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June 10, 2007
Why VC Funds Aren't Shrinking
For my money, the best entry in my friend Marc's three-part-er (see 1 and 2) on the venture business is the third one. While the other two are useful enough, it is in the last one where Marc ponders one of the deep mysteries of venture capital: Why an asset class with such horrible recent returns still has such a large -- and growing! -- amount of money under management.The gist: It has to do with one of those great tricks the market has a habit of pulling. Professional investors figured out that a) they were under-exposed to alternative investments (which includes venture); and b) that they had a bad habit of pulling out at the trough. So, they reversed things, upping their allocation to venture and hanging tough with the asset class, just as things went to shit in 2001. That meant that they hung tough after the biggest venture bubble in history, which has kept the asset class far better fed than it has right to be, neatly dooming returns in the process.
Aren't markets such wonderful humiliators?
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It is a great point.
However, it is a classic prisoner's dilemma case. If, after the bubble, only a handful of venture funds had stuck to their investing guns and kept funding the sector...they would have enjoyed excellent returns going forward.
Given the usual cyclicality of VC funds ("hey the sector just blew up -- let's stay away from it forever. Or until the few farsighted exceptions/diehards start producing >25% returns...") their strategy 'ought' to have worked. What confounded it was that EVERYBODY tried to be contrarian at the same time. Which is impossible, of course...
To misquote Yogi Berra: "That sector is so unpopular that everybody goes there now."
Spot on, Duncan. You nailed it with your closing line. The smart money is too damn smart for its own good, while everyone else is just happy to follow the smart money around, thus invalidating the contrarian strategy.
As a colleague just put it to me, in an age of transparency you can't just be contrarian, you have to be counter-contrarian.
Here is a real contrarian view for you. The entire asset universe is going to underperform CASH, in the coming bust. I am no gloom-and-doomer (ok, just a little bit), but just look at how an entire generation of people feel entitled to prosperity. No, this is not to say a bust is coming next month, or even next year. It is to say that a lot of ratios (rent to mortgage, price to earnings, Tobin's Q ratio, Dow to Gold etc) have to mean-revert, and even undershoot their long term averages. That process won't be much fun. It is inevitable.
Great post...Wow, Marc's blog is great.