It might be hard for the ordinary business owner or consumer to imagine having "too much" money. But that's exactly where the venture capital industry finds itself: with too much money available for the number of emerging enterprises able to offer the promise of an excellent return.
"Capital overhang is a big issue that keeps coming up over and over again," said Fergal J. Mullen, a general partner at Highland Capital Partners who focuses on software and services companies. Mullen said he looks for companies in Europe that need to come to the U.S. "to really hit that home run" or for U.S. firms that need to penetrate the European market.
Mullen spoke as a member of the panel "State of the Venture Capital Industry: Past, Present and Future" at the 11th Annual Venture Capital & Private Equity Conference held on February 5th at Harvard Business School.
Intel Capital, the chipmaker's venture division, has scaled back somewhat from the hyper investment levels of 2000, "but I've always thought it was really important in the venture market to stay in the market, be in the market consistently," said Jim McCall (HBS MBA '84), managing director. "We still do about 100 deals a year," and have averaged about $300 million over the last three years.
Intel has also kept a broad presence internationally, with investment professionals in twenty-five countries, McCall added. The company is particularly optimistic on China, India, and Russia.
Too Many Deals?
HBS professor William A. Sahlman, the panel's moderator, noted: "One of the historical factors in the venture capital industry…wasn't too much money chasing too few deals. It was too much money going into too many deals in the same industry, so it was very hard for any individual companies to succeed, and valuations got pushed up…I wonder if you think that phenomenon has gone away?"
Marc A. Friend, a general partner with twenty-year-old Summit Partners, said the reason you see "five of everything starting at the same time" in the early stages is because smart people are looking at the same data.
"You've got big companies that are addressing wide markets and there are gaps in the product portfolio," he said. "Engineers and product developers leave those companies to start their own businesses to fill in those gaps. And they're rarely alone."
You will see lightening striking more than once in the same place, and I would never fight it.
— Jim McCall, Intel Capital
Added McCall: "That (big) company has five competitors, and the same teams are seeing the same data, so everyone starts, you know, the wireless RFID securities token business at the same time. I would argue that there is a natural phenomenon that you will see lightening striking more than once in the same place, and I would never fight it."
Mullen agreed that sitting out a market simply because it is crowded with players isn't necessarily the best strategy. "What you've got (to do is) be sure that you're into the first five or six: the guys that have a real chance of making it. And that means they're early to market, that they're ahead in their product development; that means they're the right people for the job…and the market can develop. You've got to make sure you can get these guys to an exit, first, second or third," Mullen said.
"And a good exit," added Sahlman.
"I feel like it's a pretty natural process to find several in a certain space," said McCall. "We will invest in five or six companies, and it's very possible they could be competitors with each other" sometimes, he said, simply because it's as important to support the development of the technology.
A company does not have to be first to market with a new technology if its product is better or easier to use than what is already on the market, Friend said. "You don't have to be the first, I would argue. In some respects, you have to find your niche and you have to be the best."
Investors With No 'off' Button
Sahlman noted that in the history of venture capital, the money that limited partners made available for investment has ebbed and flowed. That phenomenon seems to be shifting, he said.
"One theory is today the money doesn't go away. The limited partner community has defined venture as an asset class; they're going to stay in the market no matter what. If they can't get an allocation at a top-tier fund, they're going to go further down the food chain…so I think there's no equilibrating mechanism right now," Sahlman said. "Is that a problem?"
"There's a lot of capital out there now trying to be placed," noted Mullen. "The statistics are almost overwhelming."
He said estimates indicate there are about 700 venture capital or private equity firms currently active, and it is expected they will raise more than $230 billion this year.
"I heard somebody say recently that the position on whether the glass is half-full or half-empty depends on whether you're pouring or drinking," Friend said.
Limited partners are looking not only at placing money with top-tier funds, but with emerging funds. "It's great news if you're looking to get into the business," Friend said.
He added that many new funds are focusing on narrow sub-sectors, companies designing very specific types of software, for example. "You'll get market fragmentation and specialization," he said.
"Software-only (funds) turned out to be a great bet," Sahlman said. "Hummer Winblad, which did PeopleSoft and other things back in the early days, in fact really hit it out of the park."
King Of The Hill
One participant asked how long top-performing funds that showed returns in the top quartile managed to stay there.
"There aren't that many firms that persist in the top quartile," said McCall. Friend said most of Summit's funds that were ten years old or older were in the top quartile, and he said he believed the 1999 fund he's involved with would likely occupy a similar spot when exits were made and the returns counted. "But that means single-digit (internal rate of return)," he said.
Sahlman said that one reason maintaining a top position is such a challenge is that competitors will seek to follow in a successful fund's footsteps.
"Every strategy attracts competitors and copiers, particularly if it's successful. So it's interesting to think about how you have to morph what you're doing just in response to people copying your strategy," he concluded.
Reflecting on the last fifteen years in venture capital, Intel's McCall observed, "It's been a pretty wild ride." He recalled making twenty-five to thirty deals a year in the mid-1990s, a pace that accelerated to $1 billion a year in 1999 and 2000. Like many of those who invested in emerging high tech companies just before the bursting of the Internet bubble, Intel Capital still has some regrets from those heady days.
"I think back on the 2000 investments and wish we had not done a lot of that," McCall said. "We're still getting a few exits out of that right now, but smaller exits for the most part."
The conference was sponsored by the HBS Venture Capital & Private Equity Club.