VC’s Mathematical Challenge

There is no doubt that the venture industry is going through a major house cleaning right now. Much of the pruning that should have been done post Bubble is finally going on now as LP's start to wake up and pull back a bit from the asset class. One of the main challenges has been the mismatch between LP demand in the category and the declining liquidity of it. The main question people as is what is the right amount of capital that should flow into the business annually to keep it healthy. Let's look at the mathematics from the exit perspective:

Average annual number of acquisitions:250
Average sales price:$80 million
Average annual number of IPO's:100
Average value of IPO:$150 million
Total annual value of venture backed exits:$35 billion
(IPO's have been down below 10 recently and above 200 in healthy times but below 60 for the past 8 years)
(sale & IPO values have fluctuated but these are swags)

Assumed VC ownership at exit:70%
Exit Value going to VC's:$24.5 billion
Target Fund multiple:2.5-3x
Capital Deployed to hit:$8-10 billion

This means that for the industry to continue (a la 1990's) generating IRR's north of 20% net in this exit environment, no more than $10 billion should be flowing into it during any given year. If the IPO market wakes up, this number goes up. If it stays asleep, it goes even lower. In a strong year (250 IPO's & 300 acquisitions at $200 million & $120 million avg values respectively), total annual exit value jumps to nearly $90 billion. Filter this through and the industry could handle roughly $25 billion in new capital.

Well, until just the first quarter of this year, industry fundraising has been north of $30 billion for several years and the exit markets have been significantly below even the initial levels above. Our industry stays healthy if no more than $10-15 billion per year is raised. So, we've been at 2x that rate. The LP's have hopefully figured this out and we'll see smaller brand funds and fewer total funds.

How many funds can survive in this kind of market? Let's do the math again:
Couple of mega-mega funds like NEA, Oak, TCV & Menlo: say 5 x $2 billion each = $10 billion
Number of brand funds:say 25 x $500 million each = $13 billion
Number of next tier funds:  say 40 x $200 million each = $8 billion
Fundraising cycle: every 3 years
So, just these initial 70 funds results in $10 billion+ per year raised.

Assuming that there will be around 300 funds around in total, this leaves about $5 billion/yr for the remaining 230 groups. Using the 3 year cycle, this results in each of these funds being under $65 million in size. If the exit environment remains moribund, then all of these number have to discounted even more to get to $10 billion in total industry dollars annually.

So, the industry has to drop from 500-600 groups to 300 groups and the LP's need to pair everyone back. No more $4 billion Mega-mega funds, no more $700-800 million brand funds, no more $300-400 million next tier funds and no more $100-150 million remaining funds. If the LP's don't do this, we end up north of $25 billion per year again and terrible returns.

Can LP's contain themselves? We'll see once conditions start to improve in the economy. In the interim, it will be ugly times for VC fundraising…