[This also appears as a guest post at PandoDaily]

Over the weekend, I read Sarah Lacy’s PandoDaily article that the VC shakeout is taking too long.  It’s rather thoughtful and definitely worth reading if you haven’t had a chance to yet.

There are some obvious structural reasons why a shakeout in the venture capital industry takes a long time.  We all know that VC funds are typically structured as limited partnerships with a 10 year life, so even if firms are no longer investing and don’t raise a new fund they take a long time to go away.  Sarah also points to the vast global wealth that has to get allocated somewhere as well as a small bump in long term average returns, now that the generally terrible performance of funds from the 2000-2002 time frame (after the tech bubble of the late 90s crashed) no longer factor in to 10 year returns.  It’s been my experience that average returns of the whole VC industry get more attention than they really merit.  Having talked with many active venture LPs over the years I see little marginal impact, in terms of new funds being raised or new LPs investing in VC, based upon an uptick in industry average returns since LPs don’t really approach VC as an index.

So what’s actually happening?  Are there a bunch more shoes to drop?  Or are we “there” yet in terms of a venture shakeout?  Well first it’s worth understanding the distinct phases of exactly how a VC firm dies.

• At Risk – Usually starts with a firm beginning to see challenges in large portions of its portfolio, or in keeping the partnership together, or in the viability of the firm’s core strategy as broader markets start to shift (e.g. there’s a heck of a lot fewer pure-play cleantech VCs today than 5 years ago).
• Purgatory – Next phase is when these internal concerns start to get external validation.  Typically this is when VCs “pre-market” or explicitly try to fundraise a new fund among existing and potential new LPs, only to be rebuffed.  It’s possible for firms to pull back from this brink but somewhat rare.
• Deadpool – VC firm admits to itself (the GPs) and its existing LPs that the firm will not raise a subsequent fund.  The lights are usually still on, both literally and metaphorically, and there are often follow-on investments in existing portfolio companies still being made.  Some of the firm’s partners may move on to new jobs during this phase but at least some are usually still around.
• Defunct – At this point firm is done making even follow-on investments and has largely liquidated the portfolio one way or another.  The lights go off and whoever is still there moves on.

The reality is that it takes many years (5-8) for these phases to play out for a given firm that ultimately dies.  VCs are not like the Neil Young lyrics… they don’t burn out but instead fade away.  Or VC firms are main sequence stars rather than supernovas, for the astrophysics inclined.  It’s not just because of the 10 year fund life either… because VCs make early investments in companies that take a long time to build, and because persistence of performance from one fund to the next is weaker than you might think, it’s not obvious even to the VCs themselves or their LP investors when a particular firm becomes “at risk” or even in “purgatory”.

Ok so now that we understand the distinct phases of VC firms that ultimately die, what other factors are at work in the shakeout underway?

1) The VC Shakeout is 3-4yrs Old, Not 10 – While there was definitely a rough patch for the VC industry in the wake of the early 00’s tech crash, the reality is that much of the last decade was pretty good for the venture biz.  There was a healthy amount of capital ($20-30B annually) invested in VC funds during the 2003-2008 timeframe.  Yes, it was less than the $100B+ that came in ’99-00 but that was bubble driven aberration no matter how you look at it.

In the mid 2000’s VC’s were largely prospering.  The entire US economy was booming (in an unsustainable debt binge, in retrospect) from 2004 through much of 2008, and the tech world was booming along with it.  The IPO market remained closed to IT startups, but there were big acquisitions like Google buying YouTube for $1.65B (Fall 2006) and late stage financing rounds for companies like Facebook (Microsoft round at $15B valuation in Fall 2007). Kevin Rose was on the cover of BusinessWeek.  A huge cleantech boom occurred and battery companies like A123 went public along with biofuels companies like Amyris, Gevo, and others, though in retrospect this was more of a bubble driven by unsustainable government subsidies (A123 is bankrupt and the biofuels companies trade at a fraction of their IPO valuation).  This was also the period when VC started expanding seriously in emerging markets like India and China, and many LPs put new capital into these OUS funds.

The reality is that it wasn’t until the GEC (Global Economic Crisis, Great Recession, Credit Crunch, call it what you will) of late 2008 and early 2009 that the shakeout really began for venture capital.  This is when LPs started pulling back and VCs who didn’t have emerging winners in their portfolio started to struggle.  So yes it still probably seems slow, but this shakeout is only a couple years old not a decade old.

2) Rebirth of Some Firms – Mobius Venture Capital is now defunct.  For those who aren’t familiar, Mobius was a VC fund with offices in Silicon Valley and Boulder CO and at it’s peak Mobius had $2B+ under management.  But out of Mobius came today’s Foundry Group, a firm that’s prospered in the last five years.  Similarly you’ve seen a handful of firms which once had very large funds ($500M – 1B+) managed by large partnerships which have reinvented themselves as smaller, more focused firms (in terms of stage / geography / sector).  Atlas Venture and Mayfield Fund are both good examples of firms which are being reinvigorated in this way.  So while the shakeout has meant most of the firms that reach the “at risk” or “purgatory” phases will go away, there will also be a small group of reinvented firms or new firms that get created in the process.

3) Sometimes The Promise of Success Turns Into Actual Success – Setting aside very late-stage VC or growth equity type investors, successful VCs always raise new funds on the promise of success rather than actual (realized) returns of the most recent fund.  For some firms that promise seems very sound based on funds well before the most recent one (e.g. the Sequoia’s and Greylock’s of the world) or sometimes its based on the entrepreneurial successes of the founders of new firms (e.g. A16Z today or Founders Fund or General Catalyst a few years ago).

But those VC firms who face struggles in raising subsequent funds based on the promise of success occasionally experience actual success.  This typically occurs well after the typical 2-4 year cycle of raising new funds, but sometimes if a firm sticks together and invests well and/or gets lucky the porfolio will turn out to be a success (see note below).  In these rare cases, and they are rare, a firm might be able to raise a new fund 5-7 years after their prior one because what was once the promise of success has become demonstrable success.

4) VCs Keep Quiet About Fading Away – As described above, VC firms usually die gradually and quietly rather than spectacularly and publicly as is sometimes the case for startups.  This is largely for self-serving reasons… VC firms that may be approaching death usually hold out hope that they will eventually have good exits from their portfolio and perhaps be able to raise new funds (#3 above).  And I think it’s at best bad form (and at worst outright deception) when VCs who have little or no capital to make new investments aren’t clear with entrepreneurs about their situation.

But believe it or not VCs would probably be doing the entrepreneurs they’ve backed and the LPs who’ve entrusted them with capital a disservice by shouting from the rooftops about their own demise.  When VC firms are in the “purgatory” or “deadpool” phases above, the entrepreneurs of the startups the firm has backed are often still relying on them to provide substantial follow-on capital.  And often this capital is provided to these founders alongside capital from still vibrant VCs who take the behavior and status of existing investors very seriously.  Similarly even when a VC firm is on the demise, most LPs (college endowments, pension funds, and the like) are heavily relient on the GPs of that firm to manage the portfolio to the best of their ability.  Your average endowment may be a highly sophisticated investor across many asset classes, but they simply don’t have the human beings on staff to manage and liquidate a portfolio of illiquid startup investments.

Let me be clear… I’m not saying the VC industry is populated by a bunch of Mother Theresa’s.  Most dying VC are out to save their own skins by keeping their firm’s demise on the DL, and IMO even then they should be totally transparent with their stakeholders (LPs and entrepreneurs).  But it is also typically in the interests of those same stakeholders for the VC firm’s challenges not to be broadcast widely.

So I appreciate that for most, both inside and outside the VC industry, this shakeout is taking a long time.  As a VC myself I’m not looking for sympathy for industry brethren that may face struggles.  But I think it’s worth illuminating for all why the shakeout is playing out over years not months.  We’re in the middle innings, but by the same token there’s no way the clock will be turned back on this one.

=============

Note: While “venture” returns for a single investment would be making 10x+ multiple on your investment, this is of course balanced by other investments in a given VC fund that lose money or only generate a modest return.  So at a fund level (e.g. a VC fund’s entire portfolio in aggregate, net of management fees and carried interest) a good return from an LP’s perspective would be 2.5-3.0x typically, which in most cases would  to >20% IRR.