Worried all the way to the bank

VC confidence declines as their returns increase. Here’s why both make sense

By Sarah Lacy , written on August 5, 2015

From The Venture Capital Desk

The venture industry is weird right now.

On the one hand, you have everyone publicly and privately freaking out about burn rates, valuations that everyone knows won’t hold up in the public markets, the cost of building companies in crazy-self-inflated San Francisco, and a total abandonment of any sense of capital efficiency.

On the other hand, funding levels keep increasing, wild burn rates are encouraged, crazy San Francisco rents at crazy terms are signed, and more than 30 new unicorns have got their horns so far this year.

An outsider would be forgiven for being confused: So, you all think these things are totally unsustainable and bad for our ecosystem, so… why do you keep doing them?

Well, two sets of data came out yesterday that help provide an answer.

The first was a survey of investor sentiment, showing that VCs “faith” in the health of their industry is sliding, due to worries about inflated valuations.

It’s an annual study conducted by the University of San Francisco’s Mark Cannice which aims to measure the industry’s expectations for the next six to 18 months. This is the second quarterly decline and is the lowest point in sentiment in some two years.

But as my Mississippi-born father used to say when I’d catch him breaking a house rule, “Do as I say, not as I do.”

VCs actions show a different story, investing nearly $20 billion into new companies in the same quarter, and increasing north of 70% year-over-year already in July. It’s on pace to be the biggest funding year since 2000.

So what gives? Two things. The first is VCs are pissy because everyone keeps blaming them for a bubble, when they aren’t actually the ones causing a lot of the frothiness in the late-stage market. As we’ve written before: The funny thing about this market is actual VCs aren’t doing the bulk of the “venture capital” investing. The late-stage mania -- which is, to be clear, not the only insane part of this market, just the most insane part -- is being largely driven by mutual funds, hedge funds, corporates, and international investors.

In this Pandoland video, James Freeman of Blue Bottle literally explains how a superior almond milk cappuccino helped close his $70 million round from Fidelity. It’s a charming story mostly told for effect. . .but also, eehhhhhhhhhsshhh. A cappuccino was worth $70 million in this market. An excellent cappuccino, I’m sure... but... a cappuccino nonetheless.

Venky Ganesan of Menlo Ventures put it in more snobby terms in the survey:

Both seed-stage and late-stage venture is experiencing frothiness as the tourists have arrived and they are paying prices that the locals won’t. I expect a correction in the near term especially when the Fed raises interest rates, but the long-term picture remains very strong. 

But VCs can’t be too mad at them: Because right this second, they are also benefitting. This has become a crazy free spigot of cash-- occasionally even money that cashes out early investors-- at wildly advantageous terms. It puts off an exit-- which is a short term bummer in some cases-- but it also allows these companies to go through growing pains and scaling while still private. (Can you imagine the whipsawing valuation of Uber, had the company been public during its Fall of scandals last year?) For the best companies, the hope is that, like Google, LinkedIn, and Facebook, putting an IPO off ultimately yields a super-unicorn. For weaker companies, the hope is they get time to grow into their valuations. All that mutual fund, hedge fund, sovereign wealth “tourist” cash is essentially financing these experiments.

Put another way: VCs get the near-term advantages of a capital-is-free market without actually having to write the craziest checks.  

Sure, this is also creating some ticking time bombs: Walking dead unicorpses, exits that won’t seem like successes because the private valuations have been bid up so high, unsustainable burn rates that could outright shutter decent companies if the capital winds shift, and public down rounds.

But so far, the good is outweighing the bad. And as Henry Blodget explained in our PandoMonthly years ago, you can only lose your money once by being too heady in a market like this. You can lose it multiple times by sitting on the sidelines. There’s not a lot VCs can do other than enjoy the benefits and call them tourists, so that when all this inevitably shakes out, they can point a finger somewhere.

On paper at least, those public market “tourists” are giving everyone better returns than they’d have if they were reliant on public markets. That may not be the same as real cash-in-the-bank returns, but it can certainly help with fundraising and other kinds of market momentum that benefit VCs.

That brings us to the second study to come out today, from Cambridge Associates, long the benchmark in determining actual returns. Turns out actual cash-in-the-bank returns are pretty damn good too. Payments going back to LPs -- a VC’s own investors -- set a 14-year record last year with more money and stock going back to LPs than any year since… 2000. Some $30 billion went back to the bosses of the VCs-- a nearly 40% increase from 2014, the third good year in a row for the industry. In fact, this is the twelfth straight quarter in which VCs have sent more money back to LPs than they’ve “called” to invest in startups. That hasn’t happened since… the late 1990s.

Venture returns did better than the public markets in all time periods except the three-year time horizon. One-year performance was a whopping 21%, compared with 13% for the Nasdaq. It was the third highest return of the past fifteen years trailing only 2013 and … 2000.

Uh oh. 2000. Late 1990s. 2000. Cue the scary music.

Duh! Duh! Duuuuhh!!

Everyone can see something bad is gonna happen at some point. But for now, VCs are in a near-term advantageous cycle. The longer venture returns outperform the markets and interest rates stay low, the more those “tourists” will keep investing in private equity. That keeps paper valuations for early stage stay VCs high, as mega-deals skew up valuations of their investments to levels they’d never get in the public markets. And all that has lead to yet another impressive stat: VCs are using all of this momentum (that they are so verbally worried about) to raise shitloads of cash themselves. Last year VCs raised $32.9 billion-- a 62% increase over the previous year and the highest total since 2007. Bear in mind VCs make money two ways: Through returns and also lucrative management fees for funds under management.

Yeah, VCs are worried all the way to the bank. There used to be a bumper sticker spotted around the Valley in the early 2000s that read “Please lord, just give me another bubble.”

Thanks, tourists!