Rumors of VC death are exaggerated

They may be growing angel wings, but VCs aren't dead yet

Market shifts are like slingshots for the imagination—a forceful tug can launch the mind into wild flights of fancy.

That seems to be what’s happening in the VC world. No doubt the total amount of dollars allocated to Venture Capital from LP sugardaddies has decreased and will remain lower over the next few years than in the past few. But the cries of a broken model or the end of venture capital as we know it are overblown, according to data-heavy post from Bill Gurley this morning.

It’s a long read, but the best explanation of what’s actually happening that I’ve come across. Here are the main points:

1) The reduction in LP allocations to VC is NOT due to poor VC performance. The LP pullback is caused in part by the fact that illiquid investments in VC are not re-valued on a daily basis. As the LP funds decrease by 30% or more, a larger percentage is left in alternative illiquid assets, at least on paper. Compounded by the need for cash, LPs are compelled to reduce the amount allocated to VC to achieve ideal portfolio diversification.

2) As a high-risk asset class, venture capital is naturally expected to fair better in good times and worse in bad times than more conservative investments. LP managers know this. The S&P is down in the last decade, so VC should also be expected to be down. VC has not underperformed--it's done exactly what's expected.

3) Contrarianism will keep investors in the VC category.

Gurley’s comments echo what Tim Chang told me last week—VC will shrink, maybe ½ the funds currently in existence will die, but the industry won’t go away.

One of the interesting consequences will be that VCs will begin stepping on angels’ toes. Wilson Sonsini partner Caine Moss sees three reasons for this: VCs have to deploy capital and they haven’t done much of that in the last two quarters; VCs are still skittish and many smaller fundings is lower risk that a few big ones; for IT, the cost of innovation is a fraction of what it used to be.

So how much capital will actually flow into startups in the next few years? Given that VCs are paid to forecast the future, they may already have adjusted. From Gurley’s post:

VC firms invested about $3.7B in the second quarter of 2009. Interestingly, this number is about half of the recent peak of around $8B/quarter. It is also quite similar to the investment level in the mid 1990s, prior to both the Internet bubble, and the rise of the aggressive asset allocation model. So from that perspective, this, meaning the investment level we see right now in Q2 of 2009, may be what it is going to be like in the future.