The Fall of U.S. Venture Capital

During a tour of investors in the US, I was able to observe the current state of U.S. venture capital. Briefings in New York and visits to investors in Boston and Chicago all went smoothly. I managed to brief a total of 10 companies who were investing in our Apex GLOBIS Partners fund. We are constantly sending out annual and quarterly reports to investors, and we also report through a series of emails. Furthermore, our investments have been successful and we have been turning them into cash, paying dividends to investors, so I thought our investors had a very good idea of our situation. However, in the course of my visits with them, I had to change my thinking as I realized that, in fact, investors hardly had any understanding of the state of our fund at all. I realized that the only way to have them really understand was to be in the same time and place, explaining things to them face to face, while looking directly into their eyes.

Thankfully, our investment track record is astoundingly solid for the fund formulated in 1999. There were a few sharp digs from investors, but ultimately each investor commented that ours was the best-performing fund in the world. I felt that we had made some progress in terms of constructing a relationship of mutual trust with our investors.

After my presentation, I inquired about the state of VC in the U.S. and Europe, and the attitude of investors changed immediately. They all showed a mixture of resignation and anger regarding U.S. VCs and their investment situation. Their results were absolutely dire.

I have to go back a bit. In 1999, GLOBIS tied up with Patricof & Co. (now Apax), and at that time I was trying to learn VC investment methods from the U.S. and Europe, since I blindly believed that U.S. VC was amazing, given the presence of so many brilliant people and the creation of so many jobs. Yet, as time went on I realized what was really going on, as I saw people running around in a money game, and I began to have some doubts. Aren’t most U.S. venture capitalists just running around in a money game? The point at which my doubts about U.S. VC really came to a head was April 2000. Until then, VC investment was reasonably good, and I never reached the point of having definite concerns. Then in March 2000, the reality I observed following the collapse of the NASDAQ was nothing short of a disaster. This was substantiated by my conclusion after this business trip, which is that U.S. VC in the latter half of the ’90s was pursuing the same investment method as real estate investors in Japan during the bubble.

Seeing U.S. investors at this stage convincing themselves that everything will be OK once the market recovers seemed to me to be exactly the same stance as real estate investors in Japan who left everything to the market. The only difference was that in VC, they are entrusted with other people’s money. That is, even if investors sustain a loss, venture capitalists still receive their management fees, so basically they never lose. Venture capitalists don’t make a loss and even now are receiving significant fees and living an affluent life. Investors, on the other hand, have lost out, and this is at the root of their irritation and rancor.

Here is why I think it is the same as the bubble era in Japan:

1) An increase in momentum deals
Internet-related investments can be characterized by their neglect of due diligence; investment decisions are made on the spur of the moment. Behind this is the myth of perpetual expansion, a psyche that if you do not invest immediately, you will get left behind. So people become impatient for fear of losing opportunities to make money. Venture capitalists, on their side, don’t properly pay attention to valuation, believing that the value of their investment will be just like Yahoo or eBay. This is exactly the same as during the real estate bubble in Japan.

2) VCs that have forgotten to be hands-on
As venture capitalists make the decisions to invest without conducting due diligence, they do not really know much about the business. Obviously they can’t maintain the appropriate governance structure so entrepreneurs can do as they please. Venture capitalists no longer get together with entrepreneurs to formulate strategy, create the organization together, assist with recruiting, or get involved in marketing or creating alliances. This hands-on style of investment has all but disappeared. In other words, the prevailing venture capitalist is all about making deals in which value is created by finding a good deal with the intention of selling it later, rather than creating value through sound management.

3) VCs that are all about scaling up their funds
Then venture capitalists started to be concerned only with scaling up their funds as much as they could to make a load of money. One venture capitalist told me that the secret of succeeding in CV is to invest as early as possible and maximize the amount in the fund. If you do this, you can get a lot of fees, employ talented people and scale up. Scaling up early on means you can get a lot of money. This, he said, is the secret to winning at VC. Is this really the right way? I can’t see anything in this stance that takes into account the perspective of the investor, or anything about working together with entrepreneurs. (Needless to say, I don’t think that everyone was like this in an exclusive sense, but there certainly is a tendency to play this money game.)

Because everyone is operating according to this “secret to success,” a great many VCs have been created with billion-dollar funding (funds in excess of 100 billion yen). Each VC charges fees of 2% or more, so annual salaries of more than 2 billion yen are secured. Even if the amount of the fund grows, the number of partners does not significantly increase, so the only thing they are thinking about is increasing the amount per investment without increasing the number of investments. Previously, they would have been investing 200-300 million yen per investment, but now the average investment per VC is in the realm of 1-1.5 billion yen. Obviously, valuation also increases (and with it each partner is able to make a profit).

So momentum investments increase, hands-on engagement is forgotten, and a dash is made to scale up, meaning that at some point the bubble will burst, leaving behind the wreckage of poor investment.

Added to 10 trillion yen invested as VC money in 2000 are “angels” (individual investors), corporate VCs and the companies that purchased them at a high price (amortizations of over 100 trillion yen by JDS Uniphase and of over several hundred billion yen by Cisco are still fresh in mind).

Furthermore, some 10 trillion yen in bank loans and also vendor loans from communication device manufacturers (Cisco, Nortel, etc.) were provided to the regional telecommunications company CLEC. According to a report by one research company, there are more bad assets now than there were at the beginning of the ’90s when the savings institutions collapsed. I’m not certain whether this is true, but am I really imagining things when I think I can sense something of the bubble era in Japan in the U.S. today?

In the midst of all this, one doubt rises up. How on earth could U.S. venture capital, which produced so many legendary success stories in the past, fall so simply? I examined this by reviewing the history of U.S. venture capital.

I developed my own analysis of many U.S. VCs, and came up with following similarities:

– Legendary VCs rose up in the early ’70s. The average age of venture capitalists at the time was about 35.
– They started from small funds, ranging roughly from 500 million yen to 2 billion yen. 
– Most funds were formed primarily by those who had experience in a venture business or corporate management.
– Each of them had a sense of mission to create a new U.S. industry.

And, although small, the only ones who survived did so after repeated failures, steadily building up their know-how and then succeeding. They were schooled by adversity in many battles, experiencing the ebb and flow of the economy. These VCs won the trust of investors, as a result, their funds gradually growing larger, and in the ’90s their funds also reached the scale of 10-20 billion yen.

In the 1990s, capitalists who had carried out legendary investments reached their 60s and retired, entrusting the industry to those behind them, the majority of whom were MBA holders who only understood the analytical investment method. In the ’90s, the U.S. bubble began to form, and as explained above, the trend toward scaling up funds prevailed. All of a sudden MBA holders with no business experience flooded into VC, bringing with them a drive to scale up and maximize profit.

In terms of imparting knowledge, nothing is more difficult than VC. Most of today’s venture capitalists only have experience investing during a period of expansion, tasting a small success in a short period of time, leaving them thinking that investment is easy. Even if a clever analysis of the industry is undertaken, there are no “right” answers for creating and expanding a company; no one can teach you this.

Consequently, more money quickly poured into venture capitals and the scale of each fund grew. Previously, investment had been something like a club, but now joint investment was decreasing and each fund was chasing after the same kind of deals. Excessive competition broke out among venture firms, and due to the imbalance in supply and demand, a bubble began to form that could burst at given time. This ultimately lead to many examples of failure (similar to the famous case of the VC investment failure in disk drives in the 1980s that is taught at business schools, but in an even larger sector).

To test this hypothesis during my business trip, I held several conversations with clients. Along the way, I had a chance to speak with a legendary venture capitalist.

This is what he said:

“Supposing 1,000 companies a year sprang up between 1996 and 2000. Of these, only 2% are still operating independently or are still in business even after having been purchased by other companies. Just 2%. Out of these, there is just one in the black. Out of a few thousand companies that received investment between 1996 and 2000, only eBay succeeded. Amazon and Yahoo are only surviving thanks to the support of investors. Out of 1,000 companies, just 2%, and one successful company.”

“How did it end up like this? Why has no one stopped this kind of investment?” I asked.

“That was a crazy time.” He replied. “No one could stop naïve investment. Partners who had just come aboard had tasted small successes and accepted requests for VC investments too easily. No matter how strongly I spoke out, the conditions were such that new partners simply would not listen to what I had to say.”

The sadness on his face as he said this made a real impression on me.