The Venture Capital Overhang is Gone and a Shortage is Looming

By our calculation, the Venture Capital overhang is gone. With the recent wave of new funds being raised, we’ve seen comments of concern from the media and other venture capitalists that miss the math. Looking at industry data as of the end of 2004, we estimate less than $10 billion is still available from funds raised around 2000, with most of that probably needed for reserves and not available for new investments.

There seems to be general confusion about how to figure out how much money is really available for new investments. Some overhang calculations take the gross amount of money raised over a period and simply subtract investments, calling the remainder overhang. This calculation does not subtract fees and expenses. It also does not factor in the investment reserves for future rounds.

So, let’s review the math. According to Venture Economics, Venture Funds in aggregate raised approximately $300 billion from 1993 through 2004, with $105 billion in 2000 alone.

Since 1993, $325 billion has been invested. Looking year by year, the rate of investment has kept pace with the capital raised. The investments from 1993 through 1999 are also partially funded by money raised prior to 1993. In order to take into account the lag due to a 4-5 year investment cycle, we have chosen to only subtract the investments since 1999. Since 1999, $262 billion has been invested. That leaves $30 million for fees, expenses, reserves, and new investments.

I estimate fees and expenses at 10% on average over the lives of the funds during this period.  I observed that most of the 1999 and 2000 funds invested money very quickly, reducing average fund lives. In addition, most funds will reinvest fees and expenses to the extent possible. We expect many observers will be surprised to see that as much as $30 billion has been paid for fees and expenses. This leaves an effective overhang of only $8.5 billion.

I was recently quoted regarding these calculations. 

Business 2.0 Article On VC Overhang

Whatever money is still available, almost all 1999-2001 funds are at the end of the contractual period allowed for new investments, so most of this is likely reserved for follow-on investments. After 4-5 years of investment, a reasonable number of companies created during this tough market are reaching revenue, allowing liquidity during the second half of 10-year fund lives.

Follow-on investments can keep weak companies operating artificially, creating continued competition in the markets in which these companies operate. In terms of competition, the good news is that the dropout rate has increased. In the last five years, we have seen estimates that roughly 5,000 venture-backed companies have either been acquired or gone out of business. While there are still a few thousand companies that may languish and not achieve liquidity, the competitive climate for private companies is allowing more revenue generation, profitability and liquidity.

Is a new overhang developing? Most venture funds will have raised new funds in 2004 or 2005. New funds are significantly smaller than funds raised in the last cycle. In the aggregate, the $18 billion raised in 2004 was less than the $21 billion invested in 2004. These levels are well in line with long-term averages.

More importantly, exit values exceeded money invested in 2004.  Accourding to Thomson Venture Ecomonics and the NVCA, the total value of disclosed M&A transactions jumped to $15 billion in 2004, up from $8 billion in 2003.   As many deals are not disclosed, the real number was even higher.  IPO values of $11 billion brought the aggregate exit value to $26 billion in 2004.   

Recent venture data highlights that prices have recovered from depressed levels, mostly justified by higher exit values, but we have not seen prices rise significantly on average.

We have seen some isolated price increases in mid-to-later stage deals starting around the end of last year. We view this as partly a function of 1999-2001 vintage funds needing to make their last investments in order to avoid refunding fees for capital committed but not drawn.

Looking to the 4-5 year new investment cycle for vintage 2004/2005 venture funds, we see very healthy market conditions. As discussed, the dollars available to invest are significantly lower than recent years. Increases in IT spending are justifying the creation of higher quality private companies. Financial markets are supporting increased M&A and IPO activity at higher prices. The net impact should be a positive venture returns.

Investment has kept pace with fundraising for the last 11 years