Investing at the Bottom of the Venture Capital Cycle

Mike Kwatinetz and Cameron Lester are general partners at Azure Capital Partners.

The current imbalance in the supply and demand for venture capital is creating opportunities for V.C. funds.

New limited partner commitments to venture capital funds have dwindled in recent years. This scarcity of capital has created its own Darwinian effect, with a new breed of start-ups flourishing as a result of innovation rather than capital-induced growth. As these companies mature, however, many of them are looking to venture capitalists for the money and expertise to realize their potential.

Back when the Nasdaq peaked in March 2000, liquidity was abundant, with unprecedented valuations for initial public offerings and acquisitions. Because of this bubble, venture capital returns in the 1990s skyrocketed. And as investors grew increasingly bullish on venture capital, limited partner commitments into new venture capital funds shot up to a high of $86 billion in 2000, well over 300 percent of the level two years earlier.

This oversupply of capital, coupled with inflated public market valuations, led to a substantial drop in 10-year venture capital returns and a parallel fall in stocks on the Nasdaq.

Last year, limited partner commitments to venture capital slowed to about $12 billion, the lowest level since 2003. In addition to concerns about venture capital returns, many limited partners are still constrained because of liquidity issues from the recent global financial crisis. As a result, many venture capital firms have shut down and others have raised smaller funds.

But the tables are turning at the bottom of the cycle, providing new opportunities.

The scarcity of available venture capital stands in stark contrast to the number of exciting high-growth start-ups seeking capital. These young companies are innovating at the forefront of major trends that are reshaping industries, among them mobile computing, social media, software-as-a-service/cloud computing, next-generation advertising, broadband access and explosive new e-commerce models.

Many current start-ups leverage a capital-efficient cloud platform upon which to build and distribute their products and services. Driven by the success of seed-funded businesses like Facebook, Zynga and Groupon, an ecosystem of angel investors and microfunds has emerged to get these young companies up and running, creating what appears to be a “mini bubble” in that asset class. As a result, there are more seed-funded technology and Internet companies than ever.

Most angels and microfund investors do not maintain meaningful capital reserves. They depend primarily on traditional venture capitalists to finance the companies in their portfolios that require follow-on rounds of financing. Because of the contraction in the venture industry, however, there is an imbalance of supply and demand, with many more companies seeking funding than available venture capital can provide.

As a result, today is a great environment for venture capitalists to invest in businesses that have matured beyond the seed stage — companies that have typically grown to at least $1 million to $5 million in revenue and are expanding rapidly. And because of the shortage of available venture capital, their valuations are often compelling.

At Azure, for example, we are able to obtain meaningful ownership positions in this market with a modest amount of capital. In fact, a $1 million investment in a new portfolio company in 2010 bought us over 12 times what it did in 2000.

Meanwhile, liquidity for venture capitalists is increasing as we enter a multiyear wave of technology and Internet mergers and acquisitions. For a long time, the shrinkage in the market for initial public offerings limited exit opportunities for venture capital. The M.&A. market, however, is now expanding rapidly to fill the gap.

Several factors are contributing to the growth in mergers and acquisitions.

First, technology companies have huge war chests available for acquisitions. The 18 companies with the largest cash balances have a total of more than $262 billion on hand, for example. We estimate that they collectively generated more than $147 billion in operating cash flow in 2010.

To put those numbers in perspective, all American venture-backed M.&A. volume in 2010 totaled $34 billion, according to Dow Jones VentureSource. In other words, the annual cash flow for these 18 large players was more than 400 percent of the amount of all the M.&A. activity in the market. And there are plenty of smaller players that are active acquirers as well.

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