Tuesday, November 25, 2008

The VC landscape

Mark Peter Davis, of DFJ Gotham posted in the Silicon Valley Insider excerpts from his speech about 'why VC's aren't investing anymore'. He was clearly exaggerating for effect, as we are in the midst of a slowdown, not meltdown in the VC space.

The capital allocation issue, where institutions seek to diversify their investments into various buckets, is a big problem. Ironically, the decrease in the value of public stocks, means they are under allocated to this area, and many are seeking to lessen their investments in 'alternatives (including venture) to re balance. This macro situation only partly masks the micro effect....returns in the venture market have disappointed many institutional investors. Over the past 5 years, the Venture market has been a bit constipated as many dollars were invested, but too small a % were returned. Positive net portfolio returns are a different, and more difficult, story. The economic situation, 'the denominator' problem highlighted in the piece, clearly exacerbates an already difficult environment.

The only long-term solution is around innovation that opens new markets, or fundamentally destabilizes an existing one. Only by pushing the envelope (yes, taking risks) will investors and entrepreneurs garner the type of sweet returns that justifies investment in the asset class vs alternatives, such as 'vulture' investing (downtrodden public companies), 'secondary' investing (buying LP interests from individuals/institutions interested in reallocating), or 'value' investing (low p/e stocks). An arch focus on profitability, at the expense of innovation, is a path that surely leads over a steep cliff.

Despite a terrible economic environment, in the midst of the early 80's we saw the IPO's of Oracle and Microsoft. Two companies that were riding fundamental paradigm shifts that brought institutions running to the venture asset class as tangible returns were available in the dawn of a new paradigm. Capital efficiency in the internet area is clearly important, but alone, is not sufficient to drive stellar returns necessary to support investments at the pace of the last decade.

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