Venture capital growing pains: Should the market diet?

Transcription

1 Journal of Banking & Finance 22 (1998) 1089±1104 Venture capital growing pains: Should the market diet? Paul A. Gompers a,b, * a Harvard Business School, Morgan 483, Soldiers Field Road, Boston, MA 02163, USA b NBER, Cambridge, MA , USA Abstract This paper examines recent trends in the venture capital market and current research that explores the impact of these trends. High returns in the venture capital industry caused by the surging market for venture-backed initial public o erings and recent reductions in the capital gains tax rate have led to dramatic increases in venture capital commitments. This rise in fundraising has had dramatic e ects on various segments of the venture capital market which may indicate overheating. The terms and conditions of venture capital limited partnerships have changed re ecting the growth in demand for venture capital services. The share of pro ts retained by venture capitalists has increased while the restrictiveness of the partnership agreements has eased. Venture rms are raising substantially larger funds with increasing pressure to nd investments, thereby moving to later stage investments. The price of investments has also responded to the growing desire to increase investment. Finally, institutional investors are increasingly looking internationally for new investment opportunities in venture capital to avoid potential market excesses. Ó 1998 Published by Elsevier Science B.V. All rights reserved. JEL classi cation: G2; G3 Keywords: Venture capital; Fundraising; Asset returns Tel.: ; fax: ; pgompers@hbs.edu /98/$19.00 Ó 1998 Published by Elsevier Science B.V. All rights reserved. PII S ( 9 8 )

2 1090 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± Introduction Venture capital has attracted increasing attention in both the popular press and academic literature. The venture capital market has expanded its scope of investments and continues to grow at an astonishing rate. The recent growth of the venture capital industry has been accompanied by an increase in academic research that addresses issues related to its form and function. This paper examines the recent growth in venture capital commitments and its impact on market participants. I attempt to draw on academic research that explores the causes and e ects of these recent changes. While the paper examines academic research, its primary focus is empirical in nature. A substantial body of theoretical work has examined aspects of the venture capital market and is beyond the scope of this paper. Much of the theoretical exploration examines the role that venture capitalists play in mitigating agency con icts between entrepreneurial rms and outside investors. The improvement in e ciency might be due to the active monitoring and advice that is provided (Marx, 1994; Hellman, 1994), the screening mechanisms employed (Chan, 1983), the incentives to exit (BergloÈ f, 1994), the proper syndication of investment (Admati and P eiderer, 1994), or the staging of investment (Bergmann and Hege, 1997). This work has improved our understanding of the factors that a ect the relationship between venture capitalists and entrepreneurs, focusing on issues that are critical to the role venture capitalists play in the formation of new companies. This paper looks at the industry conditions that prevail today in the venture capital market and what e ect these conditions are having on the behavior of venture capitalists as well as the characteristics of transactions in the industry. I argue that the recent high returns in the venture industry resulting from the active initial public o ering market has spurred greater fundraising. The surge in fundraising during the past three years has put upward pressure on prices and led to massive increases in stock distributions to venture capital investors. Additionally, venture capitalists have responded to greater capital in a variety of ways. First, the relative amount of money invested in early stage companies has declined. Venture capitalists have also been able to increase their compensation and reduce restrictiveness of the limited partnership agreements that govern their investment behavior. In response to these changes, investors are increasingly looking abroad for investment opportunities. The current interest in venture capital by investors and policy makers leaves ample room for important research. First, establishing whether venture capitalists add value beyond relieving capital constraints is an important area of interest. If countries and states want to promote venture capital, what aspects of the venture market are most critical for insuring success of young, entrepreneurial companies? Similarly, establishing implementable recommendations for venture capital promotion is important. Finally, understanding the

3 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± portfolio implications of venture capital investing needs to be established. What is the ``true'' riskiness of a portfolio of a portfolio of venture capital investments? The rest of the paper is organized as follows. Section 2 discusses recent patterns in venture capital fundraising and analyzes their cause. The e ects of these fundraising patterns are analyzed in Section 3. Potential areas of future research are discussed in Section 4. Section 5 concludes. 2. Venture fundraising The venture capital industry has been characterized by high levels of variability over the past thirty years. The annual commitments in Fig. 1 represent pledges of capital to venture funds raised in a given year. This money is typically invested over three to ve years starting in the year the fund is formed. As Fig. 1 shows, prior to the late 1970s, very little venture capital owed into the Fig. 1. Commitments to the Venture Capital Industry. Commitments are de ned as the amount of money that are pledged to venture capital funds in that year. Amounts are in millions of 1996 dollars. Source: Venture Economics and Asset Alternatives.

4 1092 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089±1104 industry. The annual ow of money increased by a factor of ten during the early 1980s, peaking at just under six billion 1996 dollars. From 1987±1991, however, fundraising steadily declined. Over the past ve years, the pattern has been reversed represented a record fundraising year. The rst half of 1997 is running at level 80% higher than the previous record year. What accounts for these fundraising patterns and what are their consequences? Various factors may a ect the level of commitments to venture capital organizations. Poterba (1989) argues that many of the changes in fundraising could arise from changes in either the supply of or the demand for venture capital. Poterba stages that decreases in capital gains tax rates might increase commitments to venture capital funds not by increasing the incentive of individuals to invest in new venture capital funds, but rather by increasing the desire of workers to become entrepreneurs and thereby increasing the need for venture capital. The increase in demand due to greater entrepreneurial activity leads to a greater quantity of venture capital in the market. Gompers and Lerner (1997b) explore the issues empirically and nd that regulatory changes have had an important impact on commitments to venture capital funds. Gompers and Lerner nd support for Poterba's capital gains tax rate claim; lower capital gains taxes seem to increase the amount of venture capital by increasing the demand of entrepreneurs. The Department of Labor's clari cation of ERISA's prudent man rule in the late 1970s allowing pension funds to invest in venture capital has had a generally positive e ect on commitments to the industry by increasing the supply of funds. This policy change even seems more dramatic when one examines the composition of venture capital commitments. The rule change opened the door to tremendous capital resources. Pension funds controlled over $3 trillion by the end of the 1980s. Stocks and bonds performed extremely poorly during the 1970s, the same time that venture capital was earning in excess of 25% per year. Pension fund managers saw venture capital as a way to earn excess rewards. In 1978, a year in which only $218 million was raised by venture capital funds, individuals accounted for the largest share (32%) while pension funds supplied just 15%. By 1988 when over $3 billion was committed to venture capital, pension funds accounted for 46%, by far the largest share. The participation of individuals had fallen to the lowest fraction of new money committed (8%). Gompers and Lerner also nd that performance in uences fundraising. Higher returns lead to greater capital commitments to new funds. Fig. 2 shows that the annual return on venture capital has been quite variable. 1 In the early 1 As discussed below, the actual calculation of returns for venture investments and their correlation with other asset returns is problematic. New research is needed to improve these measures.

5 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± Fig. 2. Return on venture capital. The average annual internal rate of return on venture capital funds is plotted by year. Source: Venture Economics. 1980s, returns on venture investments were quite high. From the mid-1980s through early 1990s, however, returns were extremely low. Average returns on venture investments were largely in the single digits. Starting in 1993 returns increased substantially. These returns are largely driven by the strength of the initial public o ering (IPO) market. A Venture Economics (1988) study nds that a $1 investment in a rm that goes public provides an average cash return of $1.95 in excess of the initial investment with an average holding period of 4.2 year. The next best alternative, an investment in an acquired rm, yields a cash return of only 40 cents over a 3.7 year mean holding period. Black and Gilson (1998) argue that the health of the venture capital market is in fact dependent on the existence of a vibrant public market that allows new rms to issue shares. Fig. 3 makes this link even more explicit. The annual volume of fundraising is graphed along with the annual market value of venture capital-backed IPOs. Clearly, few rms were going public in the 1970s and very little venture capital was raised. The growth of the venture capital industry in the early 1980s was mirrored by a similar growth in venture-backed rms going public. The decline in fundraising in the late 1980s was actually preceded by a decline in the initial public o ering market. Finally, the growth in venture capital fundraising in the 1990s was also preceded by increases in the IPO market activity. This trend reinforces the linkages between the public and private equity markets. Many institutions, primarily public and private pension funds, have increased their allocation to venture capital and private equity under the belief

6 1094 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089±1104 Fig. 3. Venture capital fundraising and the IPO market. The bar graph shows real value of venture capital commitments in millions of 1996 dollars. The line graph is the market value of venture capital-backed IPOs. Source: Gompers and Lerner (1997b).

7 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± that the two sectors are largely uncorrelated. Once again, the di culty of calculating returns for venture capital investments can cause large problems for portfolio allocations. As the available data indicate, however, returns and investment activity in both sectors are intimately linked. To ignore the correlation is fraught with potential dangers. Another impact of the growing venture capital industry coupled with the strong IPO market is the growth in venture capital distributions. Venture capitalists can liquidate their position in a portfolio company by selling shares on the open market after it has gone public and then paying those proceeds to investors in cash. More frequently, however, venture capitalists make distributions of shares to investors in the venture capital fund. Many institutional investors have received a ood of these distributions during the past several years and have grown increasingly concerned about the incentives of the venture capitalists when they declare these transfers. Gompers and Lerner (1997c) examine how investors might be a ected by current distribution policy. They look at stock price reactions around distributions of equity by venture capitalists. Fig. 4 presents the cumulative abnormal returns for their sample of distributions. They nd signi cant increases Fig. 4. Stock price around distribution of equity by venture capitalists. The graph plots the cumulative abnormal return from 60 days prior to distribution to 120 days after distribution. Source: Gompers and Lerner (1997a).

8 1096 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089±1104 in stock prices prior to distribution. For the entire sample, cumulative excess returns for the six months prior to distribution are strongly positive, between +15% and +21% (depending on the benchmark used). Around the distribution, abnormal returns are a negative and signi cant )2.0%, comparable to the market reaction to publicly announced secondary stock sales. While the actual size and magnitude of post-distribution returns is sensitive to the benchmark, certain distributions are associated with substantial negative returns. 3. Venture fundraising and market dynamics The patterns documented in Section 2 have important implications for the operation and e ciency of the venture capital market. The changes in the venture capital industry indicate that the market is entering a period in which ``overheating'' is a potential problem. Whether the changes documented below will lead to severe retrenchment in the coming years is an open issue. Caution is, however, warranted when considering the current state of the market. One of the most dramatic e ects of the increase in venture capital fundraising is on the pricing of transactions in the private equity market. The argument is often made by venture capital practitioners that the amount of money owing into the industry can dramatically a ect the prices at which deals are done or even the likelihood that certain bad deals get funded. If there are only a certain number of worthy projects to nance, then a substantial increase in the amount of venture fundraising may increase the prices that are paid to invest in these companies These higher prices may ultimately a ect the returns on investment in the industry. Sahlman and Stevenson (1987) chronicle the exploits of venture capitalists in the Winchester disk drive industry during the early 1980s. Sahlman and Stevenson believe that a type of market myopia a ected venture capital investing in the industry. During the late 1970s and early 1980s, nineteen disk drive companies received venture capital nancing. Two thirds of these investments came between 1982 and This is the period of rapid expansion in Fig. 1. Many disk drive companies also went public during this period. Over $800 million was raised in public o erings by While industry growth was rapid during this period of time (sales increased from $27 million in 1978 to $1.3 billion in 1983), it is questionable whether the scale of investment was rational given any reasonable expectations of industry growth and future economic trends. Similar stories are often told concerning investments in software, biotechnology, or the Internet. The phrase ``too much money chasing too few deals'' is a common refrain in the venture capital market today. Gompers and Lerner (1997a) examine this issue at the industry level. They utilize a dataset of over 4000 venture investments between 1987 and 1995 developed by the consulting rm VentureOne, as well as detailed information on

9 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± capital in ows. Gompers and Lerner construct a hedonic price index that controls for various rm attributes that might a ect rm valuation including rm age, stage of development, and industry, as well as macroeconomic variables such as in ow of funds into the venture capital industry. In addition, they control for public market valuations through indexes of public market values for rms in the same industries and average book-to-market and earnings-toprice ratios. The results support contentions that a strong relation exists between the valuation of venture capital investments and capital in ows. While other variables also have signi cant explanatory power ± for instance, the marginal impact of a doubling in public market values was between a 15% and 35% increase in the valuation of private equity transactions ± the in ows variable is signi cantly positive. A doubling of in ows into venture funds leads to between a 7% and 21% increase in valuation levels. The overall price index can be seen in Fig. 5. The index is constructed such that the price level in the rst quarter of 1987 is set equal to 100. The index controls for di erences in the underlying deals in the venture industry. While prices rose somewhat in 1987, they declined and remained quite at through the 1990s. Starting in 1994, however, prices steadily increased. This increase Fig. 5. Price index of venture capital investments. The relative price of venture capital investments controlling for the attributes of the portfolio company. Source: Gompers and Lerner (1997d).

10 1098 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089±1104 coincides with the recent rise in venture fundraising. The regression results show that this rise in fundraising is an important source of the increase in prices. The results are particularly strong for speci c types of funds and funds in particular regions. Because funds have tended to become larger in real dollar terms, many venture capital organizations have attempted to increase the capital per partner and invest larger amounts of money in any particular investment. Firms have attempted to do this in two ways. First, there has been a movement to nance later stage companies (as discussed below) that can accept larger blocks of nancing. Second, venture rms are syndicating less. This leads to greater competition for making later stage investments. Similarly, because the majority of money is raised in California and Massachusetts, competition for deals in these regions should be particularly intense and venture capital in ows may have a more dramatic e ect on prices in those regions. The results support these contentions. The e ect of venture capital in ows is signi cantly more dramatic on late stage investments and investments in California and Massachusetts. The e ect of public markets, however, seems to be symmetric. Increases in public market prices increases all private equity prices, independent of region or stage of development. Gompers and Lerner also examine whether increases in venture capital in- ows and valuations simultaneously re ect improvements in the environment for young rms. If shifts in the supply of venture capital are contemporaneous with changes in the demand for capital, their inferences may be biased. They show that success rates ± whether measured through the completion of an initial public o ering or an acquisition at an attractive price ± did not di er signi cantly between investments made during the early 1990s, a period of relatively low in ows and valuations, and those of the boom years of the late l980s. The results seem to indicate that the price increases re ect increasing competition for investment. A second major e ect of the increase in venture capital fundraising is on the structure of venture capital limited partnership agreements. These agreements, which govern approximately 80% of venture capital commitments in the US, are often held as model organization forms (Sahlman, 1990; Porter, 1992). The contracts spell out the compensation and conditions that govem the relationship between investors (limited partners) and the venture capitalist (general partner). Gompers and Lerner (1996, 1997d) show that relative negotiating power has an important impact on the terms and conditions in venture capital limited partnerships. Compensation and covenants are critical for aligning the incentives of venture capitalists with those of investors. The limited partnership organizational form places restrictions on the ability of investors to intervene in the dayto-day activities of the venture fund. Few of the common corporate control mechanisms, e.g., active boards of directors or a market for corporate control,

11 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± are utilized in venture limited partnerships. Consequently, the signi cance of contractual speci cations in the partnership agreement are paramount. In the current fundraising environment, established venture capital organizations have the luxury of raising new funds with little e ort. In fact, their most di cult job is often determining how to ration the intended investment of potential investors. In these situations, the venture capitalist can raise money on his own terms. Funds raised over the last several years are witnessing large increases in fees with a concomitant reduction in the number and restrictiveness of covenants. Institutional investors have little recourse if they want to continue investing in private equity. If they refuse to invest, many others will step in to take their place. The importance of this shift in the balance of power is critical in the future health of the industry. The change in fundraising has also changed the investment strategy of venture capital rms. As rms continue to raise larger and larger funds, the amount of capital per partner continues to grow. This leads to increased pressure to make larger investments. Any given partner can only monitor a certain number of deals and e ectively serve on only a limited number of boards. This means that general partners need to make larger investments. Gompers (1995) documents the pattern of larger investments. The venture capitalists increase investment size in two di erent ways; by reducing the size of their investment syndicate and by moving towards later stage investments. Venture capitalists often syndicate their investments with other venture organizations. Instead of making the entire investment itself, a venture capital rm would typically bring in several other venture rms to aid in the due diligence, provide additional insights, and help monitor the rms progress. These tended to improve the quality of the investments as well as to diversify the risks over a larger number of investments. In the current fundraising environment, however, venture capitalists often reduce the size of the syndicate or even make the entire investment themselves. This allows the rm to put more capital to work more quickly. It may also, however, have detrimental e ects on the quality of investments. Venture organizations are also increasing the size of investment by shifting their focus to later stage companies. As Fig. 6 shows, the relative amount of capital committed to early and seed stage companies has steadily declined. Early and seed stage rms require smaller investments than later stage rms. If a venture capitalist move ``upstream'', he can make larger investments. While this puts more money to work, it may create a nding gap for early stage rms. Many industry observers have expressed concern about this pattern and have argued that new e orts should focus on developing early stage funds. Without early stage capital, there may be a capital gap for young, emerging companies. This may ultimately reduce the number and quality of later stage investments. Lerner (1998) argues that the free market is already addressing this problem in new and innovative ways.

12 1100 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089±1104 Fig. 6. Fundraising by venture capital organizations and investments in early stage rms. Venture capital fundraising is the amount committed to funds raised in the given year. Early-stage distributions are the amount of money invested in early or seed stage companies in the given year. Source: Asset Alternatives and Venture Economics.

13 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± The trends in the US venture capital market have led institutional investors to reduce their dependence on the US market. Increasingly, investors are looking for private equity alternatives abroad. The di culty is, however, that outside of the US, there is little venture capital. Black and Gilson (1998) argue that the key source of the US markets competitive advantage in private equity is the existence of a robust initial public o ering market. Venture capitalists can commit to transfer control back to the entrepreneur when a public equity market for new issues exists. This commitment device is unavailable in bank centered markets like Germany and Japan. 2 Jeng and Wells (1997) do an extensive empirical examination of factors that in uence venture capital fundraising in 21 countries. They nd the strength of the IPO market is an important factor in the determinant of venture capital commitments, echoing the conclusions of Gilson and Black. Jeng and Wells nd, however, that the IPO market does not seem to in uence early stage commitments as much as later stage commitments. Finally, Jeng and Wells nd that government policy can have a dramatic impact on the current and longterm viability of the venture capital sector. The paper argues that future work is needed before policy can be implemented. The di culty for US institutional investors interested in international private equity, however, is the ability to nd experienced managers in other markets. Few of them exist. Similarly, many countries, especially those in Continental Europe, have few exit options and private equity managers often nd themselves with portfolios of companies that they cannot liquidate. A challenge for the venture capital industry is how to clone the US success and transport the model abroad. Clearly, the interest on the part of institutional investors as well as government policy makers is quite high. Unfortunately, very little is known about implementation and public policy. 4. Areas for future research While the discussion above emphasizes recent work on the dymamics of the venture capital market, there are clearly many opportunities for further investigation. For example, little is known about the relative performance of similar private companies that received and did not receive venture capital - nancing. Many rms take an active policy to avoid venture capital because they feel that the terms venture capitalists impose are too costly for the company. 2 The de nition of venture capital is quite di erent in Europe and the US. In Europe, venture capital refers to all private equity including buyout, last stage, ard mezzanine nancing (which represent the majority of the totals). In the US, these are separate classes.

14 1102 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089±1104 Amit et al. (1990a, b) argue that many of the better rms will choose to opt out of the venture capital market in this situation. Is this the case? Do rms with better opportunities really avoid venture capital? What role does the venture capitalist play? Similarly, little is known about the true industry risk-return characteristics. Industry convention is to hold all investments at investment cost until a subsequent investment causes a revaluation of the company. This ``staleness'' of the portfolio value severely dampens the true volatility in venture capital returns. The inability to observe underlying values also severely reduces computed correlations between private equity market returns and public equity market returns. A more comprehensive examination of the returns' pattern in venture capital, correcting for the lack of price observability would be important for institutional investors who must decide how to allocate their investment portfolio. In addition, while recent work has examined international patterns of venture fundraising, no work has yet undertaken a study of the relative e ciency of the technological innovation process in di erent nancial systems. Is the US venture capital model really superior to the Japanese model of innovation within a large company? What are the critical elements of success in each market? Merton (1995) has argued that the actual institution is not the important element of the nancial system, it is the function, The same economic function can be performed by di erent institutions in di erent markets. Research that could examine relative e ciency would be very important for policy decisions. A careful examination of the e ects of nancing patterns on the rate and pattern of technological innovation is a fertile area for future research. 5. Discussion and conclusions This paper has examined the patterns in venture capital fundraising and their e ect on the structure and function of the US venture capital market. The extreme volatility of fundraising has not gone unnoticed. Numerous industry observers have expressed concern about the impact of these shifts on the pace and direction of technological innovation by US rms. (For a summary of many of these discussions, see National Advisory Commission on Semiconductors, 1989.) Recent research has documented important e ects of these fundraising cycles. The cycles a ect pricing and rate of investment, the discipline of venture capital rms, and the relative bargaining strength of venture capitalists. While these patterns are shown to be present, the present research does not argue for e orts that actively reduce fundraising. Institutions are already responding to current market conditions by looking for alternatives to the American private equity market.

15 P.A. Gompers / Journal of Banking & Finance 22 (1998) 1089± Similarly, none of the existing research indicates that current funding levels are too high. Recent returns on venture capital have been high and many successful new technologies are being developed and commercialized. In many ways, the record fundraising comes at a time when the breadth of technological opportunities is much larger than it has ever been. Advances in communications, computers, the Internet, and bio-medical sciences have broadened the potential areas of investment and increased the ability of the entrepreneurial sector to absorb more private equity. In addition, the venture industry is more experienced now than it has ever been. Most venture capital general partners have a decade or more of experience. Fund tracking organizations have made the ability to benchmark performance easier and more e cient. While the research may not argue for reducing venture capital, clearly more research is needed to assess its impact on a broader level. The industry is often held up as a key source of America's competitive advantage. Understanding how that competitive advantage operates and why it has been so successful is a challenge for future research. Acknowledgements I would like to thank Josh Lerner for helpful comments. Discussions with Felda Hardyman and Bill Sahlman were invaluable to generation of ideas in this paper. Research support was provided by the Department of Research Harvard Business School. References Admati, A., P eiderer, P., Robust nancial contracting and the role for venture capitalists. Journal of Finance 49, 371±402. Amit, R., Glosten, L., Muller, E., 1990a. Does venture capital foster the most promising entrepreneurial rms? California Management Review, 102±111. Amit, R., Glosten, L., Muller, E., 1990b. Entrepreneurial ability, venture investments, and risk sharing. Management Science 36, 1232±1245. Berglof, E., A control theory of venture capital nance. Journal of Law, Economics, and Organizations 10, 247±267. Bergmann, D., Hege, U., Dynamic venture capital nancing, learning, and moral hazard. Working paper. Yale University, New Haven, CT. Black, B., Gilson, R., Venture capital and the structure of capital markets: Banks versus stock markets. Journal of Financial Economics 47, 243±277. Chan, Y., On the positive role of nancial intermediation in allocation of venture capital in a market with imperfect information. Journal of Finance 38, 1543±1568. Gompers, P.A., Optimal investment, monitoring, and the staging of venture capital. Journal of Finance 50, 1461±1489.

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