Post on 15-Jul-2015
Copyright © President & Fellows of Harvard College
Journey Conference
October 25, 2012 Israel
Felda Hardymon
The Future of Venture Investments Cycles, Trends and Opportunities
VC is really an adolescent asset class Venture capital is still very young:
• Not recognized as a real asset class until 1978
Venture capital is still very small:
• In largest market, U.S.:
• Only about 4000 professionals.
• Average of 1,500 companies funded for first time annually, 2000- 2008.
• Relative to 1 million businesses started annually.
• In Israel:
• Less than 250 professionals
• Less than 25 Series A’s each year—many more seed deals
VC is really an adolescent asset class Venture capital is still very young:
• Not recognized as a real asset class until 1978
Venture capital is still very small:
• In largest market, U.S.:
• Only about 4000 professionals.
• Average of 1,500 companies funded for first time annually, 2000- 2008.
• Relative to 1 million businesses started annually.
• In Israel:
• Less than 250 professionals
• Less than 25 Series A’s each year—many more seed deals
Whether or not you raise venture capital: if you are in high tech—the health of the VC industry affects you
Venture capital has had a profound impact in the US economy • 13% of all public firms at end of 2008.
• 8% of market capitalization ($2.0 trillion).
• 6% of total employees.
• Particularly true in high-technology industries.
And over the past decade has become important globally
• Israel ahead of the curve on this—active VC since mid-80’s; a real industry in the early 90’s
• VC responsible for bringing dozens of multi-nationals to Israel through M&A
Venture capital has had a profound impact in the US economy • 13% of all public firms at end of 2008.
• 8% of market capitalization ($2.0 trillion).
• 6% of total employees.
• Particularly true in high-technology industries.
And over the past decade has become important globally
• Israel ahead of the curve on this—active VC since mid-80’s; a real industry in the early 90’s
• VC responsible for bringing dozens of multi-nationals to Israel through M&A
VC is the oxygen for high tech innovation
Today The Theory The Reality Current State Starting a Company Now What Works
Venture Capital
The Theory
Georges Doriot’s insight
Worries about dangers of post-War stagnation in U.S. Current system did not work well: • Limitations of banks, public markets. Need for new financial institution playing three roles: • Sorting. • Certifying. • Governing.
What VCs Do Selection
• Pick which projects to back
• Driven by profit share self interest (carried interest)
Credential
• Indicate to acquirers, banks, large customers, potential employees, etc that this is a substantive project
Governance
• Regularly monitor progress at a meaningful level and effect changes if necessary
What VCs Do Selection
• Pick which projects to back
• Driven by profit share self interest (carried interest)
Credential
• Indicate to acquirers, banks, large customers, potential employees, etc that this is a substantive project
Governance
• Regularly monitor progress at a meaningful level and effect changes if necessary
What VCs don’t do
Run Companies
Because of its structure, VC is a long latency business
Blind pool
• May be a broad investment charter (healthcare vs. IT, start-up vs. growth equity, etc).
Long lock-up
• 10-15 years
Long investment life
• Time to liquidity 5-10 years
Apprenticeship
• 15-20 years to know if a VC investor is any good
13
The Venture Capital Intermediary Chain
Savers Gatekeepers (e.g., Fund of Funds)
Venture Firms
Portfolio Companies
IPO
3 – 10 Years 3 – 10 Years
Fund Managers
(e.g., Pension Funds)
14
The Venture Capital Intermediary Chain
Savers Gatekeepers (e.g., Fund of Funds)
Venture Firms
Portfolio Companies
IPO
3 – 10 Years 3 – 10 Years
Fund Managers
(e.g., Pension Funds)
Historically American and European; recently SWFs and Asia have become important. It is a longer chain for Israeli VCs.
VC Interim Performance is Hard to Measure
Mark to market cannot be accurate
• Comparison based: But what are comps for new businesses?
• Interim financings often more affected by exogenous variables (fund cycle, buzz, speculation, etc) than by company performance
• Company progress often driven by a series of experiments and is inconsistent over time until established.
VC fund performance quite dependent on liquidity environment—which varies greatly over time.
Venture Capital
The Reality
Big Hits Drive VC Actual Performance
It is a risky business
• Over half of VC investments do not return what’s invested
About 15% of VC investments drive all VC returns
Great companies are started every year, BUT there are only a few and access is key
• Drives tiering of the business
• Exacerbates VC cycles
Makes allocation of time more important than allocation of capital.
VC is Cyclical
Greatly affected by IPO/M&A cycle
• First real measurement of VC fund performance
• Liquidity itself is a big indicator for raising a new fund
Underlying start-up cycle
• Macro economics (recessions help!)
• Innovation cycles
• Role models
Returns negatively effected by overfunding
NOTE: Debt cycle is not a performance factor (does affect LP fundraising somewhat)
The VC industry underperforms when overfunded
20 28
18 9 10 9 13 15 18 20
33 34 34
52 56
75 82 77
14
- 18 - 23 - 32 - 40
- 20
0
20
40
60
80
100
Strong Returns
Bad Returns
Firming Returns
Good Returns
Bad Returns
LP R
etur
ns (
%)
Very Good Returns
20 28
18 9 10 9 13 15 18 20 19
33 34 34
52 56
75 82 77
14
- 18 - 23 - 32 - 40
- 20
20
40
60
80
100
Strong Returns
Bad Returns
Firming Returns
Good Returns
Bad Returns
Source: Cambridge Associates
1
10
100
1,000
10,000
100,000
1,000,000
PC Boom Internet Boom
Dol
lars
Com
mit
ted
to
US
VC
Fu
nds
($M
)
70s 80s 90s 00s
U.S. fundraising and pooled IRR
0
20
40
60
80
100
120
140
160
180
0.00
5.00
10.00
15.00
20.00
25.00
30.00
1969
-197
5 19
76-1
979
1980
19
81
1982
19
83
1984
19
85
1986
19
87
1988
19
89
1990
19
91
1992
19
93
1994
19
95
1996
19
97
1998
19
99
2000
20
01
2002
20
03
2004
20
05
Fund
s (20
02 $
B)
IRR
(%)
Pooled IRR
Funds Raised
Source: HBS databases and Thomson Reuters.
U.S. fundraising and pooled IRR
0
20
40
60
80
100
120
140
160
180
0.00
5.00
10.00
15.00
20.00
25.00
30.00
1969
-197
5 19
76-1
979
1980
19
81
1982
19
83
1984
19
85
1986
19
87
1988
19
89
1990
19
91
1992
19
93
1994
19
95
1996
19
97
1998
19
99
2000
20
01
2002
20
03
2004
20
05
Fund
s (20
02 $
B)
IRR
(%)
Pooled IRR
Funds Raised
Source: HBS databases and Thomson Reuters.
VC is Not Process Driven
Judgment and effectiveness of the VC partners counts most
• Great firms are somewhat consistent across partners; merely good or second rate firms are not at all consistent across partners
• VC is an apprenticeship business
VC is Not Process Driven
Judgment and effectiveness of the VC partners counts most
• Great firms are somewhat consistent across partners; merely good or second rate firms are not at all consistent across partners
• VC is an apprenticeship business
Advice to VCs Go to the best firm you can to learn the business
VC is Not Process Driven
Judgment and effectiveness of the VC partners counts most
• Great firms are somewhat consistent across partners; merely good or second rate firms are not at all consistent across partners
• VC is an apprenticeship business
Advice to Founders Choose firm 1st, partner 2nd
Advice to VCs Go to the best firm you can to learn the business
VC may be the most concentrated financial industry on earth—because of Persistence
Returns from inception to 12/31/09. Source: Lerner analysis of Thomson/Reuters data.
Returns of all US VC funds from inception to 2010 For top 1%: 41%.
For top 5%: 70%. For top 10%: 84%. For top 25%: 104%.
VC may be the most concentrated financial industry on earth—because of Persistence
Returns from inception to 12/31/09. Source: Lerner analysis of Thomson/Reuters data.
Returns of all US VC funds from inception to 2010 For top 1%: 41%.
For top 5%: 70%. For top 10%: 84%. For top 25%: 104%.
BUT the returns of the industry as a whole do not justify the total LP money invested in VC funds
A VC firm’s track record indicates more than in any other asset class
Next Fund Last Fund ↓
Bottom
Medium
Top
Bottom Tercile 61% 22% 17%
Medium Tercile 25% 45% 30%
Top Tercile 27% 24% 48%
High likelihood that the next funds of a given partnership stays in the same performance bracket Persistence. 1% boost in past performance → 0.77% boost in next fund’s performance.
Source: Kaplan and Schoar [2005]
Fund sequence number • Positive relationship
between IRR and fund sequence number.
• First time funds perform especially poorly.
• Regression results control for vintage year effect, fund category and fund size.
• May need to be done separately for Israel—early wave of funds (early 90’s) was blessed by a rising market. Time will tell.
Source: Lerner, Leamon and Hardymon [2011]
0%
2%
4%
6%
8%
10%
12%
14%
1 2 3 4 5 6 7 8 9 10
Pred
icte
d Re
lativ
e IR
R
Fund Sequence Number
But VC has scaling limits
0%
5%
10%
15%
20%
25%
10 20 50 100 200 500 1,000 2,000 5,000
Pred
icte
d Re
lativ
e IR
R
Fund Size ($ millions)
Buyout
Venture Capital
Source: Lerner, Leamon and Hardymon [2011]
• Positive relationship between IRR and the ratio of partners to committed capital.
• Regression results control for vintage year effect, fund category, and fund size.
One Explanation: Partner to size ratio (i.e.: “Judgment … not process driven business”)
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%
Rela
tive
IRR
Ratio of Senior Professionals to Fund Size, Relative to Mean Fund
Source: Lerner, Leamon and Hardymon [2011]
• Positive relationship between IRR and the ratio of partners to committed capital.
• Regression results control for vintage year effect, fund category, and fund size.
One Explanation: Partner to size ratio (i.e.: “Judgment … not process driven business”)
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%
Rela
tive
IRR
Ratio of Senior Professionals to Fund Size, Relative to Mean Fund
Source: Lerner, Leamon and Hardymon [2011]
Remember what VCs do: Selection, Credentialing, Governance
Explanation 2: Older Firms Tend to be Less Specialized
Source: Gompers, Kovner, and Lerner [2010]
And Specialist Firms are More Likely to Have Successful Deals.
0%
1%
2%
3%
SpecializedFirm with
SpecializedPeople
GeneralistFirm with
SpecializedPeople
GeneralistFirm withGeneralist
People
Partners’ focus especially matters. Specialization assists • Selection • Credentialing • Governance
Source: Gompers, Kovner, and Lerner [2010]
VC is relatively uncorrelated to the larger business cycle
VC economics are micro not macro
• Moving from 1515100 customers just requires finding those customers
• Truly great companies are founded in all periods … regardless of economic cycle
VC results require healthy public markets for exit but not for growth
• So VC industry performance is lagged to the public markets (makes VC an uncorrelated asset from a portfolio construction point of view)
Inter-quartile ranges and medians for asset classes (c. 2006)
-10%
-5%
0%
5%
10%
15%
20%
U.S. Fixed Income
U.S. Large Cap
Equity
U.S. Small Cap
Equity
Non-U.S. Equity
Hedge Funds
Real Estate
U.S. Venture Capital
U.S. Buyouts
European Private Equity
Source: Yale [2006] and Venture Economics.
VC industry performance is lagged to the public markets
36
U.S. Equity
U.S. Bonds
Developed Equity
Emerging Equity
Absolute Return
Private Equity
Real Estate
Cash
U.S. equity 1.00
U.S. bonds .45 1.00
Developed equity .60 .30 1.00
Emerging equity .30 .20 .50 1.00
Absolute return .30 .35 .30 .30 1.00
Private equity .40 .25 .25 .10 .25 1.00
Real estate .15 .25 .20 .10 .40 .15 1.00
Cash .00 .50 .00 .00 .00 .00 .20 1.00
Modified Correlation Matrix
Source: Yale University Investments Office c. 2003 (Modified correlation matrix reflects assumptions about future interrelationships)
Lag to the public markets makes VC (& PE) an uncorrelated asset
Source: BVP research
Great Companies are Created Every Year 1980-1996
37
1982 1980 1984 1986 1988 1990 1992 1994 1996
Source: BVP research
Great Companies are Created Every Year 1997 - 2010
38
1999 1997 2001 2003 2005 2007 2009 2011 2013
Truly great companies are founded in all periods … regardless of economic cycle
So VC is subject to long latency, multiple cycles, huge concentration, and inaccurate measurement
There are few VC industry experts for all situations
• Advice is often anecdotal
• Venture capital admits a lot of styles
Investment platform, track record and acumen trumps a good story, empathy or simply domain knowledge
But most of all, it is really about Governance
Venture Capital
Current State
The Mid Sized VC is no longer viable
Middle market funds
Sector and geo specific funds
Major global funds
The Mid Sized VC is no longer viable
Sector and geo specific funds
Major global funds
Persistence has driven LP funding to higher performing funds who have expanded to take it
Firms have specialized and gotten smaller to ease fundraising and increase performance
And the two classes of firms are symbiotic
And which funds can easily raise money has narrowed considerably
Ten Years Ago
Top 1/4
Sector & Geo Funds
Now
Top 15-20 funds (most global) • Expanded into growth equity • Specialization
Sector & Geo
Funds
LPs getting ‘specialist fund fatigue’
And which funds can easily raise money has narrowed considerably
Ten Years Ago
Top 1/4
Sector & Geo Funds
Now
Top 15-20 funds (most global) • Expanded into growth equity • Specialization
Sector & Geo
Funds
LPs getting ‘specialist fund fatigue’
Differentiation key
Rise of the Super Angels
The case for Israeli VC
45
Audacious
Impatient
Independent
Passionate
Informal
Opinionated
Brash
Nonconformist
Defiant Tenacious
Optimistic
Proud
Unconventional
Outsider
Unreserved
Ambitious Aggressive
Assertive
Nimble
Pioneering Improvise
Clever
Scrappy
2011 Venture Snapshot
46
$2B invested
500 start-ups
75% foreign funds
$2.3B M&A exits ($1.9B in 2012)
7.6M people
There is a focus on innovative high tech like no where else in the World
Tech is 17.3% of the business sector GDP Tech exports close to $16 billion (41%) Over 90% of the public budgets for R&D ($7 billion in 2006) allocated to hi-tech
• Much allocated through joint ventures with VC
Source: Israeli Ministry of Finance
Commonly heard objections
•No $Billion IPO •Tech is shiny, but… •Building a business is hard •Scaling is really hard •Money is easy to lose
48
Israeli high tech is a natural for M&A Decrease in global corporate R&D is a good match for R&D centric Israeli companies
• Disruptive products and technologies (often difficult to take to market on their own)
• Partner with US tech companies Early courtship
• NB: Many venture backed US start-ups are founded in order to compete with the giants
All major US technology companies have a presence in Israel
• No language issues, loyal employees, highly productive, integrate into existing R&D centers
Financial match
• US tech companies have unprecedented cash outside of the US (can't repatriate)
• Israeli capital efficiency$100M acquisition for an Israeli company is a great outcome
Israeli high tech is a natural for M&A Decrease in global corporate R&D is a good match for R&D centric Israeli companies
• Disruptive products and technologies (often difficult to take to market on their own)
• Partner with US tech companies Early courtship
• NB: Many venture backed US start-ups are founded in order to compete with the giants
All major US technology companies have a presence in Israel
• No language issues, loyal employees, highly productive, integrate into existing R&D centers
Financial match
• US tech companies have unprecedented cash outside of the US (can't repatriate)
• Israeli capital efficiency$100M acquisition for an Israeli company is a great outcome
$ CASH BURN
Time
FINANCIAL VALUE
40 years in the desert Financial metrics base exits are rare and then unusually low
THE RISK OF NOT SELLING STRATEGIC VALUE
Strategic technology premium is unusually high for Israeli companies
Israelis haven’t raised growth capital nor have spent to scale
VALUE $ M&A VALUE
Venture Capital
Starting a Company Now
Is it a good time to start a company?
People are available
Markets are moving relatively slower
The world continues to shrink (relative advantage to Israel)
Lower costs of start-ups
More role models imply easier credibility
Many opportunities
• 45 year old IT architecture
• Replacing chemistry based pharma
!
But it is harder to grow to true scale
1. Big companies are cash rich, idea poor
• Easier to buy than build the M&A fit
2. Investors seeking pre-mature liquidity to raise new funds VC environment not good for Israeli-specific VCs
3. Long term public investors scarce
4. Mid level growth management scarce
Consumer facing Internet somewhat of an exception but starting to conform to the rest of the market
Venture Capital
What Works
Governance Hiring people smarter than you Patience coupled with long term vision Go with experienced investors Be global from day 1 Develop the ability to hire and train Avoid large banks Measure everything
Elements of Good Governance
An outside board
• Neither dominated by management nor VCs
• Finding independent, unaffiliated directors is hard
• Small (5-7)
• Characterized by respect and affection of members and role players
Best practices
• Auditing, law, compensation all have process
• Budgeting, forecasting and regular monitoring
• Allows experiments—you can be wrong and fix it
Attitude—good managers welcome the standards
Choosing investors
Value experienced investor over domain specific investor
• You can hire domain help
• Key to governance as well as credibility
• Platform vs individual
• A great firm will back up the partner
• Chemistry is important, respect is more important
• Communicate, communicate, communicate
• Anyone can want to make money—a good investor knows how to make money.
What makes a good VC Investor?
The ability to communicate The ability to get mind share Discipline A sense of equity Empathy Reputation Perspective Stability …and luck
Thank You