Where the Next Big Bets Lie for Venture Capitalists

The venture capital sector is finally bouncing back from its post-bubble blues, although it’s still a long way from the euphoria of the late 1990s. Blockbuster deals — like YouTube’s recent sale to Google for $1.65 billion and Skype’s sale last year to eBay for $2.6 billion — are giving venture investors new confidence in their ability to cash out, said a group of venture capitalists who spoke on a panel at the 2007 Wharton Economic Summit. In addition, new sectors like “clean tech,” an umbrella term for environmentally friendly technologies, and trends like the aging of populations in the developed world are creating promising investment opportunities.

Even so, times remain challenging for many venture capitalists, the panelists warned. According to David Mathias, a managing partner at the Washington, D.C.-based Carlyle Group, “15% of the firms have provided something like 90% of the returns.” One leading firm, Sevin Rosen in Dallas, Tex., decided last year to abort plans to raise money for a new investment fund, telling its investors that the industry’s business model was broken. The New York Times called the decision “a kink in venture capital’s gold chain.”  

Contributing to industry-wide woes is the fact that many more venture capitalists are fighting over a smaller pool of money and deals. “A lot of firms flowed into the sector during the bubble,” said Doug Given, a partner with Bay City Capital in San Francisco. According to a report by the National Venture Capital Association and PricewaterhouseCoopers, venture investors committed $25.5 billion in 2006, which is less than a quarter of the amount of money invested in 2000. “We’re at mid-1990s funding levels,” Mathias added. “Compare that with the bumper years that hedge funds and private equity have recently had.”  

The association report, a quarterly publication called the MoneyTree, did identify bright spots for the industry. Investments in biotechnology and medical device companies hit record highs in 2006. And China and India have begun to generate a flood of deals. The two countries accounted for about $2 billion of venture investment in 2006.

Turning the Spigot Back On

Even before the Internet bubble and post-bubble swoon, the venture-capital sector offered rollercoaster returns. Its investors take hefty risks — typically backing unproven companies with unproven products or services — and often end up losing money. “Two-thirds of VC-backed companies provide zero return,” Given noted. But when they win, they win big, which compensates for all the flops. Such storied firms as Google, Genentech and Apple Computer were originally venture funded.

Successes like those plus venture capital’s uniquely American culture led Mathias to predict that, sooner or later, the sector would come roaring back. “The theory of venture capital is eternal: You build companies and create wealth,” he said. “And here in the U.S., we have the entrepreneurial spirit, the role models, available capital and a culture of innovation.” Add to that some of the world’s best universities, which incubate a number of technological breakthroughs, and American venture capital firms should continue to be leading players, even as the business globalizes.

Culture doesn’t matter, however, if money isn’t available to back startups. But Peter Kash, chairman of New York-based Two River Group Holdings, predicted that the money spigot would reopen soon, too. Investors who have traditionally shied away from venture capital, like rich families, have begun to show interest in the sector, and wealth is growing around the globe. “Worldwide, there are 70,000 people with at least $30 million in assets each. And there are 950 billionaires in the world, with a total of more than $3.5 trillion in assets.”

Of course, these people, like prior investors in the sector, will expect generous returns on their money. The riskiness of venture deals demands that, Mathias pointed out. “If the capital markets return 8% on average, then venture capital has to return a substantial premium over that. So you will need to have expected returns of 20% to 25% and actual returns of 17% to 18%.”

Where are investors seeking these kinds of returns today? The Internet, though not the darling it was a few years ago, still gets attention, thanks to the advances in online video that, for example, powered YouTube. “Video is a key driver right now,” said Roland Van der Meer, co-founder of ComVentures in Palo Alto, Calif. “There is amazing technology coming out of MIT, Stanford and Cal Tech addressing problems like, ‘How do you render video differently and how do you insert ads in real time?'”

Clean tech, for its part, represents a host of technologies and has been propelled by widespread public concern over carbon emissions and global warming. Given the scientific consensus that human-produced pollution has heated the world, established companies are seeking ways to reduce its impact and startups are offering up all kinds of environmentally friendly alternatives.  

Consider the electric power industry, Given said. The grid of lines that delivers power to homes and businesses is inefficient and aging, and many of the plants that generate the electricity flowing through it use coal. “That format won’t work in India and China,” he said. “There, we will need to have clean energy close to populations. It took 75 years to industrialize 20% of the world’s population. In the next 25 years, we will industrialize 40% more.”

Fighting over Water

Kash predicted that global warming would alter the ways in which many businesses, not just power producers and car makers, operate. “We are already seeing the impact of global warming. In Europe, the big ski companies and chalets are dying. There was very little snow in the Alps this year.”

Environmental problems besides global warming could also create investment opportunities, he said. “For 4,000 years, people have fought over commodities. In the future, it will be clean water that they will be fighting over.” In some parts of the world, like the Middle East, countries already are running short of fresh water and have begun to turn to desalinization. As demand for potable water grows, especially in the developing world, private firms will have a greater role in its delivery.

In the developed world, health care, ranging from biotechnology to medical devices, remains an attractive field for venture investors and, because of demographic trends, will likely remain so for decades. “The aging of the baby boomers and increasing life expectancy are key drivers,” said Given, who began his career as a physician and medical researcher. “Corporations are trying to address rising health care costs. That’s a driver, too.”

The emerging field of personalized medicine also holds promise, although it’s still nascent, he noted. Advances in genetic science should eventually enable scientists to identify people prone to develop certain diseases years before they do so. In theory, researchers should then be able to devise treatments tailored to these people and their illnesses. “You will be able to identify patients who will benefit from so-called designer drugs,” he said. With early notice, a person could pay for her treatment over years or even decades as opposed to all at once, as is typically the case now.

Ironically, wealth and easy living have been a mixed blessing in the developed world. People are living longer, but they are also developing ailments of affluence, like obesity and diabetes. Treating those, too, should lead to opportunities for entrepreneurs and the venture firms that fund them.

Over the short term, Kash suggested that investors seek out companies developing cancer drugs. Cancer is already the second leading cause of death in the United States, behind heart disease. And its profile is about to get a big boost. For the first time, he pointed out, four presidential candidates, or likely candidates, have either had cancer or have a spouse who has. They are Rudy Giuliani, who had prostate cancer; Fred Thompson, who had lymphoma; John McCain, who had melanoma; and John Edwards’ wife, Elizabeth, who has breast cancer.

Increased visibility should lead to more funding for research on the disease, and it shouldn’t matter which party ultimately wins the White House. Cancer, Kash said, “has no prejudice between Democrats and Republicans.”

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