THE BEAR'S LAIR The death of venturing
By Martin Hutchinson
Venture capital fundraising in 2010 declined from US$16.3 billion to $12.3
billion, according to Thomson Reuters data. That's a far cry from the average
of over $30 billion annually in 2005-07, let alone the peak of $106 billion
raised in 2000.
Contrast those figures with the datum that the value of hedge funds closed at
$1.65 trillion in 2010 with $70 billion of new money entering the industry and
you have an inescapable conclusion: the equity financing of small business, as
well as the debt financing, is currently in a prolonged downturn.
After the new money bonanza of 1999-2000, it was to be expected that venture
capital financing would be limited once the market turned down. Indeed, the
hangover was immediate; in
2002 only $3.6 billion of new money was raised. However, 2010 is 10 years after
the dot-com crash; long before then money invested in 1999-2000 had been
invested in deals or returned to investors. Thus the downturn in venture
capital funding in 2010, when compared with the levels of the mid-2000s, is not
simply a cyclical effect.
It may however be a belated effect of the poor returns earned on the bubble
money. As of January 2011, according to Prequin, venture capital funds raised
in 1999 had an average internal rate of return of minus 12%. Even funds raised
in 2000-2007 all had negative median internal rates of return as of January
2011. Hardly surprising therefore that the massive spigot of money devoted to
the venture capital industry has run rather dry.
My Reuters BreakingViews colleague Robert Cyran has identified one problem
currently beleaguering the venture capital industry: a lack of interesting
ventures to finance. With its heavy concentration in California and its
successful track record in Internet financing, the industry has focused on
further Internet-related deals. After all, if Facebook can gain a valuation of
$60 billion only soon after reaching profitability, the potential profits from
financing the right Internet deal are immense.
The problem then is that many such ventures don't need formal venture capital
finance; entrepreneurs with savings, or with reasonable connections with past
successes in the Internet sector, can finance the deals themselves or with only
a small group of private investors. The venture capital industry's $30 million
financing of a joke website network, "I Can Has Cheeseburger" is a symbol of
the industry's weakness (and the excess of cheap money about) not of its
strength.
One possible reason why the engine of growth company formation and venture
capital financing may have stalled is the series of boom/bust economic cycles
of the last 15 years, and the focus of growth in the Internet software sector.
Huge amounts of money were made mostly by very young people in 1995-2000,
concentrated almost entirely in that sector as the stock market boom of that
period was very narrowly focused. This produced a concentration of talent
flowing into that sector in the next several years. Since the best talent was
devoted to Internet software, it is unsurprising that the start-ups were
concentrated in that sector also, so venture capital gravitated there. With
capital, company formation and innovation all concentrated in the same narrow
area of specialization, entrepreneurial and venture capital activity in other
sectors was starved of both talent and finance.
A further reason for the dearth of venture capital activity outside the
Internet software field may well have been the extraordinary rewards available
on and around Wall Street, whether in investment banks directly or through
finance-related intermediaries such as hedge funds. Able people who did not
have a particular talent for or interest in the software sector naturally
gravitated in this direction, which offered incomparably greater rewards than
had traditionally been available from finance. The ability to earn
entrepreneurial levels of remuneration through trading, without either the
risks of entrepreneurship or the long career slog of rising to the top of a
large company, made Wall Street's opportunities irresistible.
Equally, setting up a hedge fund required no significant capital as such, but
only a decent track record in a major institution and a good Rolodex of
potential investors in the fund. Outside the Internet sector, working in an
ordinary manufacturing or service organization, with a view to starting one's
own business once experience had been gained, seemed an unattractive career
direction for the best and brightest.
Of course, the extraordinary returns to entrepreneurship and huge destruction
of venture capital funds of the Internet bubble and the historically
unprecedented remuneration for even ordinary talent on Wall Street both derived
from the same cause: the loose monetary policies pursued by Fed chairmen Alan
Greenspan and Ben Bernanke since 1995. Sloppy money caused the Internet stock
bubble to inflate larger and for longer than would otherwise have been the
case. It also caused a prolonged bubble in the financial services sector, in
which artificially high returns, particularly to participants, were earned
through the use of artificially cheap leverage for over a decade.
Cheap money may also have affected the availability of venture capital finance.
If leverage is readily available, speculative hedge fund activity, leveraged to
make the returns appear superior, and private equity activity, in which
"financial engineering" is used to disguise a lackluster operating performance,
both become very easy ways to make money. Venture capital, backing new
companies with unproven business models, is by its nature very difficult,
requiring a detailed understanding of developments in a particular sector and
the technological, strategic and managerial tools being used to address them.
Conversely, private equity investment, in which a company that is already well
established is taken over, costs are wrung out to produce additional profits,
and an aggressive sales operation used to find a buyer in a relatively short
period, is intellectually relatively undemanding - and very lucrative if the
equity investment is small relative to the size of the company.
A further reason why entrepreneurial activity is down in the last couple of
years may be the lack of available debt finance. The series of gigantic Federal
budget deficits, combined with overly loose monetary policy, has allowed banks
to make high returns by borrowing short-term money, investing in Treasuries or
government-guaranteed housing bonds, and leveraging. According to Fed data, the
volume of commercial and industrial loans extended by US banks declined by 19%
in 2009 and by a further 9% in 2010. This decline in debt finance availability
will itself have had an adverse effect on company formation and on small
business expansion.
There is thus a "perfect storm" for US small business. Venture capital
availability is down, and the willingness of the smaller stock of venture
capital to invest in new ventures is further reduced by the appalling returns
the sector has earned since 2000. Good people are scarce except in the Internet
software space; those talented people without a particular aptitude for
software head for hedge funds or directly to Wall Street. Debt financing is
also hard to come by for small business, as banks have more attractive
opportunities speculating in the bond markets, courtesy of Bernanke's monetary
policies.
Needless to say, this does not bode well for US job formation. The Intuit
monthly survey of small business job formation throughout 2010 indicated a
monthly job creation total far below 100,000, showing that small business is
unable to carry out its usual function of creating about 80% of the new jobs in
the US economy. Consequently, even to the extent that the extraordinary current
levels of fiscal and monetary stimulus produce economic growth, it will be a
jobless growth that leaves exceptional numbers of people in long-term
unemployment.
The thwarted potential entrepreneurs will mostly not be among the unemployed;
being among the most able in society they will find jobs with large companies,
consultancies or on Wall Street. It will be those who would have been employed
by the potential entrepreneurs, whether in middle management, as technical
specialists or in more humble capacities, who will find their life
possibilities most hopelessly degraded.
Eventually of course the budget deficit will be reduced (no doubt creating new
unemployment - particularly in the ranks of state and local government) and
interest rates will be rapidly increased to fight an unexpected (to Bernanke)
resurgence of inflation. By reducing "crowding out" this development should
increase small business formation, make debt capital more readily available and
increase the returns to and availability of venture capital.
However, in practice the damage done to the small business and venture capital
sectors in the last decade will prove to be difficult to remedy in the short
term. That will put yet another unnecessary obstacle in the path of full US
economic recovery.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found on the website www.greatconservatives.com -
and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley,
2010). Both are now available on Amazon.com, Great Conservatives only in
a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com.
Copyright 2005-11 David W Tice & Associates.)
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