Where has all the VC money gone?

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Are we really seeing a dearth of venture capital money? There’s still plenty of venture capital firms around, but why aren’t they spending?

Most VC funds have a seven-ten year cycle. They raise money from limited partners, invest in high-growth business, hopefully exit some of those for a good return, and start returning money to investors. 5-7 years after the start of the first fund, they start to raise their next fund (hopefully on the back of a good performance in the first one), and then by ten years after the start, they have closed out fund 1 and are fully committed to fund 2.

But here’s the problem: most of the VC funds raised a shed-load money in the heady days of the dot com boom, in 1998-2000. They expanded, brought on board inexperienced VCs with MBAs who invested in poor quality businesses. They couldn’t raise a second fund because, frankly, their track record just isn’t good enough. (Of course, the credit crunch and a global recession isn’t helping. Although it is worth quoting the Sage of Omaha, Warren Buffet, yet again: “It’s only when the tide goes out that you learn who’s been swimming naked.”)

Or as Fred Wilson puts it,

So are we about to enter a period of Schumpeter’s creative destruction in the VC community that will thin out the weak and restore the VC community to healthy strength?

Well, no.

And the reason is the way in which VCs are remunerated. They get paid in two ways: a management fee of in the region of 1-2% of funds under management a year, plus a “carry”, whereby the VCs get to share in the profits of the fund, generally taking 20%.

Which means that a small-ish fund of £400 million generates management fees of as much as £8 million a year. Even if all of its investments are dud. It’s not as if the VCs that have underperformed have been underpaid.

And it explains why so few VCs go out of business. Until they cash in their fund, they can keep taking that management fee. Even if it’s just two guys in a Mayfair office.

Nice job if you can get it.

UPDATE

I wrote this post a while ago, and sat on it. Since then, I’ve had some feedback that suggests that things might be not quite as bad as I cynically painted them, particularly in Europe:

• No VC likes to sit on a failing fund. It’s bad for his career and it’s not fun. All the good ones will try to fix the problems or move.
• The real money comes with the carry. If you aren’t getting carry, you could be getting much better paid elsewhere
• In Europe, few tech funds had a fabulous dot com boom, so the creative destruction took place in 2003 – 2007, which perhaps as much as 80% of capacity coming out of the market between 1999 and 2007.

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