Capital Invested is Reaching 2000 Levels, Are Returns Destined to Suffer?
My last post discussed the nuances underlying some of the data recently released by Cambridge Associates that seem to contradict two long standing beliefs held in the VC community. This got me thinking about other conventional wisdom that might not be true, specifically the notion that returns are inversely related to the amount of capital deployed.
Conventional wisdom states that the more money that gets deployed into the ecosystem, the worse the performance of the venture asset class will be. Many well respected VCs, including Bill Gurley, have lamented about the amount of capital in the ecosystem for years. The theory typically boils down to two core arguments.
The Excess Number of Startups Argument
Venture capital returns are driven by the power law, which means that a small percentage of startups drive the vast majority of returns. More capital leads to more startups being funded, often times several in the same sector competing against each other. Because the dynamics of software, internet and mobile startups often lead to winner take all markets, the excess capital leads to an increased number of “failed” startups. In other words, the number of successful startups remains constant even though the total number of startups increases. This overfunding ultimately drags down returns across the asset class.
The Lack of Discipline Argument
While the first line of thinking addresses excess capital across the industry, the second theory address overfunding of a single startup. Too much capital into any one given company more often than not leads to a lack of discipline. Capital can mask poor fundamentals for a time but eventually every business must become sustainable (ie: profitable). If management continues to rely on the ability to raise more money, at some point the capital will run out and the business will fail. In short, companies are just as likely to die of indigestion as they are of starvation. Too much capital has the potential to lead to company failures among the companies that have raised the most money and their failure has a disproportionate impact on returns for the industry as a whole.
The Dot Com Hangover
Much of this thinking stems from the dot com crash. Despite the success of early venture capital firms in the 70s and 80s, by 1990, the venture industry was still relatively small having raised a little more than $1 billion that year. At the peak of the dot com bubble, the VC industry had exploded in growth, raising roughly $120 billion in 2000. Then came the crash and with it returns for the industry plummeted. Plotting the median net returns of the industry (data taken from Cambridge Associates) during this 10-year time period seems to show a strong correlation between dollars raised and performance. Note that for all graphs shown in this post, performance is represented as median net IRR for funds of that year’s vintage and more recent years do include paper gains that have yet to exit. The amount raised in each corresponding year is taken from Pitchbook.
Predictably, the amount of capital venture industry was able to raise fell dramatically in 2001 and 2002. Ever since then, the VC industry has been on a slow, yet steady climb in capital that has been raised. While I could not find final numbers for 2019, every indication is that it will be the highest in the last decade and approaching levels similar to 2000.
Does that mean that VC returns in coming years are destined to deteriorate, or even worse, see an all-out crash similar to 2000? After all, conventional wisdom would dictate that returns are bound to suffer.
This is what I wanted to examine because correlation does not necessarily imply causation. Instead of returns being inversely correlated with performance, what if the VC market can grow in a sustainable manner? Could it be possible that returns can scale along with an increase in dollars invested?
To explore this possibility, I wanted to examine two things. First, could there be another explanation for the correlation between capital raised and the subsequent crash in 2000? Second, is there historical evidence proving that the venture industry could grow in size and returns at the same time?
Timing is Everything
While there are several factors that ultimately led to the run up and crash in 2000, could it be possible that the influx of capital was premature, and the timing of the capital had a greater impact than the quantity? It’s a subtle distinction but one that might lead to a very different conclusion about the amount of capital in today’s market.
By 2000, there were only about 108 million people online in the US and 360m worldwide (1). For most of the world, the internet had yet to become mainstream. 93% in the East Asia and Pacific region and 99% in South Asia and in Sub-Saharan Africa had yet to come online. At the time of the dot-com-crash less than 7% of the world had access to the internet (2). Fast forward to today, there are nearly 4.5 Billion people, over 57% of the world’s population, with internet access. In the US, 95% of the population has access to the internet (3).
Furthermore, much of the core infrastructure we take for granted today had yet to be built by 2000. The ability to make payments online was in its infancy, PayPal had only been launched in 1999. Internet speeds were much slower as the vast majority of users were still on dial up. Broadband wouldn’t reach significant penetration until mid the 2000s. AWS and the cloud movement was still six years away from being available while the iPhone would not be launched until 2007. The fact that these core components were still being developed meant that there were limitations on what products and services could be delivered at that time.
But just because the internet wasn’t capable or there weren’t enough people connected doesn’t mean many of the companies were bad ideas. In fact, many of the “failed” companies from the dot com crash would see their ideas reincarnated several years later with huge success. Pets.com & Webvan were the two quintessential examples of the dot com bust. Yet Chewy (which sold for $3.35 billion) and Instacart (valued at $7.8 billion) are basically version 2.0 of these companies. Marc Andreessen has routinely talked about this concept that nearly all the ideas from the 2000s were right, they were just too early.
If this is true, then the amount of capital that got deployed in the 2000s might not have ultimately been too much for the amount of innovation that was occurring, it could have been deployed at the wrong time. Returns suffered because too much capital was deployed too soon which begs the question, are the dynamics of today’s market such that it can handle the increased amounts of capital being deployed and still deliver outsized returns?
So, what has changed in the last 20 years that would allow companies to ingest more capital and still deliver higher returns to its investors? First, “tech” is no longer an isolated industry. Technologies such as cloud infrastructure, AI and ML, and mobile are impacting every industry in our economy. As a result, venture backable companies can be built across a variety of industries that were not possible 20 years ago which is why we have seen so much innovation in industries such as Healthcare, Financial Services, Real Estate, CPG, Media, etc. This directly counters the “Excess Number of Startups” argument laid out at the beginning of this post. If there are more companies that can become successes across more industries, more capital can be deployed effectively because there will ultimately be more companies that generate meaningful returns for investors. The growth in aggregate number of successful startups as compared to 2000, allows for returns to stay high even as more capital enters the ecosystem.
Second, markets are much bigger. As we saw with the growth of the internet, companies can reach and sell to a much wider audience. Uber grew the taxi market, AirBnB grew the lodging market, the advent of the cloud grew the enterprise software market, etc. As markets grow, the companies in those markets can become much bigger as evidenced by the fact that we now have 4 companies with a market cap of over $1 Trillion for the first time ever.
Finally, companies are staying private longer which means more value is accruing to the private markets (ie: VCs). Even though it is taking longer to achieve liquidity, VCs have or are on pace to generate record levels of cash for their LPs.
These last two points address the second theory laid out at the beginning of this post as to why conventional wisdom states more capital leads to lower returns. Because companies have access to more customers and are less restricted to geographic limitations than in 2000 (remember less than 7% of the world was online at the time), it follows it would take more money to scale a company once it hit product market fit. Hence, we have seen the rise of large growth rounds in VC over recent years. More dollars are being used to go after bigger opportunities.
It’s about this time that I feel I must insert a disclaimer in this argument, mainly that there is a limit. At some point more capital sees diminishing marginal returns or even becomes harmful as too much capital can lead to lack of discipline and flawed fundamentals in building a business. We have certainly seen plenty of examples of this in recent years. However, the point of the argument isn’t that companies can take in an unlimited amount of capital. I certainly do not believe that to be the case. The argument I am trying to make is that companies can effectively deploy more capital today and generate a larger business and therefore larger returns relative to 20 years ago. Therefore, it does not automatically mean that returns will suffer simply because we are reaching capital levels similar to 2000.
Let’s see if the data supports this theory. If we go back to the original graph and plot the median net IRR over the last 20 years since the dot com crash, we see that returns have steadily increased along with the increase of capital being raised. Viewed in this lens, the amount of dollars being invested would seem much more rational even as we approach 2000 levels.
I do want to recognize there are plenty of highly valued companies that have yet to exit and many investors are sitting on paper gains, not realized returns. How those companies perform will have a huge impact on the returns of the asset class during this period. If these companies do achieve liquidity, even at exits near their current valuations, returns for traditional venture capital investors should be pretty attractive. Only time will tell but it’s worth considering that even during this period of increased capital, the data suggests that returns in VC still have the potential to outperform other asset classes.
Historical Precedent
While it may sound counterintuitive, there is historical precedent for returns to scale along with the amount of capital deployed. We just have to look back prior to the dot com crash and into the 1980s.
In his book, “VC: An American History”, Tom Nicholas chronicles the growth of the venture industry. According to Nicholas, the VC industry rose in provenience during the 80s due to favorable government policies, lowering of the capital gains tax, the adoption of the Limited Partnership structure, and successes from early venture funds in the 60s and 70s such as ARD, Arthur Rock & Company, Sequoia, Kleiner Perkins, Venrock, Greylock and others. As word spread of their success and regulation surrounding investing in venture funds loosened to allow pension funds to invest in the asset class, the money followed. “Annual new commitments to VC funds had been about $100 to $200 million during the 1970s, but they exceeded $4 billion annually during the 1980s.” (4)
The meteoric rise in VC commitments from the 70s to the early 80s looks very similar to the rise in capital commitments leading up to the 2000 dot com crash. According to conventional wisdom today, this 20x — 40x increase in capital during this time period should have meant disaster for returns. Except, the opposite happened. Returns rose throughout the 1980s.
According to data from Cambridge Associates (6), returns steadily climbed during the decade. Today’s conventional wisdom would state that returns should have done the exact opposite during this time frame. Instead, the semiconductor industry, which developed in the 60’s and 70’s, laid the foundation for a wave of new innovation and startups. This period of time not only was able to effectively absorb this influx of capital, but actually benefited from it.
If we use the period of the 1980’s as a comparison rather than 2000, growth does not necessarily imply lower returns. Just as companies in the 1980’s built their products on top of a maturing semiconductor industry, companies in the 2020’s will benefit from prior innovations in the internet, cloud computing, mobile, machine learning, crypto and more.
So, which will it be? Will returns suffer due to so much capital (a la 2000) or has the VC market simply grown in size (a la 1980s)? Ultimately, there is a natural limit to how much capital the VC ecosystem can digest before returns start to suffer. The question is are we seeing an expansion of that limit and if so, by how much? Only time will tell.
(1) https://royal.pingdom.com/incredible-growth-of-the-internet-since-2000/
(2) https://ourworldindata.org/internet
(4) VC: An American History by Tom Nicholas
(5) https://thebhc.org/sites/default/files/beh/BEHprint/v023n2/p0001-p0026.pdf
(6) https://www.cambridgeassociates.com/wp-content/uploads/2015/05/Public-USVC-Benchmark-2014-Q4.pdf
