The evolution of venture capital from a cottage industry to a mature asset class will manifest itself in several ways in 2006, the National Venture Capital Association (NVCA) predicts. According to NVCA President Mark Heesen, venture capital will witness a fundamental shift in risk taking, investment complexity and participants.
“The venture capital industry has reached an echelon of maturity that brings with it a universal sense of prudence and discipline that will begin to impact decision making in 2006,” said Heesen. “The coming year will be characterized by less risk, less hype, and more intricacies within investment sectors. This maturity will serve us well as we will face fresh challenges with exit markets, new power players, and competition, both globally and here in the United States.”
Though the association agrees that risk taking will remain the cornerstone of venture capital, it will become much more calculated as VCs leverage past experiences when making investment decisions. Consequently, we will not see rapid investment increases in new sectors but rather a gradual ramp up over a period of several years. Industries in which venture capitalists have already been climbing the learning curve and are expected to see more investment in 2006 include energy, bioinformatics, and mobile computing. The “learning curve tenet” will hold true for entry into new geographical regions as well. The pace of visits to China and India may accelerate, but investment dollars will remain low for several more years.
The association forecasts that investment in Internet-based businesses will continue strongly, less the exuberance that characterized the beginning of the decade. There will be healthy competition within hotter sectors, yet VCs will fund far fewer “me too” companies.
“There will not be another bubble as we simply do not have the liquidity to fund one, the exit market to fuel one, nor the ‘tourists’ to create one,” said Heesen. “The venture capitalists investing today are veterans who have a profound sense of responsibility and are making decisions on sound business criteria. We don’t expect widespread froth.”
The US IPO market is not expected to rebound considerably in the coming year, which has several major implications, according NVCA predictions. Companies will continue to rely on the acquisitions market as an easier, safer exit strategy but will also search for more innovative opportunities. More companies will consider going public on foreign exchanges or soliciting offers from private equity firms. However, the economic and psychological implications of a thin IPO window will begin to make an impact. Venture firms will find themselves in the position of having to support their portfolio companies longer as the proper strategy is selected.
While there is a great deal of talk about the blurring of lines between hedge funds, buyout funds and venture funds, there is not expected to be a major merging of these alternative asset classes in the coming year. It is likely the industry will see multiple types of funds within a firm as a viable strategy. However, it is unlikely that individual hedge fund managers will cross lines into venture capital.
While the entree of hedge fund managers is not an area of significant concern for the venture industry, there is a growing unease about an excess of liquidity in the buyout and hedge fund spaces. The VC industry would like to see these asset classes exercising the same fundraising discipline that they themselves have been exhibiting in the current cycle which will conclude in 2006 after raising an estimated $65 billion.
It is still unclear how much impact powerful publicly-traded Internet players like Google, Yahoo and EBay will influence VC industry. These organizations are still in their formative stages which makes them entrepreneurial, but unpredictable. Their role as an acquirer or funding source for young companies, if sustainable, will likely be complementary rather than competitive to the venture capital industry. Many smaller start-ups that are developing features for the Internet are not candidates for venture funding and are best suited to partner with a corporation early in their lifecycle. The innovation pipeline is strong enough that there are plenty of opportunities to go around.
A continued lackluster IPO market will begin to impact venture returns in 2006 as these exits have historically driven the industry’s out performance. The acquisitions market can produce respectable returns of 4- 10x investment but cannot alone support the level of cash distributions expected by limited partners. Without these larger IPO driven distributions, the venture industry will not be in a position to achieve the above market returns which limited partners have historically enjoyed.
We expect to see slight upticks in total VC investment and fundraising in 2006 — but no more than 10%. The number of venture firms may decline slightly as those unable to raise follow on funds choose not to continue. This drop will be offset by veteran venture capitalists spinning out from existing firms to start their own emerging funds.
Industry experts agree that, despite the challenges, 2006 will be a positive year for venture capital investment, not only for an industry that has reached maturity but for its stakeholders including entrepreneurs, institutional investors, and the country as a whole.
“In the coming year, the survivors from the post-Bubble meltdown will be nearing that three-to-five-year sweet spot for M&A opportunities. So while overall deal volume will remain stable, the deal values will go up markedly since these companies were the strong performers that had to make do during the lean years with less generous backing. So the potential return on investment for this class of targets should be higher as well,” said Mary Macdonald, Vice President, Thomson Financial.