Venture Capital: The Art of Picking the Few from the Many

Venture capital (VC) has never been a mega-industry, but many who work in the sector seem happy with the current state of affairs.

VC funds raised $20.6 billion in 2012, Thomson Reuters reported, but this amount is dwarfed by the $311 billion that was raised by the private equity industry, including venture capital, in 2012, according to research firm Prequin.

The sector has also had some recent ups and downs in terms of fundraising. The latest figures show that the VC industry has shrunk since raising $25.6 billion in 2008, but is recovering from the depths of the financial crisis in 2010 when fundraising fell shy of $14 billion.

When it comes to looking ahead to the future of the VC industry, speakers on the venture capital panel at Wharton’s 2013 Private Equity & Venture Capital Conference were optimistic about producing strong returns for their investors despite a “new normal” that may leave the industry with less money to work with for the foreseeable future.

“In some ways, [our relatively small size as an industry is] a good thing, because venture capital as an asset class is hard to scale,” said Imtiaz Kahn, principal portfolio manager for pension and endowments at The World Bank. As an investor looking for promising VC funds, Kahn realizes that the business of investing in young companies is inherently difficult and risky. The key to success is taking care in picking the few really good opportunities from the many, he noted, and remembering that there are always some stars whether the market is growing or shrinking.

Since venture capital is so inherently risky, it is hard to generate consistent returns over the long term, which keeps investors from pouring assets into the sector, Kahn said. “It’s difficult. You want to go with the best-returning funds, and those are limited…. The bar is really high for adding a new fund to our portfolio. We haven’t added a new venture capital firm in a few years.”

Limited funding for the industry does have its benefits, added Michael F. Bigham, a partner at Abingworth, a VC firm with offices in London, Menlo Park, Calif., and Boston that specializes in life sciences and health care. There are still plenty of young firms to invest in and prices are good, he said, and if too much money were to flow into the industry, prices might increase to the point where it is difficult to make profitable investments. Over the long term, conservative funding will be “very healthy” for the industry, Bigham noted, predicting good returns over the next five years.

The VC Funding Evolution

Funding for the VC sector has evolved in recent years, leaving what some describe as a barbell-shaped industry — a few very large funds, a lot of very small ones and little in between. “There is a paucity of $100 million to $500 million funds,” said Matt Harris, managing director of Bain Capital Ventures, the venture operation at Bain Capital. Only a few years ago, most funds fell into this mid-sized category, he added.

The recent trend toward very big and very small funds has occurred because limited partners have been attracted to the high-performing funds, which has helped them grow even larger, while others have moved to small funds that operate in niches that are too modest to soak up money, explained Harris.

Large investors, such as pension funds, gravitate to the big VC operations because it is too difficult for these investors to perform due diligence on a large number of small funds, Kahn added. Meanwhile, the very small funds are big enough to serve the needs of wealthy individuals and families, he said.

New Opportunities

While money is tighter than it once was, panelists at the Wharton conference agreed that investment opportunities abound.

“All the Wall Street guys who used to brag about the cool restaurants they were invested in are now bragging about the tech companies they are invested in,” joked panel moderator Brett Topche, managing director of MentorTech Ventures, a seed- and early-stage venture capital fund that invests in companies that emerge from the University of Pennsylvania.

New companies in need of VC support are springing up at a rapid clip, said Harris. “Many of our young people are deciding to be entrepreneurs,” he noted. “It’s a wonderful thing.”

This rise in entrepreneurship is due to the fact that it is now fairly easy and inexpensive to start a software company, explained Adam Enbar, a team leader at Charles River Ventures, a Boston and Menlo Park, Calif.-based VC firm focusing on technology and new media. Many tech start-ups, for instance, are developing applications for smartphones and tablet computers, he said.

This environment can be challenging for a VC fund trying to separate the good opportunities from the bad. Some start-ups are jumping on the bandwagon, trying to cash in on an idea that has already been successfully developed by another firm, Kahn noted. “I think that’s sometimes concerning,” he admitted.

While Harris agreed that there are many “me too” ideas in the market, he cautioned investors against immediately writing off a young firm with an unoriginal idea. Original ideas can begin to surface once a company starts making progress, he said. “One thing we know about entrepreneurs is that where you start is sometimes very different from where you end,” he noted.

VC funds can also find opportunities in markets that don’t have a lot of “pizzazz,” Harris pointed out. For example, over the last decade Harris has been working with firms that are developing alternative payment systems, such as variations of PayPal for retailers, which provide easier business-to-business transactions. He has also been looking at ways to use new types of data to underwrite consumer and business lending. “I do a lot of payment stuff. I think there are many more chapters to that book,” he said.

The panelists also discussed the rise of New York City as a tech center that is challenging Silicon Valley. “You don’t have to be in Silicon Valley anymore,” Enbar noted.

Twenty years ago, a tech start-up would have had a tough time hiring engineers and finding capital if it was not in Silicon Valley, Enbar added. But in recent years, start-ups have begun to think more about where their customers are located. “If you’re thinking about where your customers are, more often than not they’re in New York.”

A Word of Advice for Young Entrepreneurs

Topche asked what advice the panelists would give to young people interested in starting companies, or in joining start-ups.

“Find a company that’s exploding,” said Enbar, observing that it is fairly easy to start a business but difficult to make one grow. Though the idea of joining a firm with only five employees may seem appealing, “more likely than not you’re just going to learn how a company fails,” he noted.

Young entrepreneurs should also think about their firm’s long-term prospects, Enbar added. “Don’t work on problems that are difficult and unimportant,” he said. “If you’re going to do something, make sure you’re solving a problem that will keep you going beyond the [VC backer’s] exit.”

Harris said that when he thinks about whether to back a young firm, he looks for what drives the entrepreneur, favoring ambition that originates with “a life lesson, not a whiteboard.” He prefers individuals who are focused on an idea, not just on getting rich.

“In the absence of an authentic impulse to go build something, don’t build something,” he advised. Instead, “join a company that’s already building something.”

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