The Biggest Loser Can Be The Biggest Winner

Bill Gurley has a great post on Above The Crowd called "What Is Really Happening To The Venture Capital Industry?"

Let's start with his picture. It tells a thousand words.
I don't think the VC industry is going to be the biggest loser though. I think we'll be the biggest winner. Just like someone who takes off 100 pounds and gets healthy again.

Bill's assertion is that a few brilliant investors raised their allocations to alternative assets in the early 90s from low single digits (say 5%) to high double digits (sometimes as high as 25%) and supercharged their returns. Everyone saw the results and copied them. What worked in a small way with a few investors doing it failed to scale (as always) and the alternative asset classes got overfunded and returns plummeted.

Bill makes the related point that venture capital is actually a small player in this story and the buyout business is the big player. He predicts that as this overfunding of alternative assets unwinds over the next decade, we will see dollars flowing into buyouts and venture capital decline by at least 50%.

I think Bill's analysis is spot on, but we also need to add the fact that all of this happened in parallel with the Internet and Telecom revolutions. Around the same time that smart investors were scaling up their commitments to venture capital and buyouts, the venture capital business had some of its best years ever. Venture capital funds that were raised between 1994 and 1997 put up fantastic returns. So these smart investors who doubled, tripled, or quadrupled down on VC and buyouts also timed those bets brilliantly.

None of this was repeatable or sustainable at scale. The venture capital business has now produced ten years of single digit returns (at best) and people are calling it "broken".

Regular readers of this blog have heard me opine on all of this ad naseum and you know where I stand on it. We need to get the venture capital business back to raising and investing less than $20bn per year on a sustainable basis. We are there now in terms of dollars being invested in startups. The last quarterly numbers were sub $4bn. And the amount of money coming into the VC business this year will be even less than what is going out.

The diet has begun. We are getting healthy again. I can see it in the market and I believe we will see it in the returns soon enough.

#VC & Technology

Comments (Archived):

  1. Aaron Klein

    How do the lessening capital needs of web startups affect that number? Do you see the need for more shrinkage in the total capital in the VC asset class than you thought previously?

    1. chrispadfield

      Worth noting that only a % of total VC capital goes into web companies (anyone got recent stats?) with lower capital needs. You can fund a lot of web companies for every Telsa Motors, drug company, med-tech company, fuel cell company etc.

      1. Aaron Klein

        Sure. I was just curious what the impact should be of that change.

    2. fredwilson

      web startups only account for something like 20-25% of all VC investmentsi don’t think it is that impactful

  2. Matt Chua

    Good post and link. I still think what the venture industry needs to change, more than control the LPs stuffing money in the asset class, is to get back to building businesses. Over the past decade or so (my life) there has been a migration of money managers and investment bankers into the industry…and company building is very different than managing money. I am glad that you often address what it takes to be a VC and how to build better businesses, so that people can understand a successful company is built by a team, including investors, and the investors should be more than a source of cash.

  3. William Mougayar

    As someone in the trenches of entrepreneurship, I’m frankly tired of the macro-economic debate between VC’s about how top-end heavy, or bloated or whatever the problem is with the model’s metrics. These are right now excuses and impediments to moving along and investing in the right ventures. I like Fred’s stance of “let’s move along” with this thing. So let’s move along, and let us get back to a healthier discussion and excitement about the new ventures themselves, and less about bickering about the model itself. When VC’s start to invest again and take risks (like we are), the model will take care of itself.

    1. David Semeria

      I don’t know if it will, William.The malaise runs deeper than just the liquidity funnel. I have trouble articulating this feeling, but it involves the industry being more risk averse than in the past. In other words, the dreamers have lost out to the realists. And that’s a great pity.

      1. Carl Rahn Griffith

        Too many metrics means too little instinct.The relatively recent obsessions with ARPU/CPC/CPM etc has reduced much of the web community to metrics, simply because we can measure them – and, boy, do we measure them ….

        1. David Semeria

          Bang on Carl.I used to look at recently funded startups and say “wow!”. That really happens any more.

          1. ShanaC

            I’m unimpressed as well, I think we ought to create a snark-o-meter. That way we all know what to invest in. If it goes off, then we know not to.

          2. David Semeria

            If it were only that easy…

          3. ShanaC

            The point is to have fun in a MST3K sort of way while we wait out the misery.

        2. ShanaC

          Power often comes from the ability to measure.

          1. Carl Rahn Griffith

            I love stats and the analysis of. But …How many great businesses were built via Excel?Excel comes later. With the suits.

          2. ShanaC

            In person, I’m really not a suit person at all. I own turquoise women’s trouser socks, for goodness sakes (and get compliments on them all the time with my one suit or in causal clothing). And I am an art student. If I have to, I can pull off the power suit, but it isn’t as much as laughing at myself in the power suit.Further, I am someone who knows I should learn to master Excel much better than I know how to do now (suggestions on this one?).There are definite theories of history that one of the reasons the West progressed so fast in the Renaissance and Enlightment, and in scientific inquiry, is because of our obsession with quantifying and describing with numbers. It’s one of the reasons I put up Foucault in the booklist. He describes this idea of governmentality and ability to wield power by parsing down people to their statistics, especially in the case of modern medicine and how the state chooses to interfere. The same could be true of a modern corporation. Weird concept; it might be why SAP works, though.

      2. fredwilson

        I don’t think so. The risk takers are just different firms these days

    2. valto

      Agreed. I would like that excess fat to be “spread on top of new startups” on their preseed/seed level, so we can have more new growth “material” for later stages and also see failures on much earlier (cheaper) levels.

  4. Allen Laudenslager

    The limiting factor on new business is never new ideas, it’s money. Far too many good ideas get lost because the “idea person” is not a presentation person or a business plan person. The idea is still good it’s the investors who need to tool up.

    1. Greg Gentschev

      This whole trend seems to indicate that the limiting factor is indeed good ideas and people who can execute them. There’s tons of money sloshing around in VC, and it hasn’t brought to light more good ideas – at least not enough to support the returns of the industry.

  5. Morgan Warstler

    Would significantly beating back Sarbox help? What changes (that are politically feasible) are needed, if any?

  6. Seenator

    Fred,I actually just posted saying “Its all David Swenson’s fault”-…I am blaming him not only for the over funding in the VC busines but also for the sub prime crisis :)Nik

  7. chris dixon

    Hey Fred – Agree with you, but think the other big problem with VC is people getting rich off management fees leading to perverse incentives.

    1. Steven Kane


    2. fredwilson

      I agree chris. That’s why I like 100mm and less fund sizes. Its hard to get rich off of 2mm per year in fees with three partners and a staff

  8. Denny Chapin

    There seems to be a difficult assertion you’ve made: both that the boom was good for VCs and that the leaning of investments is also good for VCs–in this sense being overweight and slimming down are both ‘healthy’. The statements don’t contradict one another necessarily, BUT I’m having a hard time imagining how we describe when the VC market is “too fat”.I mean it’s just a metaphor, but I’m wondering. Is it good when there’s bloat AND good when that bloat is getting trimmed down?

    1. fredwilson

      Its not good being fat. It was good going from thin to fat, for a bunch of unsustainable reasons. But being fat has been bad

  9. kidmercury

    here’s the unfortunate truth:1. venture capitalists refuse to have an honest discussion about the true causes of this allegedly unforeseeable economic crisis. this is important because the cause of economic crisis (the federal reserve system) is what has hurt the VC industry the most and is the primary reason there has been a decade of lackluster returns (not because smart business people went dumb for a decade), and the reason why many think the industry is dying (although dying is code word for “getting disrupted,” so not as bad as it may seem and in fact quite beneficial, once we embrace the truth that sets us free). also, failure to understand the crisis has led VCs to support policies contrary to their best interests (i.e. bailouts, obama, sitting around being silent while govt robs them, etc) while talking about everything under the sun except proposed real solutions (reform of the federal reserve system) 2. for the most part VCs don’t actually care about the economic crisis (they may say otherwise, but actions speak louder than words) and they are desperately hoping they can go on living in ignorance. for the most part VCs just care about the stock market casino, so if govt is going to print money and put it in the casino known as nasdaq, hooray! we can just call it “capitalism” and if anyone tries to use silly things like logic and common sense to point out the futility and inherent unfairness of such policies we can just live in denial and say it is their opinion. 3. VCs are still largely dependent upon the IPO casino, which is broken. will VCs step up to the plate to fix the problem? all signs point to no, as evidenced by points #1 and #2. this is an important point because without the IPO casino VCs will have trouble realizing returns on their investments.all of this smacks of an industry getting disrupted but living in denial. somewhat humorous given how much VCs focus on disruption — but alas it is not so fun to be on the receiving end of a disruption, is it. anyway, incumbents facing disruption can expect to go through the five stages of crisis: denial, anger, bargaining, depression, acceptance. the little secret is that you can actually skip all the steps and go straight to acceptance, but only when you embrace the truth that sets you free (which is basically what acceptance is). IMHO we’re still in the denial phase. the good news is that how long we stay there is entirely up to us.

  10. Thunder Capital

    You say the VC industry needs to be under $20 billion. I agree that it’s supposed to be shrinking, however with the government providing subsidies for greentech (Obama has provided billions?) and such, why play the numbers game?There may be so many startups out there right now that may be profitable in the future, especially with more M&A transactions from the billion dollar corporation. I just don’t agree that there is a $20B figure, and that we should learn from past history but not live in the past.

    1. fredwilson

      Read my post called the VC math problem (you can google that) and you may think differently

  11. sigmaalgebra

    Gurley’s post seems to be making a fundamental error with the W. Sharpe capital asset pricing model (CAPM).The good news is that avoiding the error should improve returns for LPs, VCs, entrepreneurs, and the buyers at exit.In particular, Gurley wrote:”First, one of the key tenets of finance theory is the Capital Asset Pricing Model (CAPM). … These fund managers have one primary tool in their search for optimal returns: deciding which investment categories (referred to as ‘asset classes’) should receive which percentage of the overall capital allocation.”To the extent that the LPs address this search for optimal returns with the CAPM they would be shooting themselves in the gut.What the CAPM says is, if you are blind and the only chance you have to improve how you get around is a long, thin stick, then it is optimal to use that stick. Moreover, if everyone is blind and using the sticks, then can say some curious things about a ‘market risk-return line’. However, if not blind, then in principle can do much better on both risk and return.Laureate H. Markowitz said, if have expected returns and covariances of returns, then can set up an optimization problem to select a portfolio to minimize variance of return subject to a specified minimum expected return.Laureate W. Sharpe said that if everyone does what Markowitz says, then there is a ‘market risk-return line’ and the only question left is what point to select on this line via ‘leverage’.BUT, if some people have more information or other information than just the expected returns and covariances of returns, then in principle they can get much higher returns at much lower variance than from either Sharpe or Markowitz. It’s all in the old “What do you know and when do you know it?”.In more detail, what a player sees are not just the Markowitz expectations but the conditional expectations given what additional information the player has. These conditional results are quite free to be much different from the Markowitz results available otherwise.For stocks on the NYSE etc., the data assumed by Markowitz might be about all people would have.Part of the confusion is from the usual ways of teaching elementary probability: So, buy a stock today for $1. We will sell it in 30 days at $X. Then X is a random variable. So far, so good. Then an implicit assumption that except for the expectation and covariances,. X is ‘truly random’ and independent of everything else we can know now. No: In principle, X can be heavily dependent, even determined by, other information we have now.E.g., suppose we are watching a movie of a roulette game. To us it all looks nicely ‘random’. But to someone who has already seen the movie, it is all quite predictable!So, all an LP can do is throw darts at the VCs, and all a VCs can do is throw darts at the entrepreneurs? Right? Is that what we want to assume?Of course not. Instead, an entrepreneur is supposed to have a powerful, valuable, new idea. Then a VC is supposed to look at the work and know more than from dart throwing, and the LP supposed to listen to the VC and know more than dart throwing. So, all three of entrepreneur, VC, and LP are supposed to know more, more than just the same long thin stick all the blind people are using.When A. Bectolsheim wrote his check for $100,000, he likely thought that he had just seen something and wasn’t just throwing a dart.A good VC can tell their LP: “With us you are not stuck just throwing darts at ‘the VC asset class’. We’re better than that, and we can show you how.”.Net, good entrepreneurs, VCs, and LPs should do better than CAPM dart throwing, and the CAPM does not constrain them.

    1. fredwilson

      Wow. You understand this stuff way better than me (and Bill)

      1. sigmaalgebra

        Just trying to contribute and be clear. I believe that Bill is making a big, huge mistake, and so are his LPs.Here is an explanation likely easier to understand: CAPM says what to do if are just throwing darts at sectors. The CAPM says how many darts to throw at each sector. That’s about as clear as I can make it.The CAPM is not ‘optimal’ outside of a lot of assumptions: Have to accept the goals of expectation and variance, a ‘market effect’ that yields a ‘market risk-return line’, and have exactly the expectation and covariance data specified, no less and no more. So, with a lot of other information, CAPM might be much less good than the best possible in any reasonable sense. That extra information is much of what we strive for.For the ‘sectors’ on the NYSE, such dart throwing might be about the best can do, that is, unless can get a guy to ride a motorcycle to the airport and ask a question about the destination of a Gulfstream! I don’t know if such information collection is legal or not, but with it, for the CAPM, for that one investor, f’get about it.Sorry to pull the rug out from under the CAPM for all of VC and PE investing by all the large institutions, but apparently it’s about time.For the venture capital sector, dart throwing is absurd. Who throws darts at venture firms? That makes less sense than, say, throwing darts at white table cloth restaurants, French wines, movies, or, horrors, pop music! Gee, I don’t even throw darts at the Met: I like Mozart, Rossini, Donizetti, Puccini, and Verdi, only ‘Der Rosenkavalier’ by R. Strauss, and Wagner only in small doses where there aren’t any! For Schoenberg, the French, the Russians, especially the English, f’get about it! LPs go to Le Cirque and just throw darts at the wine list? Really? Amazing.Instead of darts, the LP has you, Bill, Doerr, Moritz, etc. sitting there explaining in great detail what is special about your firms, investments, and entrepreneurs. Then it’s up to the LPs to process that information, and that’s not CAPM dart throwing. Gee, instead, an LP might have to think a little! Horrors!Not unreasonable: As an entrepreneur, I have to look through the fog, find a path, think, type, and get there. Do so, routinely. What’s so tough about finding way through the fog? That’s what we all are supposed to do, right?Gee, where do I apply to be an LP?Naw, to be worth $500 million, I’d better just keep typing my software!

        1. fredwilson

          I think ron conway throws darts albeit intelligently. That’s not a critique. Just an observationI also agree that throwing darts is not a good metaphor for VC and PE

          1. sigmaalgebra

            There can be more details on how to apply the CAPM, but, net, nothing in that finance portfolio allocation theory can stop a good entrepreneur, VC, and LP from making $1 billion and doing much better than the ‘optimal’ results of the theory. The main means is just for all concerned to do well doing their work.

  12. Glenn Gutierrez

    Diets are good for people and for markets. This definitely makes lots of sense. Interested in seeing how the space will unfold in the next 3 years.

  13. MattCope

    So far I’ve seen VC’s present this as a demand side problem – there’s too much money chasing after too few deals.What about the supply side of the equation? If we entrepreneurs produced enough quality deals, we could feed the guy on the left, for sure.

    1. marshal sandler

      Matt there has aways been more money to invest, than good deals to invest in ! It has always been an economic crap,shoot !

    2. fredwilson

      Its not about quality deals per se. Its about how many billion dollar valuations can be created per year. The data is pretty conclusive on that. Not enough to service 40 to 50bn of fresh capital flowing into VC each year

      1. MattCope

        Historical data is pretty conclusive on that – but as you know, past performance is not necessarily indicative of future outcomes.If we entrepreneurs could collectively produce $150bn in valuations going forward, we could absolutely support $40-50bn in invested capital.

        1. fredwilson

          Right. And when that happens, I’m all for more capital coming into the business. Note I used when, not if

  14. Dan Cornish

    One reason why the VC industry got so fat is because they pushed out legitimate competition. They created a monopoly in tech business creation and acquisition. What I mean by this is other than Google, Yahoo and a few others how many technology companies have been investing and buying young companies. If there are really good ideas which are capable of creating a profitable business, than existing companies should be lined up outside the door trying to buy said companies. The reason why this is not happening is because the VC industry has pushed prices so high that only the richest companies can play in this game. The way this rigged game is played is that VCs fund these companies so they have to sell at a very high multiple which can only be paid for by stock in public companies. In effect large companies can manufacture money out of thin air to buy companies. How many companies are aquired by using existing cash flow? This should be a good measure of what a company is really worth. Or another yard stick is how much will an acquired company contribute to the bottom line of a company?Take for example. It was sold for a very high multiple, the investors made a bunch of money, but itself is not really making money. It might have made a great little $1-3 million acquisition for a content company, but it is certainly not worth what was paid for it. There are numerous examples of this.When small and mid-sized companies can compete again with VCs, then to me this will be the sign that the VC industry is the right size. After all, if you do not have competition than how can you really price a company?

  15. ShanaC

    I don’t like the metaphor of diet. Being female, it reminds me of Yo-Yo diets that I know some people subscribe to. They’re more unhealthy and cause worse problems in the long run. I’d say we are looking for managed fund homeostasis. As in organisms.It seems that people are upset because they can’t figure out what their balance in life for these assets should be. It isn’t going to be the same answer for everyone. It’s the same thing for a healthy body too. The market is like an ecosystem, and each position is one cell in it. It takes time to develop health, it isn’t about bloat, or slim, it’s about a kind of physical comfort for these managed funds so that one can judge accurately what is going on. It’s not about huge returns, it’s about consistent, everyday life with some fluctuation…homeostasis, as it were. Managers should be able to walk away knowing that they are performing within a tolerable risk for what they need. Instead, they seem to be yo-yoing, which is not a way to get a fund or one’s life in balance.The optimal goals, as with all things, is health. I read the original article, It isn’t pessimism that we are looking at, it is a lack of balance, as in all things in life. Technically, VC Funds are illiquid assets (that should over time turn liquid). And they have a draw down commintment on them in order to keep a churn for those illiquid assets growing. Further, those illiquid assets better be good liquid assets, because they eventually have to move and become liquid. People seem to chase the maximum money of the right now, not realizing that their could be costs ahead, bigger costs than the pervious right might be worthwhile to think of the homeostasis and the fact that the market lives and fluctuates, grows and dies, like a real being, for a moment, and to play on it for investing. Might make it easier….

  16. William Mougayar

    Judging by the little comments/replies Fred has left here, he’s probably as tired with this debate as well? Or just enjoying a deserved break?

  17. Alex Hammer

    Testing out the commenting system. It’s really cool.

  18. Mark Essel

    Who doesn’t love a great visual analogy like this? What successful VC funds have done is paint a fantastic image. Of course their strategy can’t simply be recreated, but maybe learning about their motivators, measures, and timing is worth our attention.I’m not a venture capitalist, or an angel investor. I’m a user, and sometimes a developer. I’m curious about understanding systems, in order to help make intelligent predictions. Venture funding ties into a type of trend prediction that fascinates me, and I hope as it contracts into a healthier space we can witness new world changing companies get the resources they need to grow and mature.I’m blinded a little by my love of Internet tech and collaboration. But there are still a good 3-4billion people on our planet that don’t regularly use or have access to this technology. Maybe my focus should be on getting the web to more users?