How Big a VC Industry does the Economy need?

Jonathan Ortmans, President, Public Forum Institute

In the midst of much speculation surrounding the upcoming decisions on how to best address the poor performance of venture capital (VC) in the U.S., a new study on VC opportunities and returns offers myth-busting findings. In “Right-Sizing the U.S. Venture Capital Industry,” Kauffman Foundation Senior Fellow Paul Kedrosky draws interesting conclusions on the size the industry needs to be in order to function as an economic force. In particular, he argues that the sector must shrink if VC is to provide competitive returns and secure its own future as a credible asset class.

This report comes at time when the VC industry is trying to obtain more support from the government to reverse the negative investment trends and declining performance. VC returns have stagnated and declined, with the industry having seen little recovery since its golden days of the late 1990s and worsening with the economic crisis. Because many have equated VC with entrepreneurship, the industry’s plea of poverty has generated serious concern. The National Venture Capital Association (NVCA) claims that venture-backed companies from 1970-2005 accounted for 10 million jobs and $2.1 trillion in revenues by 2005 (equivalent to 17 percent of U.S. GDP) because of its early-stage support to many successful, high-growth companies. In this regard, Kedrosky’s report highlights that companies can obtain risk capital from several other sources, such as banks and angels. In fact, only around 0.2 percent of the estimated 600,000 new businesses created in the U.S. every year obtain venture funds in recent years. Kedrosky also found that even among the Inc. 500 list of the fastest-growing private companies in the U.S., less than one-in-five companies had venture investors.

“Right-Sizing the U.S. Venture Capital Industry” examines the change in VC performance. There are at least three possible explanations, and they are all interrelated. There could be too much capital allocated to venture, resulting in higher valuations and lower exit multiples. The second explanation points to the shrinking exit markets (particularly IPOs), which prevent venture investors from earning the same returns as they have historically. The third explanation is that the venture business itself might be structurally flawed, with the core markets (e.g., IT and telecommunications) now mature and less capital-intensive delivering sub-standard returns.

Explaining poor returns by looking at the post-Sarbanes-Oxley IPO environment is the wrong approach according to this study. Kedrosky reveals that while the number of venture-backed IPOs has declined with a market less accepting of young, money-losing firms, it did not decline to levels completely different from the levels seen before the dot-com period, with the exception of 2008. “It is a mistake to say that the problem is the exit market—it would be more correct to say there is a problem with what venture investors once were able to bring to market, but no longer can,” Kedrosky argues.

With regards to the third explanation, the study points out that despite the maturing of the core sectors, technology-related venture capital investing still accounted for more than half of all investments (by dollar value) in the U.S. in 2008. Thus, a smaller VC sector that reflects the shrinking capital requirements and opportunities would be healthier.

So the real problem for the industry is one of capital and the correct solution is to address that: it needs to adjust for the shrinking size of the opportunities in markets that offer venture-ready characteristics. In fact, Kedrosky argues that the contraction is inevitable because poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this underperforming asset. This means that we can expect limited partners to shrink their allocation to the asset class in the coming years, lowering valuations and improving overall exit multiples.
For a copy of the report, click here.

 

Jonathan Ortmans is a senior fellow at the Kauffman Foundation where he focuses on public policies to promote entrepreneurship in the U.S. and around the world. In addition, he serves as president of the Public Forum Institute, a non-partisan organization dedicated to fostering dialogue on important policy issues.

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