Download - The Future of Venture Investments Cycles, Trends and Opportunities

Copyright © President & Fellows of Harvard College

Journey Conference

October 25, 2012 Israel

Felda Hardymon

The Future of Venture Investments Cycles, Trends and Opportunities

VC is really an adolescent asset class Venture capital is still very young:

• Not recognized as a real asset class until 1978

Venture capital is still very small:

• In largest market, U.S.:

• Only about 4000 professionals.

• Average of 1,500 companies funded for first time annually, 2000- 2008.

• Relative to 1 million businesses started annually.

• In Israel:

• Less than 250 professionals

• Less than 25 Series A’s each year—many more seed deals

VC is really an adolescent asset class Venture capital is still very young:

• Not recognized as a real asset class until 1978

Venture capital is still very small:

• In largest market, U.S.:

• Only about 4000 professionals.

• Average of 1,500 companies funded for first time annually, 2000- 2008.

• Relative to 1 million businesses started annually.

• In Israel:

• Less than 250 professionals

• Less than 25 Series A’s each year—many more seed deals

Whether or not you raise venture capital: if you are in high tech—the health of the VC industry affects you

Venture capital has had a profound impact in the US economy • 13% of all public firms at end of 2008.

• 8% of market capitalization ($2.0 trillion).

• 6% of total employees.

• Particularly true in high-technology industries.

And over the past decade has become important globally

• Israel ahead of the curve on this—active VC since mid-80’s; a real industry in the early 90’s

• VC responsible for bringing dozens of multi-nationals to Israel through M&A

Venture capital has had a profound impact in the US economy • 13% of all public firms at end of 2008.

• 8% of market capitalization ($2.0 trillion).

• 6% of total employees.

• Particularly true in high-technology industries.

And over the past decade has become important globally

• Israel ahead of the curve on this—active VC since mid-80’s; a real industry in the early 90’s

• VC responsible for bringing dozens of multi-nationals to Israel through M&A

VC is the oxygen for high tech innovation

Today The Theory The Reality Current State Starting a Company Now What Works

Venture Capital

The Theory

Georges Doriot’s insight

Worries about dangers of post-War stagnation in U.S. Current system did not work well: • Limitations of banks, public markets. Need for new financial institution playing three roles: • Sorting. • Certifying. • Governing.

What VCs Do Selection

• Pick which projects to back

• Driven by profit share self interest (carried interest)

Credential

• Indicate to acquirers, banks, large customers, potential employees, etc that this is a substantive project

Governance

• Regularly monitor progress at a meaningful level and effect changes if necessary

What VCs Do Selection

• Pick which projects to back

• Driven by profit share self interest (carried interest)

Credential

• Indicate to acquirers, banks, large customers, potential employees, etc that this is a substantive project

Governance

• Regularly monitor progress at a meaningful level and effect changes if necessary

What VCs don’t do

Run Companies

Because of its structure, VC is a long latency business

Blind pool

• May be a broad investment charter (healthcare vs. IT, start-up vs. growth equity, etc).

Long lock-up

• 10-15 years

Long investment life

• Time to liquidity 5-10 years

Apprenticeship

• 15-20 years to know if a VC investor is any good

13

The Venture Capital Intermediary Chain

Savers Gatekeepers (e.g., Fund of Funds)

Venture Firms

Portfolio Companies

IPO

3 – 10 Years 3 – 10 Years

Fund Managers

(e.g., Pension Funds)

14

The Venture Capital Intermediary Chain

Savers Gatekeepers (e.g., Fund of Funds)

Venture Firms

Portfolio Companies

IPO

3 – 10 Years 3 – 10 Years

Fund Managers

(e.g., Pension Funds)

Historically American and European; recently SWFs and Asia have become important. It is a longer chain for Israeli VCs.

VC Interim Performance is Hard to Measure

Mark to market cannot be accurate

• Comparison based: But what are comps for new businesses?

• Interim financings often more affected by exogenous variables (fund cycle, buzz, speculation, etc) than by company performance

• Company progress often driven by a series of experiments and is inconsistent over time until established.

VC fund performance quite dependent on liquidity environment—which varies greatly over time.

Venture Capital

The Reality

Big Hits Drive VC Actual Performance

It is a risky business

• Over half of VC investments do not return what’s invested

About 15% of VC investments drive all VC returns

Great companies are started every year, BUT there are only a few and access is key

• Drives tiering of the business

• Exacerbates VC cycles

Makes allocation of time more important than allocation of capital.

VC is Cyclical

Greatly affected by IPO/M&A cycle

• First real measurement of VC fund performance

• Liquidity itself is a big indicator for raising a new fund

Underlying start-up cycle

• Macro economics (recessions help!)

• Innovation cycles

• Role models

Returns negatively effected by overfunding

NOTE: Debt cycle is not a performance factor (does affect LP fundraising somewhat)

The VC industry underperforms when overfunded

20 28

18 9 10 9 13 15 18 20

33 34 34

52 56

75 82 77

14

- 18 - 23 - 32 - 40

- 20

0

20

40

60

80

100

Strong Returns

Bad Returns

Firming Returns

Good Returns

Bad Returns

LP R

etur

ns (

%)

Very Good Returns

20 28

18 9 10 9 13 15 18 20 19

33 34 34

52 56

75 82 77

14

- 18 - 23 - 32 - 40

- 20

20

40

60

80

100

Strong Returns

Bad Returns

Firming Returns

Good Returns

Bad Returns

Source: Cambridge Associates

1

10

100

1,000

10,000

100,000

1,000,000

PC Boom Internet Boom

Dol

lars

Com

mit

ted

to

US

VC

Fu

nds

($M

)

70s 80s 90s 00s

U.S. fundraising and pooled IRR

0

20

40

60

80

100

120

140

160

180

0.00

5.00

10.00

15.00

20.00

25.00

30.00

1969

-197

5 19

76-1

979

1980

19

81

1982

19

83

1984

19

85

1986

19

87

1988

19

89

1990

19

91

1992

19

93

1994

19

95

1996

19

97

1998

19

99

2000

20

01

2002

20

03

2004

20

05

Fund

s (20

02 $

B)

IRR

(%)

Pooled IRR

Funds Raised

Source: HBS databases and Thomson Reuters.

VC is Not Process Driven

Judgment and effectiveness of the VC partners counts most

• Great firms are somewhat consistent across partners; merely good or second rate firms are not at all consistent across partners

• VC is an apprenticeship business





Advice to VCs Go to the best firm you can to learn the business





Advice to Founders Choose firm 1st, partner 2nd

Advice to VCs Go to the best firm you can to learn the business

VC may be the most concentrated financial industry on earth—because of Persistence

Returns from inception to 12/31/09. Source: Lerner analysis of Thomson/Reuters data.

Returns of all US VC funds from inception to 2010 For top 1%: 41%.

For top 5%: 70%. For top 10%: 84%. For top 25%: 104%.

VC may be the most concentrated financial industry on earth—because of Persistence

Returns from inception to 12/31/09. Source: Lerner analysis of Thomson/Reuters data.

Returns of all US VC funds from inception to 2010 For top 1%: 41%.

For top 5%: 70%. For top 10%: 84%. For top 25%: 104%.

BUT the returns of the industry as a whole do not justify the total LP money invested in VC funds

A VC firm’s track record indicates more than in any other asset class

Next Fund Last Fund ↓

Bottom

Medium

Top

Bottom Tercile 61% 22% 17%

Medium Tercile 25% 45% 30%

Top Tercile 27% 24% 48%

High likelihood that the next funds of a given partnership stays in the same performance bracket Persistence. 1% boost in past performance → 0.77% boost in next fund’s performance.

Source: Kaplan and Schoar [2005]

Fund sequence number • Positive relationship

between IRR and fund sequence number.

• First time funds perform especially poorly.

• Regression results control for vintage year effect, fund category and fund size.

• May need to be done separately for Israel—early wave of funds (early 90’s) was blessed by a rising market. Time will tell.

Source: Lerner, Leamon and Hardymon [2011]

0%

2%

4%

6%

8%

10%

12%

14%

1 2 3 4 5 6 7 8 9 10

Pred

icte

d Re

lativ

e IR

R

Fund Sequence Number

But VC has scaling limits

0%

5%

10%

15%

20%

25%

10 20 50 100 200 500 1,000 2,000 5,000

Pred

icte

d Re

lativ

e IR

R

Fund Size ($ millions)

Buyout

Venture Capital


• Positive relationship between IRR and the ratio of partners to committed capital.

• Regression results control for vintage year effect, fund category, and fund size.

One Explanation: Partner to size ratio (i.e.: “Judgment … not process driven business”)

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

Rela

tive

IRR

Ratio of Senior Professionals to Fund Size, Relative to Mean Fund


• Positive relationship between IRR and the ratio of partners to committed capital.

• Regression results control for vintage year effect, fund category, and fund size.

One Explanation: Partner to size ratio (i.e.: “Judgment … not process driven business”)

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

Rela

tive

IRR

Ratio of Senior Professionals to Fund Size, Relative to Mean Fund


Remember what VCs do: Selection, Credentialing, Governance

Explanation 2: Older Firms Tend to be Less Specialized

Source: Gompers, Kovner, and Lerner [2010]

And Specialist Firms are More Likely to Have Successful Deals.

0%

1%

2%

3%

SpecializedFirm with

SpecializedPeople

GeneralistFirm with

SpecializedPeople

GeneralistFirm withGeneralist

People

Partners’ focus especially matters. Specialization assists • Selection • Credentialing • Governance

Source: Gompers, Kovner, and Lerner [2010]

VC is relatively uncorrelated to the larger business cycle

VC economics are micro not macro

• Moving from 1515100 customers just requires finding those customers

• Truly great companies are founded in all periods … regardless of economic cycle

VC results require healthy public markets for exit but not for growth

• So VC industry performance is lagged to the public markets (makes VC an uncorrelated asset from a portfolio construction point of view)

Inter-quartile ranges and medians for asset classes (c. 2006)

-10%

-5%

0%

5%

10%

15%

20%

U.S. Fixed Income

U.S. Large Cap

Equity

U.S. Small Cap

Equity

Non-U.S. Equity

Hedge Funds

Real Estate

U.S. Venture Capital

U.S. Buyouts

European Private Equity

Source: Yale [2006] and Venture Economics.

VC industry performance is lagged to the public markets

36

U.S. Equity

U.S. Bonds

Developed Equity

Emerging Equity

Absolute Return

Private Equity

Real Estate

Cash

U.S. equity 1.00

U.S. bonds .45 1.00

Developed equity .60 .30 1.00

Emerging equity .30 .20 .50 1.00

Absolute return .30 .35 .30 .30 1.00

Private equity .40 .25 .25 .10 .25 1.00

Real estate .15 .25 .20 .10 .40 .15 1.00

Cash .00 .50 .00 .00 .00 .00 .20 1.00

Modified Correlation Matrix

Source: Yale University Investments Office c. 2003 (Modified correlation matrix reflects assumptions about future interrelationships)

Lag to the public markets makes VC (& PE) an uncorrelated asset

Source: BVP research

Great Companies are Created Every Year 1980-1996

37

1982 1980 1984 1986 1988 1990 1992 1994 1996

http://www.pixar.com/index.html�

Source: BVP research

Great Companies are Created Every Year 1997 - 2010

38

1999 1997 2001 2003 2005 2007 2009 2011 2013

Truly great companies are founded in all periods … regardless of economic cycle

So VC is subject to long latency, multiple cycles, huge concentration, and inaccurate measurement

There are few VC industry experts for all situations

• Advice is often anecdotal

• Venture capital admits a lot of styles

Investment platform, track record and acumen trumps a good story, empathy or simply domain knowledge

But most of all, it is really about Governance

Venture Capital

Current State

The Mid Sized VC is no longer viable

Middle market funds

Sector and geo specific funds

Major global funds

The Mid Sized VC is no longer viable

Sector and geo specific funds

Major global funds

Persistence has driven LP funding to higher performing funds who have expanded to take it

Firms have specialized and gotten smaller to ease fundraising and increase performance

And the two classes of firms are symbiotic

And which funds can easily raise money has narrowed considerably

Ten Years Ago

Top 1/4

Sector & Geo Funds

Now

Top 15-20 funds (most global) • Expanded into growth equity • Specialization

Sector & Geo

Funds

LPs getting ‘specialist fund fatigue’

And which funds can easily raise money has narrowed considerably

Ten Years Ago

Top 1/4

Sector & Geo Funds

Now

Top 15-20 funds (most global) • Expanded into growth equity • Specialization

Sector & Geo

Funds

LPs getting ‘specialist fund fatigue’

Differentiation key

Rise of the Super Angels

The case for Israeli VC

45

Audacious

Impatient

Independent

Passionate

Informal

Opinionated

Brash

Nonconformist

Defiant Tenacious

Optimistic

Proud

Unconventional

Outsider

Unreserved

Ambitious Aggressive

Assertive

Nimble

Pioneering Improvise

Clever

Scrappy

2011 Venture Snapshot

46

$2B invested

500 start-ups

75% foreign funds

$2.3B M&A exits ($1.9B in 2012)

7.6M people

There is a focus on innovative high tech like no where else in the World

Tech is 17.3% of the business sector GDP Tech exports close to $16 billion (41%) Over 90% of the public budgets for R&D ($7 billion in 2006) allocated to hi-tech

• Much allocated through joint ventures with VC

Source: Israeli Ministry of Finance

Commonly heard objections

•No $Billion IPO •Tech is shiny, but… •Building a business is hard •Scaling is really hard •Money is easy to lose

48

Israeli high tech is a natural for M&A Decrease in global corporate R&D is a good match for R&D centric Israeli companies

• Disruptive products and technologies (often difficult to take to market on their own)

• Partner with US tech companies Early courtship

• NB: Many venture backed US start-ups are founded in order to compete with the giants

All major US technology companies have a presence in Israel

• No language issues, loyal employees, highly productive, integrate into existing R&D centers

Financial match

• US tech companies have unprecedented cash outside of the US (can't repatriate)

• Israeli capital efficiency$100M acquisition for an Israeli company is a great outcome

$ CASH BURN

Time

FINANCIAL VALUE

40 years in the desert Financial metrics base exits are rare and then unusually low

THE RISK OF NOT SELLING STRATEGIC VALUE

Strategic technology premium is unusually high for Israeli companies

Israelis haven’t raised growth capital nor have spent to scale

VALUE $ M&A VALUE

Venture Capital

Starting a Company Now

Is it a good time to start a company?

People are available

Markets are moving relatively slower

The world continues to shrink (relative advantage to Israel)

Lower costs of start-ups

More role models imply easier credibility

Many opportunities

• 45 year old IT architecture

• Replacing chemistry based pharma

!

But it is harder to grow to true scale

1. Big companies are cash rich, idea poor

• Easier to buy than build the M&A fit

2. Investors seeking pre-mature liquidity to raise new funds VC environment not good for Israeli-specific VCs

3. Long term public investors scarce

4. Mid level growth management scarce

Consumer facing Internet somewhat of an exception but starting to conform to the rest of the market

Venture Capital

What Works

Governance Hiring people smarter than you Patience coupled with long term vision Go with experienced investors Be global from day 1 Develop the ability to hire and train Avoid large banks Measure everything

Elements of Good Governance

An outside board

• Neither dominated by management nor VCs

• Finding independent, unaffiliated directors is hard

• Small (5-7)

• Characterized by respect and affection of members and role players

Best practices

• Auditing, law, compensation all have process

• Budgeting, forecasting and regular monitoring

• Allows experiments—you can be wrong and fix it

Attitude—good managers welcome the standards

Choosing investors

Value experienced investor over domain specific investor

• You can hire domain help

• Key to governance as well as credibility

• Platform vs individual

• A great firm will back up the partner

• Chemistry is important, respect is more important

• Communicate, communicate, communicate

• Anyone can want to make money—a good investor knows how to make money.

What makes a good VC Investor?

The ability to communicate The ability to get mind share Discipline A sense of equity Empathy Reputation Perspective Stability …and luck

Thank You

Download - The Future of Venture Investments Cycles, Trends and Opportunities

Top Related