Fred Wilson has posted a very thought-provoking piece, arguing that the VC industry is raising too much money. His essential argument is that VCs are raising so much money that the total number and amount of exits cannot possibly deliver a good industry-wide IRR.
I agree with Fred’s analysis, but wanted to go a little deeper. This post originally appeared as a comment on Fred’s blog.
As an asset class, VC has become terribly overinvested. While the dot com bubble was partially to blame, the hidden cause was the massive rush into VC by endowments and pension funds.
All the major institutional investors were jealous of David Swensen’s returns at Yale, and concluded that the reason Swensen outperformed was that he invested in illiquid asset classes like VC.
As a result, the VC industry ballooned to its $25 billion/year size. It was simply a matter of supply and demand.
And at $25 billion/year, VC is simply too big to deliver good returns. True, there are only so many exits, but that too is a symptom and not a cause.
VC companies tend to play in the specific fields of technology and biotech. Both those markets are a certain size; simply pumping more money into company formation doesn’t change the fact that the major technology buyers such as Wall Street aren’t going to increase their spending more than 5-10% per year.
In the end, all company value comes from the net present value of future cash flows. And cash flows come from customers. And customer spending fundamentally scales with global GDP.
When VC was a small asset class, it had plenty of headroom to grow. But the larger it gets, to closer its returns will get to the overall equity return, with the added negative of illiquidity and volatility.