Sunday, June 28, 2009

Invent...According To Craig Barrett And Others...The Way Out Of This Mess...And Where Did Venture Capital Go, Really?

Thomas Friedman, a NY Times columnist and also a best-selling author (Hot, Flat and Crowded, among other things) recently published an article entitled "Invent, Invent, Invent" which is anchored largely by his interview with Craig Barrett, former Intel Chairman while the two were at a conference in St. Petersburg, Russia.

According to Friedman, Barrett and others (Jeff Immelt from GE is also quoted) the financial adversity we are facing allows America, "with its unrivaled freedoms, venture capital industry, research universities and openness to new immigrants, has the best assets to be taking advantage of this moment - to out innovate our competition."

Barrett goes on to end, "sometimes I worry, though, that what oil money is to Russia, our ability to print money is to America. Look at the billions we just printed to bail out two dinosaurs, General Motors and Chrysler."

I think this is interview represents an excellent viewpoint and I will now stop paraphrasing the can read it yourself by following the link below.

My partners at Arrowpoint ( and I generally agree with what is being said here, and we have been making similar observations for the past year or so in private meetings, conferences and in statements to the press. But when Barrett highlights venture capital, a subject that my partners and I believe we understand intimately well, I feel compelled to offer some disagreement.

Venture Capital In America Today

As with most intellectual endeavors, venture capital (VC) describes a concept, a plan and that plan's execution. I am confident that the VC CONCEPT is as robust today as it was when the Knights Templar came up with it in the 1100's. Back then it might have more aptly been called Ad-venture capital. And Columbus did pretty well with Ad-venture capital provided by Spain's Queen Isabella.

The concept is shockingly simple. Find a nascent enterprise which has the promise to change the world in an important way, put small amounts of (ordinarily borrowed) capital to work to allow the enterprise's leaders to acquire resources, help them as best as is possible and then monitor their progress. If things work out as desired then the world, the enterprise and its backers all prosper. If the venture doesn't fare well, then investors, if they are prudent, will stop supporting it well before all the capital disappears. As a concept, VC has always been and will continue to be a compelling business idea.

The PLAN for VC is equally simplistic. A successful enterprise will grow, create new employment, stimulate R&D, expand markets, develop a loyal customer base and eventually, it will be worth many times the initial investment. The liquidity that ultimately arrives (and this can take much patience) has the potential to make all the enterprise's constituents prosperous.

EXECUTION is the nightmare. In VC (as it has been through the ages) there are so many elements that can scuttle the best plans. If investors select the wrong investment subject, or imprudently deploy too much capital into a company, they can be annihilated. Conversely, if the enterprise is under funded, it may wither and die. The best designed products are often riddled with costly defects. Markets may not develop, for many, sometimes uncontrollable reasons (including the economic environment.) Competition is a necessary but potentially deadly evil. The management team directing the enterprise may turn out to be berserk, or merely incompetent. Candidly, there is so much that can go wrong with a VC backed company that it makes this investment area one of the riskiest on earth. Yet when it works well, the results are magnificent.

Ironically, since the problem categories involved in VC are generally well-understood, and the capital under management is normally extremely limited, the systemic risks to society are highly constrained and the systemic benefits have historically been well worth the risks. If contrasted with other investment classes such as exotic or derivative securities (one small example) where the risks are very misunderstood and the capital (with the government's help) is seemingly limitless, VC looks like a walk in the park.

Nevertheless, much has been written about VC and its performance during the past decade or so. Some argue that the financial returns to limited partners have been so dismal that the entire industry has become dysfunctional. Others say that this is just a cyclical phenomenon. There are many opinions and apologies out there but I think if we layer the issues, a clearer image emerges. And let's just assume that the VC that Mr. Barrett speaks about, that which sparks innovation, concerns only early-stage and early-emerging organizations (those that have their feet on the ground but can't get running just yet.)

Issue #1 (The Cornerstone) The industry has raised $100s of billions from their limited partners (predominately large institutions) and this is far too much money for true, early stage VC.

Issue #2 (Excessive Greed) The general partners who manage VC firms almost always charge a management fee, which is a percentage (customarily 2-3% per year) of the institutional capital committed to the VC firm. You can do the math here. If a fund, with say 5-10 partners manages $500M or $1B at a crack (and several funds within a firm can and do coexist...I call that "cascading,") then the general partners can become pretty rich without returning one cent to their investors.

Issue #3 (Limited Supply) There simply aren't enough early stage companies around that can absorb all this capital. For the best opportunities, in the past, VC competitors bid up prices to the point where it may be hard to ever see an investment return. Often the VC firms (collectively) attempt to plow too much money into the exceptional opportunities because they want to increase their investment allocations, with respect to the numerator governed by fund size.

Issue #4 (Swimming Upstream) VC partners are usually smart about most things (often in hindsight) and they have, for a while now come to grips with the three issues listed above. Accordingly they have often sought investments like buyouts, building manufacturing plants, and such that were usually appropriate for large corporations and/or investment vehicles organized for those purposes. But in years past, we've seen VCs pour $50-$100 million in trying to build a chip fabrication plant or for that matter, a Segway scooter that never had a viable market.

Because the investment funds need to be spent in order to justify all those management fees, and since usually there is a pretty tight timetable to disburse investment money, many VC firms who traditionally embraced early stage markets changed their business footprint to accommodate larger deals, even though they may not be qualified for this new business model. In fairness, some VC firms recognized their dilemma and returned unused capital back to their investors, the limited partners.

Issue #5 (Money For Early-Stage Investments Is Now Scarce) I think we can take that as a fact not only because it makes logical sense, but also because many (perhaps most) early-stage entrepreneurs are screaming about it.

What Is Happening Now And What Might Happen In The Future?

1. There are numerous excellent, former VC firms who have successfully made the move upstream, and I believe that they ought to stay there because the early-stage dynamics and investment profile no longer fits their fund sizes or their business temperament.

2. The financial press has reported that other, well-established firms are unable to secure limited partner commitments for future funding. Essentially, this means that those firms will slowly wind down.

3. Some new early-stage firms may spring up to fill the void. Their parameters regarding (small) fund size will be very strict, and they will avoid capital-intensive investment opportunities. In all likelihood, they will require a longer timetable for making initial investments. Moreover, I suspect that they will be pretty stringent when pressed for additional capital by their companies. They will be more active/creative in seeking earlier exits for their investments, and they may even retain some equity in a situation where a portfolio company is acquired.

4. The firms that moved upstream should then welcome developments as suggested by the above scenario since that would bring new, more mature companies to the large firms' attention.

5. I have to credit my entrepreneur friend David Spitz for this one. "We may well see a dramatic contraction in the supply of LP funds – maybe 40-60% of recent levels – as endowments, pension funds, etc. are all staring once-in-a-career 20-40% declines in asset value, driving a fundamental re-evaluation of asset allocation and appetite for “risk” capital. I (David) wouldn’t be surprised to see 40%-50% fewer discrete VC firms in the next five years as funds die off and liquidate, with an increased concentration of capital at the top (old school – Sequoia, KP, etc.) and bottom (new firms) of the pyramid."

Finally, if I happen to rub elbows with Mr. Barrett at a fancy convention somewhere (yeah, right?) I promise that I will give him this blog address and will ask him if he can help make 3 and 4 above happen!

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