The “New Normal” is a characterization popularized by PIMCO, the big bond fund, to describe a low-rate, low-return environment that they expect to persist for a considerable period. This environment is affecting all aspects of financial investing, and it should be no surprise that it is transforming the venture capital industry.
What has emerged is a new venture ecosystem, characterized by “capital efficient” funds which raise a modest amount of capital and can deliver good returns to their investors with $50M “quick flip” exits. When there are few IPOs and the number of Billion Dollar Babies can be counted on a couple of fingers, this is the only approach that makes sense for the limited partners (LPs) who invest in venture funds. The big funds are refocusing on long-term capital-intensive cleantech projects, which are more in character private equity deals. The statistics are vivid: as reported by Silicon Valley Bank and summarized in the attached chart, small funds have returned dramatically better than big funds.
The funds below median are 24x more likely to return over 2x cash-on-cash to LPs than the funds above median (48% vs 2%):
To make this work, the capital efficient funds are investing in lean startups: ventures that follow a set of principles to enable a small amount of capital to go a long way:
- Open source – which is low cost and has been stress-tested
- Cloud services – low capital to the startup and easy to scale
- Browser/App-phone clients – free to the startup and wide-spread
- Rapid product iteration – letting the market give feedback quickly
- Socially-connected – very low cost customer acquisition
- Pervasive mobile – enabling a whole new set of applications
Venture capital produces great returns during waves of innovation. John Doerr, the inimitable leader of one of the premier funds, Kleiner Perkins, calls this the Third Wave after the PC revolution (1978-1983) and the Internet (1994-2000). This wave has not yet been succinctly characterized, but the leading candidate name is Cloud Computing.
An immediate criticism of capital efficiency is who builds the big infrastructure, if not venture capital? The answer is already clear: the big Internet winners are scaling out cloud computing platforms (Google, Amazon, Microsoft), and the PC leaders are clearing the forest with new client devices, such as the iPhone and the iPad from Apple.
The technology model of every era of innovation defined the predominate venture capital model – the funds designed themselves to leverage the trends. The last era drove megafunds to lay the railroad tracks of the Internet. This era in contrast is about working at higher levels of the technology stack than operating systems, computers, cellphones or networks. Now that the tracks have been laid, what are the new apps that people will love?
The always-connected Internet cloud provides the answer: the eternal beta application, launched quickly, changed constantly, always seeking to find the combination of fun and function that captures the hearts and minds of users.
The disruption of the New Normal venture model is likely to affect a whole passel of current funds. It has been much noted how the amount of money going into to venture capital has decreased, and this is putting the squeeze on mid-sized funds. What has been less noted is that the New Normal model may cause LP capital to rapidly switch from traditional VC funds to the new breed of capital efficient funds.