In a recent survey of over 500 venture capitalists worldwide, the National Venture Capital Association and Deloitte LLP reported the widespread view, that in the next five years VC investment in the United States and Europe would decline significantly, while such investment in Brazil, China and India would continue to dramatically increase. Yet, the survey authors continue, “Despite the challenges, U.S. venture investors remain optimistic regarding the quality of the opportunities in the U.S., with most predicting a stable or improving environment for valuations and deal flow.” This seems to contradict the survey conclusions. Is this optimism about the future of U.S. venture funds just “whistling past the graveyard,” or is it justified?
The venture funds of other countries increasingly can avail themselves of their own governments’ assistance. Recently, governments worldwide have rolled out extravagant funding measures to foster and prop up local venture capital funds in a variety of industries. Examples of recently unveiled large governmental funds to promote home-grown venture capital funds include Canada (Teralys), the U.K. (Innovation Incentive Fund), France (Strategic Investment Fund), Israel (Tender for Israeli Life Sciences Funds) and Russia (Rusnano). Similar governmental efforts have a checkered history; see Josh Lerner’s 2009 book, “Boulevard of Broken Dreams.” But at least these governments are trying to help. By contrast, the U.S. today seems intent on imposing a host of new regulatory and tax hurdles, which tend to decrease the attractiveness of venture capital funds to investors. As Mark Heesen, president of the NVCA put it recently, “The uncertainty and potential impact around many of the policies that have been discussed in Congress in recent months has contributed to an investment climate that is viewed as increasingly unfavorable by a majority of the venture capital industry. This course must change if we wish to remain competitive with other nations over the long term.”
Although our government is not making life easier for the U.S. venture capital industry, help can come from unexpected quarters. Recently we were able to organize a pending investment of tens of millions of dollars in a North American venture fund client of ours, funded by an overseas governmental agency. Many countries still value investments in U.S. and Canadian VC funds as a useful bridge to the U.S. markets and U.S. deal flow, although clearly such deals are not easy to find. The private sector also is sending out positive signals. For example, earlier this year I moderated a panel of wellknown major venture fund LP’s whose outlook on the future of U.S. venture capital, as an asset class, was surprisingly and unabashedly bullish. Subsequent conversations with other LP’s and investment bankers in the U.S. and Europe have provided confirmation of this perspective. Their consensus was that, despite dismal returns from the venture capital industry in the past decade, the future is bright for venture funds as an asset class. In fact, they made a telling comparison to the fund environment 10 years ago. In contrast to those heady days, today valuations are down, deal pipelines are full, and amateur hour in the VC business finally is over. Thanks to those factors, they predicted that the coming decade will bring historically superlative returns for U.S. venture capital as an asset class.
Of course that was in February, prior to Washington’s intensified efforts to “reform” the financial landscape. The uncertainty caused by new legislation and regulation has taken its toll. Furthermore, even if the tide of private sector venture funding is rising, this time it will not lift all boats. In fact, the LP’s on my panel flatly predicted that over half of currently existing U.S. venture capital funds will end after their current fund is concluded. Limited partners are more restrictive today about which funds they invest into, and the conditions they impose on those funds (as is seen by the influential ILPA pronouncements of late 2009). Consequently, we are seeing a Darwinian survival of the fittest for many individual U.S. venture funds; while at the same time, paradoxically, a resurgent outlook for U.S. venture capital as an asset class.
One side effect of this environment is that many hard-pressed VC funds favor later-stage investments, hoping to hit the proverbial “home run” in the few remaining years left to their funds. The stronger funds, the survivors, are becoming more selective about their investments, stingier on valuations, tougher on terms, and more careful about due diligence. Faced with this reality, entrepreneurs should take aggressive advantage of whatever resources are available, including lawyers, accountants and other friendly advocates who possibly can provide an edge. In addition, they should explore alternative sources of funding, such as angels, strategic investors, private placements and other creative financing solutions. Ironically, however, new Federal legislation also complicates angel investing and private placements somewhat, just when entrepreneurs most urgently need their support.
To prevail in this challenging environment, one must leave no stone unturned, use all the resources at one’s command, and remain flexible, creative and patient. Despite the tight funding environment, the best teams still will prevail and thrive.