<blockquote>
'There is thus a “perfect storm” for U.S. small business. Venture capital availability is down, and the willingness of the smaller stock of venture capital to invest in new ventures is further reduced by the appalling returns the sector has earned since 2000. Good people are scarce except in the Internet software space; those talented people without a particular aptitude for software head for hedge funds or directly to Wall Street. Debt financing is also hard to come by for small business, as banks have more attractive opportunities speculating in the bond markets, courtesy of Ben Bernanke’s monetary policies.
Needless to say, this does not bode well for U.S. job formation. The Intuit monthly survey of small business job formation throughout 2010 indicated a monthly job creation total far below 100,000, showing that small business is unable to carry out its usual function of creating about 80% of the new jobs in the U.S. economy. Consequently, even to the extent that the extraordinary current levels of fiscal and monetary stimulus produce economic growth, it will be a jobless growth that leaves exceptional numbers of people in long-term unemployment. The thwarted potential entrepreneurs will mostly not be among the unemployed; being among the most able in society they will find jobs with large companies, consultancies or on Wall Street. It will be those who would have been employed by the potential entrepreneurs, whether in middle management, as technical specialists or in more humble capacities, who will find their life possibilities most hopelessly degraded.'</blockquote>
The Death of VenturingBy Martin Hutchinson
January 24, 2011
SourceVenture capital fundraising in 2010 declined from $16.3 billion to $12.3 billion, according to Thomson Reuters data. That’s a far cry from the average of over $30 billion annually in 2005-07, let alone the peak of $106 billion raised in 2000. Contrast those figures with the datum that the value of hedge funds closed at $1.65 trillion in 2010 with $70 billion of new money entering the industry and you have an inescapable conclusion: the equity financing of small business, as well as the debt financing, is currently in a prolonged downturn.
After the new money bonanza of 1999-2000, it was to be expected that venture capital financing would be limited once the market turned down. Indeed the hangover was immediate; in 2002 only $3.6 billion of new money was raised. However 2010 is ten years after the dot-com crash; long before then money invested in 1999-2000 had been invested in deals or returned to investors. Thus the downturn in venture capital funding in 2010, when compared with the levels of the mid 2000s, is not simply a cyclical effect.
It may however be a belated effect of the poor returns earned on the bubble money. As of January 2011, according to Prequin, venture capital funds raised in 1999 had an average internal rate of return of minus 12%. Even funds raised in 2000-2007 all had negative median internal rates of return as of January 2011. Hardly surprising therefore that the massive spigot of money devoted to the venture capital industry has run rather dry.
My Reuters BreakingViews colleague Robert Cyran has identified one problem currently beleaguering the venture capital industry: a lack of interesting ventures to finance. With its heavy concentration in California and its successful track record in Internet financing, the industry has focused on further Internet-related deals. After all, if Facebook can gain a valuation of $60 billion only soon after reaching profitability, the potential profits from financing the right Internet deal are immense. The problem then is that many such ventures don’t need formal venture capital finance; entrepreneurs with savings, or with reasonable connections with past successes in the Internet sector can finance the deals themselves or with only a small group of private investors. The venture capital industry’s $30 million financing of a joke website network, “I Can Has Cheeseburger” is a symbol of the industry’s weakness (and the excess of cheap money about) not of its strength.
One possible reason why the engine of growth company formation and venture capital financing may have stalled is the series of boom/bust economic cycles of the last fifteen years, and the focus of growth in the Internet software sector. Huge amounts of money were made mostly by very young people in 1995-2000, concentrated almost entirely in that sector as the stock market boom of that period was very narrowly focused. This produced a concentration of talent flowing into that sector in the next several years. Since the best talent was devoted to Internet software, it is unsurprising that the start-ups were concentrated in that sector also, so venture capital gravitated there. With capital, company formation and innovation all concentrated in the same narrow area of specialization, entrepreneurial and venture capital activity in other sectors was starved of both talent and finance.
A further reason for the dearth of venture capital activity outside the Internet software field may well have been the extraordinary rewards available on and around Wall Street, whether in investment banks directly or through finance-related intermediaries such as hedge funds. Able people who did not have a particular talent for or interest in the software sector naturally gravitated in this direction, which offered incomparably greater rewards than had traditionally been available from finance. The ability to earn entrepreneurial levels of remuneration through trading, without either the risks of entrepreneurship or the long career slog of rising to the top of a large company, made Wall Street’s opportunities irresistible. Equally, setting up a hedge fund required no significant capital as such, but only a decent track record in a major institution and a good Rolodex of potential investors in the fund. Outside the Internet sector, working in an ordinary manufacturing or service organization, with a view to starting one’s own business once experience had been gained, seemed an unattractive career direction for the best and brightest.
Of course, the extraordinary returns to entrepreneurship and huge destruction of venture capital funds of the Internet bubble, and the historically unprecedented remuneration for even ordinary talent on Wall Street both derived from the same cause: the loose monetary policies pursued by Fed Chairmen Alan Greenspan and Ben Bernanke since 1995. Sloppy money caused the Internet stock bubble to inflate larger and for longer than would otherwise have been the case. It also caused a prolonged bubble in the financial services sector, in which artificially high returns, particularly to participants, were earned through the use of artificially cheap leverage for over a decade.
Cheap money may also have affected the availability of venture capital finance. If leverage is readily available, speculative hedge fund activity, leveraged to make the returns appear superior, and private equity activity, in which “financial engineering” is used to disguise a lackluster operating performance, both become very easy ways to make money. Venture capital, backing new companies with unproven business models, is by its nature very difficult, requiring a detailed understanding of developments in a particular sector and the technological, strategic and managerial tools being used to address them. Conversely, private equity investment, in which a company that is already well established is taken over, costs are wrung out to produce additional profits, and an aggressive sales operation used to find a buyer in a relatively short period, is intellectually relatively undemanding – and very lucrative if the equity investment is small relative to the size of the company.
A further reason why entrepreneurial activity is down in the last couple of years may be the lack of available debt finance. The series of gigantic Federal budget deficits, combined with overly-loose monetary policy, has allowed banks to make high returns by borrowing short-term money, investing in Treasuries or government-guaranteed housing bonds, and leveraging. According to Fed data, the volume of commercial and industrial loans extended by U.S. banks declined by 19% in 2009 and by a further 9% in 2010. This decline in debt finance availability will itself have had an adverse effect on company formation and on small business expansion.
There is thus a “perfect storm” for U.S. small business. Venture capital availability is down, and the willingness of the smaller stock of venture capital to invest in new ventures is further reduced by the appalling returns the sector has earned since 2000. Good people are scarce except in the Internet software space; those talented people without a particular aptitude for software head for hedge funds or directly to Wall Street. Debt financing is also hard to come by for small business, as banks have more attractive opportunities speculating in the bond markets, courtesy of Ben Bernanke’s monetary policies.
Needless to say, this does not bode well for U.S. job formation. The Intuit monthly survey of small business job formation throughout 2010 indicated a monthly job creation total far below 100,000, showing that small business is unable to carry out its usual function of creating about 80% of the new jobs in the U.S. economy. Consequently, even to the extent that the extraordinary current levels of fiscal and monetary stimulus produce economic growth, it will be a jobless growth that leaves exceptional numbers of people in long-term unemployment. The thwarted potential entrepreneurs will mostly not be among the unemployed; being among the most able in society they will find jobs with large companies, consultancies or on Wall Street. It will be those who would have been employed by the potential entrepreneurs, whether in middle management, as technical specialists or in more humble capacities, who will find their life possibilities most hopelessly degraded.
Eventually of course the budget deficit will be reduced (no doubt creating new unemployment—particularly in the ranks of state and local government) and interest rates will be rapidly increased to fight an unexpected (to Ben Bernanke) resurgence of inflation. By reducing “crowding out” this development should increase small business formation, make debt capital more readily available and increase the returns to and availability of venture capital. However in practice the damage done to the small business and venture capital sectors in the last decade will prove to be difficult to remedy in the short term. That will put yet another unnecessary obstacle in the path of full U.S. economic recovery.