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March 5, 2007

Cyclicality in VC Returns -- and in VCs

Some ruminations from Seat 5A high over Illinois ...

As I have written here before, every venture capital firm of note in the U.S. is a bubble baby. Kleiner, NEA, DFJ, Sequoia, and so on all cut their teeth by getting in early in a particular techno wave, whether it was PCs, hard-drives, enterprise software, Internet stocks, or whatever. Every wave of other-enthusiastic over-investment in an emerging sector gave birth to at least a couple of new top-tier VCs, and drove all the returns in the period.

The current wave of media and consumer investments is different. While it will almost certainly give rise to some new top-tier VC firms, it will also do what prior technology waves couldn't do: Kill off some hoary venture capitalists.

It's about time. Because it's hard not to notice that all of the top-tier firms mentioned above have been around for a long time. Kleiner, Sequoia, NEA, and so on are not exactly new arrivals to the venture business. Unlike the companies in which they invest, they have somehow survived waves of technological change, neatly continuing their dominance from cycle to cycle. It's time for a whole bunch more fresh blood.

Why have VCs, and VC firms, lasted so long? Three reasons. First, this is still a gut business, so having a few stars with a good gut will always stand you in good stead against the one-time-lucky sorts (ahem, Benchmark). But most of those good-gut people are now retired or gone. The average current partner has not had a non-bubble (or post-bubble) exit, so they have no idea what they really know.

Second, the best firms get to fish from a well-stocked pond, with a John Doer at Kleiner picking and choosing among more good deals in a week than you or I might see in an entire career. That branding effect isn't going to go away, but brand and reputation are also transportable: It doesn't take that many successes for a new venture kid on the block to have the rep that another one once did.

These first two factors are relatively well known, but a third factor is less so. It is little remarked upon, but all of the returns in the history of the venture business have been driven by IT investing. If every venture fund could snap its fingers expunge all biotech, materials, and cleantech investments over the last thirty years the returns of the venture asset class would climb very nicely indeed.

That's good and bad, of course. It's good because IT investing has created great companies, colossal financial returns, and oodles of jobs -- and jets and big boats for some name-brand VCs.

But it's bad because -- and this is the big deal here -- success has created a venture investing monoculture. Almost all of the investment and exit expertise in venture capital is clustered around one area: Enterprise technology, whether data- or software-related.

And that's great, but it's an increasingly wasted competency. Why? Because for the first time since the dawn of the modern venture business everything is a-changing. Every prior venture wave a) built on the one before it -- hard-drives begat PCs, say; b) had similar capital requirements; and c) sold to the same enterprise customers. The current wave of technology has changed technology, economics, and customers, which is a path to obsolescence for many venture investors.

All you have to do is spend a little time hanging at some of the more orthodox  Valley VCs and listen to the howls of anguish as partners try to sort out what's happening in media and consumer markets. Listen as increasingly dated investors try frantically to come up with reasons for a resurgence in enterprise software, or a reason why Company X needs $6m, not $1m, despite ample evidence to the contrary on both counts.

While it won't be pleasant, the upshot of all of this is almost certain to be some broken venture partnerships. You'll see firms split as a new generation of partners tries to steer the ship in one direction, and older partners shuffle off en masse as their competencies become irrelevant, something that never happened in any prior wave. We are used to seeing cyclicality in venture returns, but we're about to see the first real wave of cyclicality in VCs themselves.

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