The bursting of the Internet bubble, several years of unfriendly public markets, and changes in Wall Street and financial regulations have been hard on venture capital over the past decade. But not all the pressures facing the industry are external, especially in Silicon Valley. The venture community there is showing signs of middle age — moving more slowly and cautiously than before, and hitting fewer home runs than it did in younger, leaner days. As a result, experts say, the sector is having trouble producing the robust performance long associated with it. This means investors need to look at venture capital, and its impact on their portfolios, in a new way.

For context, consider that back in 1995, Fortune magazine published a story questioning whether venture capital was getting too big and institutionalized to do what it did best: Generate big returns for investors by finding an entrepreneur in a garage with a good idea, and giving him the money and support needed to grow. One sign of this unhealthy bigness, according to the article, was that the industry had raised an unprecedented $5 billion in 1994. By comparison, VC firms raised $7.5 billion in the first half of 2010, according to Dow Jones LP Source.

To observers, the 2010 number represents both a comeback (firms raised nearly $1 billion less in the same period last year) and a rightsizing (the companies raised more than $14 billion in the first half of 2008, which is startling given the downward slide on Wall Street and in the economy as a whole later that year.)

But the criticisms in the Fortune article — that increasingly fat funds and accompanying fees were changing the venture firms’ business model, and that the more money VCs raise, the harder it is to find companies that can generate big enough returns — still hang over Sandhill Road (the Menlo Park, Calif., street where a number of firms are located). In 1995, $250 million constituted a “mega-fund”; today, it’s not unusual for a single firm to have more than $1 billion under management (via overlapping funds) or for a single fund to be $500 million or more.

This time around, the VC community is also faced with a potent cocktail of high purchase valuations, long holding periods and cheaper exits, which are knocking the firms for a loop. But those problems would go away, or become smaller, if fund sizes shrank. “The capital overhang has fluctuated a bit, but for the most part there is still a huge amount of money out there,” says Bo Brustkern, a former venture capitalist who now runs Denver-based valuation firm Arcstone Partners. “It’s a problem because it means that there’s always money flowing through. Institutional investors look at the top 25 firms and can’t get in. They look at the next 25, and they’re closed [too], so you go to the next 25 and on downward until you find a firm to put your money into.”

All of those firms — the excellent, the good and the so-so — compete to place their cash into companies that need large venture investments, and that have the potential to multiply them several times over. The trouble, of course, is that “there are not a lot of places to put $30 million,” notes Chris Sacca, one of a handful of an emerging group of “super angels” who are raising small funds (anywhere from a few million dollars up to about $100 million) and investing in startups that need thousands of dollars, rather than millions, to get where they need to go.

The competition to buy is keeping valuations inflated, according to experts. And the need to invest in six-figure chunks often means coming on board later in a startup’s life cycle, when there’s less risk and more ability to put large amounts of money to work. But at that point, it’s also harder to attain the multiples the firm’s investors, or limited partners, have grown used to.

Moreover, the bigger the funds get, the less the general partners’ financial interests are aligned with those of their investors. This is because firms get the same 1% or 2% annual management fee and 20% of returns (the “carry”) that they did when their funds were much smaller. The carry was supposed to be how they made money, while the annual fee was meant to cover operating expenses during the years the money was being invested. But those expenses aren’t likely to be three or five or seven times bigger just because a firm’s latest fund is. So management fees have become an important source of profits for VC firms, especially those that have posted weak and negative returns to their investors in the post-2000 years. “Fund size is down, but not dramatically; they’re still oversized because of that fee addiction,” notes Sacca.

Long-term Trends

This is not to say that the venture industry’s days are numbered or that bushy-tailed entrepreneurs aren’t finding the capital they need; far from it. But “the flow of new funds to VCs is constricting and the industry is consolidating,” says Wharton professor of entrepreneurship Raffi Amit. In 2009, there were still more VC firms than there were in 1999, according to the National Venture Capital Association, but there were 10% fewer venture professionals and 15% fewer funds. This signals that “the dead wood is working itself out of the industry finally,” Brustkern suggests. “You have all these firms that are victims of the delayed or never-happening exit. They invested in their companies years ago, and aren’t getting fees anymore and haven’t raised a new fund, but have a fiduciary responsibility to keep their doors open until the fund winds down. They’re the walking dead.”

Yet the industry is seeing plenty of the long-term trends and disruptive technologies that create opportunities.

The life science sectors in the United States are still robust, and cleantech — including clean energy, and environmental and green products and services — is providing an entirely new and promising channel for venture money. Moreover, these companies seem well suited to receive money from today’s bigger VC funds, notes David Wessels, an adjunct professor of finance at Wharton. Taking a new drug, medical device, or wind or solar technology from conception to market requires time and sizable sums of money. But the payoff on a breakthrough biotech therapy can be sizable. And cleantech companies have been able to do the nearly impossible lately: generate excitement in a depressed IPO market, as evidenced by Tesla’s recent first-day run-up. “Tesla is a bellwether that people are interested in these alternative energy technologies,” says Robin Vasan, a managing director at Mayfield, a Menlo Park, Calif.-based VC firm that has three energy technology companies in its portfolio.

Meanwhile, Anthony Hoberman, who advises investors on venture investments at Glenrock Capital Advisors in New York, points out that several technology trends — including the rise of wireless communication, social media platforms like Facebook, and cloud computing services for businesses and consumers — are creating “an environment where venture capitalists tend to do well.” The firms “invest in small companies that use their agility to overtake bigger, well-funded companies,” he adds. “That agility is the advantage the VCs exploit, and it’s no good during periods of slow, predictable change.”

Vasan, whose focus is software investments, concurs. The growth of social media, smartphones and tablet applications, and web-based software products for consumers and businesses are “probably five to ten year trends,” he says. “Bets have been placed over the past year and more bets will be placed over the next year or two.”

Adjusting Expectations

But finding companies that are interesting and viable, and that will earn a good return for their founders, is not the same as identifying companies that will provide the multiples that venture investors are seeking.

Conventional wisdom says that a VC firm has to expect about half of the companies in its portfolio to fail, a few to earn decent returns and one or two to hit home runs big enough to make the numbers work. Without a robust IPO market, however, those out-of-the-park homeruns are few and far between. The majority of VC-backed companies have been acquired in the past few years. Unlike with an IPO, where the sky is the limit if a company can generate enough buzz, there is a cap on how much an M&A deal is likely to net. With so many science and technology companies looking for acquirers, flusher buyers like Google, Amazon, Yahoo!, Microsoft and Johnson & Johnson can hold prices down.

All in all, the exits VCs are managing to secure, even via the public markets, don’t put them ahead of their losses and fees by big enough margins. “You can’t have six failures if your successes are going to have a cap on them,” Wessels points out.

Look at the recent numbers: Venture-backed companies that went public in this year’s second quarter took a median of 9.4 years to achieve liquidity, according to Dow Jones VentureSource. The $70 million median amount of venture capital these companies raised prior to liquidity was 65% higher than even a year ago.

Meanwhile, in that same 2010 quarter, 15 IPOs by venture-backed companies raised $899 million, according to Dow Jones VentureSource. Seventy-nine M&A deals raised $4.3 billion in the same quarter. The IPOs had an average value of just under $60 million, while the M&A deals averaged only slightly less at $54 million. If one doesn’t count Tesla, which raised large sums even by today’s standards and accounted for $202 million of that IPO money, the 14 remaining deals only averaged $50 million apiece, trailing the M&A deals — hardly the grand slams the sector needs to get its numbers up.

The dot-com bubble “is becoming a distant event, and falling off the horizon for return calculations,” Amit notes. Indeed, 2009 is the first post-bubble year to exclude 1999 from 10-year returns. Returns fell last year to a 1% loss, from a 35% gain as of the end of 2008. Five-year returns managed to outpace the public market indexes but still barely topped 4%. These are average numbers, but, Amit says, “most funds today are showing negative returns to their limited partners.”

For returns to pick up, “valuations have to come down, exit values have to go up or holding periods have to get shorter,” Hoberman suggests. None of these events is likely to happen quickly, which means investors need to adjust their expectations. Reaping 30% returns is “unrealistic for any unleveraged investment,” says Wessels, who believes funds can easily keep pace with the public markets, but didn’t offer a prediction as to whether they could consistently beat them in the foreseeable future.

“Go back to 1990s and venture capital was about starting a company, making it large enough to have an impact on its own and taking it public so it would be Wal-Mart or Procter & Gamble in 20 years,” he says. “Lately, it’s becoming a surrogate for internal R&D. Start-ups set out to build a product from scratch, prove it has legs with a small market and get swallowed by a larger company.” So why invest in these illiquid, high-risk funds? “For diversification,” he notes. “You’re betting on stable returns and the opportunity to already be in the game in case something develops that will be the next big thing.”