Venture Capital Overhang Continues To Shrink

Before getting to the data, I’d like to share why I’m changing how I look at the overhang statistic:

I’ve been writing about the venture capital overhang (or amount of “dry powder” available) each quarter for a while now but never felt extremely confident in the figures I’ve reported. Unfortunately the overhang figure is highly subjective and I don’t think anyone except maybe a Cambridge Associates could even come close to accurately estimating how much uncalled capital is out there - the true overhang. As a proxy, I (and other publications) use the difference in reported venture capital fundraising and investment data (as reported by the NVCA, Thomson Reuters and PwC). The trouble with this methodology starts with the fact that both the fundraising and investment data sets are continuously changed retroactively - I’m guessing as funds and deals are backfilled into their databases. Furthermore, it’s unclear to me whether or not fundraising data for a certain period is later updated for capital raised by funds in that given vintage year after that year has passed. To make matters even more complicated, things like management fees, recycled capital and investment by U.S.-based firms outside of the U.S. are unaccounted for.

I’ve always said that venture capital industry data is often highly questionable, no matter the source, and that instead of focusing on absolute numbers, the focus should be on changes in the data. Because of this, and because of the issues with the fundraising and investment data, I’ve decided to focus on the near-term trends relating to the overhang, as opposing to trying to paint a larger picture.

Here’s a look at differences in venture capital fundraising and investment data through the second quarter of 2010:

What clearly stands out is the huge disparity between venture investment and fundraising in the second quarter of this year. I can say pretty confidently that this is probably the largest such disparity since at least 2002, when fundraising screeched to a halt but venture firm coffers were still brimming from the fundraising boom of 2000. This time around though, there are different dynamics at play. For one, the preceding fundraising bubble was not nearly as large, meaning that we may be spared another decade-long hangover and that the industry should recover faster. But this also means that competition for survival among venture firms may be fierce.

Investment can’t outpace fundraising forever. Initially I had thought that after the third quarter of 2009 we might start seeing a leveling out of the differential, but clearly I was wrong. The huge disparity in the most recent quarter shows that we may have longer to go and there may be more quarters to come with investment outpacing fundraising. This phenomenon could be thought of as sort of a market correction: fringe firms that raised funds years ago will eventually run out of capital and will be unable to raise new funds. What we should see after this “correction” is fewer firms, but higher quality firms remaining, investing in better deals at better valuations and generating better returns - not necessarily a bad thing for the industry. Something else to keep in mind is that the number of funds raising capital isn’t down as sharply as the total amounts being raised, meaning firms are raising smaller funds, which should lead to a reduction in the number and/or size of deals which also brings the industry back down to a more efficient level. 

Data: The NVCA, Thomson Reuters and PwC

Fundamental Shifts in Venture Capital Becoming Clear

I was about to do an update on the Venture Capital Overhang I’ve been tracking, but instead of the typical chart this time around I thought it’d share something interesting that stood out - for the last three quarters we’ve now seen US venture capital investment outpace fundraising (and the quarter before it was almost even):

The only other time in recent history where we’ve seen investment activity even come close to surpassing fundraising was  in 2003 following the bursting of the tech bubble. What does this mean? We have numbers clearly indicating that a fundamental shift in the industry is underway. In previous posts, I’ve mentioned how fundraising could not forever outpace investment as dramatically as it had been doing so over the past decade (creating an ever increasing “overhang” of un-invested capital, or dry powder).  Fundraising has now slowed dramatically, while venture capitalists rightfully continue to invest in what is a good environment to be doing so in.

A drop in fundraising was expected, but we may now have a “new normal” for fundraising levels. There is clearly a new standard for raising capital now, especially with so many limited partners still skeptical of the asset class. At first a fundraising slowdown was blamed on the “denominator effect,” and later it was said that many limited partners were waiting to get a clearer picture of their allocation balance before beginning to commit again. But the truth is that most limited partners will not return to commitment levels of the past and therefore we will see a natural attrition of firms in the future.

Investment may outpace fundraising for a while - until fringe firms run out of capital and are unable to raise new funds. Just as I had said fundraising could not outpace investment forever, the converse holds true as well and we surely will not see investment outpace fundraising forever either.  Think of this period (of investment outpacing fundraising) as sort of a market correction. When we had huge overhangs of capital, venture capitalists knew there were others out there with capital to deploy as well which drove up valuations and reduced returns. What we should see after this correction is fewer firms - this means higher quality firms will remain, investing in better deals at better valuations and generating better returns.

The differential in fundraising and investing should be interesting to monitor. Too large of a crossover into fundraising outpacing investment again may signal another bubble, while a leveling out should indicate a healthier venture capital industry.

Note: Data from PwC, Thompson Reuters and the NVCA.  And for clarity, the VC overhang now stands at $88 billion – down from $89 billion at the end of 2009. 

Venture Capital Overhang: Shrinking

With 2009 now behind us, full final year-end venture industry data is available. There’s plenty to glean from all the fundraising, investment and exit data. Much of it tells us what we already knew or expected: fundraising and investment are down, and exits have improved, but just slightly. There’s so much you can analyze, but I’ll focus on something I’ve done in the past, which is looking at the “venture capital overhang.” This is the difference between the aggregate capital raised by venture capitalists and the amount invested. It gives us a rough idea of how much capital VCs have available for investment, sometimes referred to as “dry powder.” The chart below shows venture fundraising, investment, the difference between fundraising and investment (as the overhang) and the cumulative overhang for the last ten years.

The cumulative overhang for the last decade for the U.S. venture capital industry totals close to $90 billion, using my methodology and data from PwC, Thompson Reuters and the NVCA. As with so much of the data on the venture capital industry, the calculation is not perfect. Things like management fees and recycled capital are unaccounted for. There’s also the issue of investments made outside of the U.S.  which are not captured in the PwC MoneyTree data.  Rather than focusing on exact numbers, its more important to focus on trends and to look at the big picture.

For one, there’s clearly capital out there for venture capitalists to invest. It’s probably becoming more concentrated across a fewer number of firms - as I mentioned in my last post, good firms will continue to be able to raise capital. The overhang number is down from my previous calculation earlier this year, which signalz to that capital will be a bit scarcer.  Going forward, we should see more years like 2009 and 2003 where the levels of investment and fundraising have less of a gap and less of an overhang is created. Now, you don’t want things going in the other direction, where we have more capital invested than raised because that would of course be unsustainable. But then some would also argue that the huge levels of overhang amassed in years past were also unsustainable, which is probably true.

There needs to be certain level of reasonability maintained in the industry and less overhang will force venture capital firms to be more prudent in deploying capital. This doesn’t mean, however, that great new ideas won’t get funded, because VCs clearly have plenty of dry powder. If anything we’ll see more early / seed stage deals which not only require less capital, but have more potential upside and also bring the industry back closer to its roots of more risk taking. 

Venture Capital Overhang: $118 Billion

This past week, the Alliance of Merger and Acquisition Advisors and research firm Pitchbook Data released a report which indicates private equity firms in the U.S. are sitting on $400 billion in overhang – the difference between fundraising commitments and invested capital. The figure is essentially the “dry powder” or uninvested capital private equity firms have at their disposal. The data was covered in a number of places over the past week, but VentureBeat writer Anthony Ha pointed out that the data does not include venture capital... so I decided to do some of my own research. Below is the chart I came up with for venture capital, using the same methodology the Pitchbook Data report uses (data from PwC, Thompson Reuters and the NVCA):

Source: PwC, NVCA, Thompson Reuters

Over the past decade, venture capital firms in the U.S. have amassed $118 billion in overhang. Of course the data is not perfect; you’d have to account for management fees, recycling of capital, etc. But it does tell us that venture capitalists are sitting on plenty of uninvested capital. Only in 2003 did the ammount of venture investment come close to equaling the amount of capital raised, and the average overhang per year is $10 billion.

The $118 billion figure isn’t too surprising. It’s pretty well known in the venture industry that lack of capital is not a major issue, in fact there might be too much capital chasing too few good deals. Also this year we’ve seen venture capitalists pull back sharply on investment amid economic uncertainly, deciding that focusing their attention on better managing and growing existing investments was a better use of time. We’re also seeing deal sizes come down as the cost of starting technology companies continues to drop. These factors explain the $118 billion and perhaps it’s being reflected in the recent slowdown in fundraising.