Competition to find the next Facebook will bring 'carnage'
A fraction of the current roster of venture capital firms is expected to survive the fallout from today's rush to invest in the next Facebook.
Venture capital firms are battling it out with traditional money managers and multinational corporations — both foreign and domestic — to do social media deals. Insiders wonder if the valuations for these companies will stay high or be a part of another Internet bubble burst.
“There is undoubtedly a lot of excitement about social media. As always in (venture capital,) a few groups will generate most of the returns from these investments,” Josh Lerner, Jacob H. Schiff professor of investment banking at the Harvard Business School, Boston, said in an e-mailed response to questions. “This has been a pattern from the industry's very beginning. VC is a very unfair game!”
And when too much capital tries to invest in a small space, returns plummet and venture capital firms get burned, industry insiders said.
“There's a lot of money chasing these kinds of deals and there's a lot of duplicative deals,” said Dave Broadwin, partner, in the Waltham, Mass., office of law firm Foley Hoag LLP. “It's a frothy environment where only a few (venture capital firms) will survive. There'll be a lot of carnage.”
Institutional investors have caught the fever. During the 12 months ended April 1, 20 venture capital funds aimed at social networking closed with $5.2 billion in institutional capital, more than double the $2.5 billion raised by 17 funds in the prior year, according to Preqin, a London-based alternative investment research firm.
“One of the reasons that digital media (including social media) is hot is that a large traditional fund can still put in a $5 (million) to $10 million size investment and hope to have an exit in some reasonable amount of time,” Mr. Broadwin said.
When Facebook goes public, it will be a landmark event, spurring other social media initial public offerings, Mr. Broadwin noted.
“There's so much attention by limited partners on social networking that they want some in their portfolio,” said Pete Bodine, managing director at Palo Alto, Calif.-based venture capital firm Allegis Capital. “People with money in Groupon, Facebook and Twitter had zero trouble raising money.”
Still, while venture capital firms raised more capital in the first quarter than they had in other initial quarters since 2001, total venture capital fundraising has been falling steadily for at least the last five years.
“There has undoubtedly been a decline in VC fundraising, and there will be exiting groups,” Mr. Lerner wrote in the e-mail. “This is consistent with the long-run pattern, where every 10 (to) 15 years there is a cleansing of the industry.”
The poor fundraising environment means many venture capital firms already are struggling.
“Historically, venture capital is not doing so well,” said Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business. “Some venture capital firms will not be able to raise funds and they will slink out of business.”
Many of these struggling firms are suffering from a hangover from the last Internet sector boom and bust.
Funds raised in 2000 and 2001 have underperformed, he said.
“It's very clear they won't raise another fund and some will go out of business,” Mr. Kaplan.
There will be some new funds. Super-angel firms, formed by high-net-worth individuals who make venture capital investments with their own money, will raise new funds with institutional capital, he said.
Venture capital executives agree with the long-term trend. Some 62% of venture capital executives worldwide predicted there would be fewer venture capital firms by 2015, with U.S. respondents the most pessimistic (92%), according to a 2010 survey by Deloitte LLP and the National Venture Capital Association.
“We are in the middle of a long-term consolidation within the venture community. It's really a process that has its roots in the bubble correction in 2000 and 2001,” said Robert Ackerman, founder and managing director of Allegis Capital.
Then, too many managers with too much capital jumped into a hyped market, which was the Internet, he said. Social media is another hyped sector.
“Clearly, there is a bubble in the social media space,” Mr. Ackerman said.
Stephen J. Socolof, managing partner of San Francisco-based New Venture Partners, agreed.
“There is already a consolidation going on in the venture capital community. If there is a cycle like we saw 10 years ago, those that were later investors in the cycle will suffer, and broadly, many will suffer from the resulting reduction in valuations and exit values, “Mr. Socolof said.
Some 9% of all $5.9 billion invested by venture capital firms in the first quarter was in media and entertainment, including social media sites, according to the most recent MoneyTree report by the National Venture Capital Association.
“Whenever an investment theme captures the fancy of the investment community, there's always a risk of it being carried a bit too far. It's a new area. It certainly remains to be seen whether it is as big as people think,” said Raymond L.M. Wong, managing director and head of private equity at New York-based alternatives investment firm Spring Mountain Capital LP.
Last month, Spring Mountain was the lead investor in NXTM LLC, a Culver City, Calif.-based digital media company that offers an online platform to bands to win a live unpaid performance by capturing the most fans.
Mr. Wong said that Spring Mountain's NXTM investment, its first in social media, is different from the average me-too social media investment.
“We looked at other social media opportunities. We wanted one that that is fundamentally an opportunity to be a new business model within an established industry,” he explained.
Traditional players are being squeezed financially because people are buying single songs on the Internet rather than purchasing an entire compact disc. NXTM takes advantage of this shift in business model and the power of social media. Bands sign on for free but over time it will become subscription based. They align all of their profiles on the various social media sites and NXTM gives them marketing information including number of fans, how those numbers have changed, fan sentiment and the identity of the most influential fans.
“NXTM would not exist if there were no social media to build upon,” Mr. Wong said.
Spring Mountain executives expect to look at other social media companies, but are being picky.
“We are mindful of not following the investment team du jour,” Mr. Wong said.
“You have a sector that has taken off and you have some big winners out there,” University of Chicago's Mr. Kaplan said.
“You are going to have these huge wins with Facebook, Zynga, Groupon. Some will have spectacular returns and at that point it (venture capital) will look like a great asset class,” he said.
This is likely to result in more capital flowing into venture capital, which could lower returns, Mr. Kaplan said.
What's more, unlike the last Internet bubble, there is a massive amount of trading of social media companies on the private markets, Allegis' Mr. Ackerman said.
Novice investors are making investments with little knowledge of the companies in which they are investing, and professional investors are “pumping up the value of some of these social media companies without the visibility or transparency that I would prefer to see,” he said.
This makes social media very “frothy” so when the social media bubble bursts, it could be a more severe reaction, Mr. Ackerman said.