But the size of those funds is shrinking, even as the amount of money available to invest in them grows. Last year, top-drawer Kleiner Perkins Caufield & Byers raised $400 million, 38% less than its 2000 fund. In 2003, Sequoia Capital raised $395 million, half the size of its 2000 fund. "There is substantially more interest to get into the top-tier venture funds than there is room," says Clint Harris, managing partner at Grove Street Advisors, a Wellesley (Mass.) consultant to institutional investors.

The result may be a dangerous spillover. Institutional investors allocate money to venture because of the industry's overall returns -- but when they look to write checks, they may find that the only willing takers are outfits with mediocre returns. For example, Skyline Ventures of Palo Alto, Calif., a health-care venture firm whose most recent fund ranks in the bottom quarter of comparable funds, according to researcher Private Equity Intelligence (PEI), was able to announce the closing of a $172 million fund in April. Flagship Ventures of Cambridge, Mass., and Atlas Venture of Waltham, Mass., are also raising money, even though their most recent funds have ranked in the bottom half of peer venture funds, PEI reports. According to PEI, 290 VC firms are trying to raise $46 billion worldwide.

Of course, past performance is no indication of future results, as almost every investment brochure notes. Top-tier firms today won't necessarily be the best performers in the future, and those in the lower rungs could move up. That's especially true if emerging fields, including energy or biotech, surpass information technology as promising sectors for startups.

Still, one well-known VC looked at these trends and got out of the business completely. Earlier this year, Howard Anderson, co-founder of Boston-area venture firms Battery Ventures and YankeeTek Ventures, was about to raise his ninth fund when he paused for a gut check. Anderson concluded that it would be nearly impossible to deliver attractive returns. Now he's quitting the venture business to teach and advise young companies. "We were, as an industry, funding too many companies that were nonviable," he says. "We were hoping the market would get irrational again and we would get bailed out."

Sluggish tech demand. A tepid IPO market. And rising costs for building startups. Even with the tech bust over, venture capital still looks like a minefield. The cleverest will survive and prosper. But those who aren't careful may still blow themselves up.

By Justin Hibbard in San Mateo, Calif.

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