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Bubbly Times for Tech VCs

Katie Benner is a Bloomberg View columnist who writes about technology, innovation, and the cult and culture of Silicon Valley. She lives in San Francisco.
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Investors probably will never bury venture capital firms under the mountains of cash that they once did in such banner years as 2000 and 2001, during the height of dot-com madness, when VCs could take in tens of billions of dollars in a single quarter.

But that doesn’t mean that there isn't a lot of easy money still washing over VCs -- and that there still isn't a lot of risk associated with that phenomenon.

Market cycles will eventually turn -- as they always do -- and the lofty valuations that startups currently enjoy will be forced to come down. So where do risks lurk in VC-land?

Pension funds and other institutions have taken a renewed interest in venture funds, and they’re expected to invest $32 billion in the industry this year, the most since 2001. Both large and small venture funds are pulling in money, according to a report from the law firm Fenwick & West.

All of that cash is moving through VC's coffers and into hot, closely-held startups such as Uber and Snapchat. Premier VC firms such as Andreessen Horowitz, Norwest Venture Partners, Accel Partners and Founders Fund have all raised more than $1 billion this year. Tiger Global, which has invested in Automattic, Warby Parker and Flipkart, is in the midst of a $1.5 billion fund raising effort. It took in $1.5 billion just five months ago. 

Silicon Valley is awash in speculation about who might get dinged if the money stops flowing. Valley entrepreneurs and investors seem to think that any fallout probably would be confined to a handful of investors and a lot of young, well-paid software engineers who can all go back to grad school.

The end of this free-flowing financial bounty, however, could have consequences down the road for investors too -- including regular people who never got to ride the valuation rocket known as Airbnb to $10 billon and beyond, but who still have their personal assets or retirement plans tethered to big institutional investors. Those institutions have been rushing into the arms of venture capital firms of late, and any disruption in the VC universe will be felt by average investors as well.

Institutions such as pension funds and endowments earmark a percentage of their cash for stocks, bonds and alternative investments in hedge funds, private equity and VC firms. Stocks are in the midst of a big rally, with the Standard & Poor's 500 Index more than doubling since the financial markets reached bottom in March 2009. As a result, investors not only hold more high-priced assets, but a bigger share of those assets are now tied up in stocks. In order to rebalance their portfolios, large and small institutions are moving some of those gains out of equities and into alternative investments (such as VC deals).

This is also happening at a time when institutional investors are thinking twice about allocating money to hedge funds, which didn’t provide much in the way of diversification when the markets tumbled during the financial crisis yet charged famously high fees for their services. Many hedge funds have also recently delivered sub-par returns to their investors.

“Lots of those funds went up just because the markets were climbing,” says Tanya Beder, the chief executive officer of asset-management advisory firm SBCC Group.

In that context, potential VC returns seem tantalizing to the institutional investors. Billion-dollar-plus valuations for closely-held companies are becoming more common, and those companies, thus blessed, are then able to raise even more money.

Uber, for example, raised $1.2 billion this summer and is reportedly thinking about raising $1 billion more. Some reports say a cash infusion could value the company at $30 billion or more. The trade-off is that once investors commit their funds to a VC firm, they are typically forced to stay put for seven to 10 years, whereas they usually aren't trapped in hedge funds for such lengthy timeframes.

So it's come to the point at which venture firms appear to be reaping a larger share of the money set aside for alternative-asset investments. A March survey of 500 institutional investors showed that 48 percent planned to increase their allocation to venture capital and private equity, while 28 percent said they would invest more in hedge funds, according to the investment firm Commonfund. 

For her part, Beder wonders what happens when stock markets fall, and those same institutional investors start looking for things to sell so they can hold more money in cash and other safer investments. If and when a slump arrives, investors who have more exposure to VC and private equity firms will have a hard time extracting their money quickly, just as they did during the financial crisis. Back then they dumped their stakes in some hedge funds and mutual funds (even those that had performed well) as stocks tumbled; and the pressure to sell exacerbated an already bad situation. 

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the editor on this story:
Timothy L. O'Brien at tobrien46@bloomberg.net