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Is Venture Capital In Crisis?

July 16, 2012 • GLOBAL ECONOMY, FINANCE & BANKING, Global Capital Markets, Governance & Regulation

By Douglas Cumming & Sofia Johan

The recent financial crisis cannot totally be blamed for the marked drops in venture capital fundraising, reduced venture investment and the hindrance of successful exits around the world, but it may have exacerbated the existing problems.  Poor returns over the past decade indicate most fund managers do not earn their fees, and investors have been increasingly wary of taking on added risk without getting the reward.  Structural changes are inevitable to the venture capital marketplace to preserve an essential source of funding for nascent high-growth companies.

State of the Venture Capital Market Pre- and Post-Financial Crisis

It is widely recognized that the venture capital industry is subject to massive booms and busts, but since the start of the financial crisis in August 2007, venture capital has been in particularly hard times, as documented in the recent Oxford Handbook of Venture Capital.1,2 To follow up-to-date specific market trends in venture capital, it is possible to access publicly available aggregated datasets such as Pitchbook3 or to purchase deal-specific data from vendors such as Pitchbook, Thompson SDC4 or Zephyr DBV.5 To illustrate the massive boom and bust in recent times, we present data from Pitchbook that shows the current state of the venture capital industry in the United States. Below, we also present data from Thompson SDC to provide an international perspective.

Definitions of venture capital and private equity have differed over time and across countries. Worldwide, the term private equity generally refers to the asset class of equity securities in companies that are not publicly traded on a stock exchange. Both private equity funds and venture capital funds invest in private equity, the difference being that venture capital funds invest in earlier stage private investments. Venture capital funds often style drift into other types of private equity investments such as late stage and buyout deals,6 some venture capital funds invest in publicly traded companies,7 and even other funds are themselves publicly listed.8 A common characteristic of most stages of venture capital investments is that although investee companies require financing, they do not have cash flows to pay interest on debt or dividends on equity. The more nascent the company, the more unlikely that the venture capital investor will be able to recoup investment amounts. Investments are made by venture capitalists with a view towards capital gain on exit. The most sought after exit routes are an initial public offering (IPO), where a company lists on a stock exchange for the first time to obtain additional financing, and an acquisition exit (trade sale), where the company is sold in entirety to another company. Venture capitalists may also exit by secondary sales, where the entrepreneur retains his or her share but the venture capitalists sell to another company or another investor, by buybacks, where the entrepreneur repurchases the venture capitalists’ interests, and by write-offs or liquidations.9

 
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