Business cycles matter but shifts in consumer taste matter more

I just had this exchange with @peHUB and I want to expand on it here motivated by Bill Gurley’s post What Is Really Happening To The Venture Capital Industry?

@peHUB said “Allocation” percentages to VC don’t matter nearly as much as does what that allocation means in terms of real dollars

I responded: @peHUB: Disagree. Allocation speaks to expected returns and LP mind-set on value of liquidity while total dollars is macro baseline

@peHUB responded to me:@phineasb But allocation % often gets determined by hard dollars. That’s basically what’s happened with CalPERS.

I believe allocation percentages do matter and matter much more than hard dollars for those working in the VC industry and for the entrepreneurs that depend on venture investment to build great companies. The aggregate hard dollars allocated to the venture industry should fluctuate just as most other markets experience expansion and contraction with the business cycle. But, a shift in the allocation to alternative assets in large portfolios is much more significant because it represents the institutional view on the risk adjusted returns that will be generated by the asset class and specifically the value that is currently being placed on liquidity — a proxy for the level of risk in the economy. This type of shift is analogous to the shifts in consumer tastes that destroy industries (away from SUV’s for example).

LP’s like CalPERS have capital requirements that must be met over a foreseeable time horizon. Their investment strategy is driven by three factors:

1. The size and timing of capital inflows from outside contributions

2. The size and timing of capital inflows from current investments

3. The projected disbursements the endowment must support

I have never managed an endowment, but it seems likely that the endowment manager happens to be is managing the sum of the uncertainty in 1 and 2 to support requests/projections for 3. Additionally, the manger has more control (or the perception of more control) of the risk she is taking in 2 than in 1. As the macro-economic environment shifts, impacting the absolute dollar levels of 1 and 2, she will shift her dollar allocations to maintain the prescribed balance in her portfolio and to meet the demands of 3. This does not imply a strategic shift in allocation, but does imply dollars flowing from one asset class to another. When this occurs, the fund raising environment for alternative asset class fund mangers will be more difficult and this higher hurdle will trickle down into the ecosystems in which they invest. The fat will be trimmed and the industry, the entrepreneurial ecosystem, will be healthier, less crowded and will resume generating excellent returns and experience growth as the economy rebounds. This is my reading of Bill’s argument and I agree with his analysis.

As Bill points out, the total allocation to venture by institutional LP’s was traditionally as small as 2% of the institution’s overall portfolio (10% of alternatives with an allocation of 20% of the total portfolio) but in recent years this commitment grew to as much as 5% as the allocation to alternatives increased from 20% to north of 50% in some cases. Given the illiquid nature of alternative assets, this implies much larger ratios of (1+2)/3 than had been seen in the past and this was supported by the growth in the economy and particularly the stock market between 1990 and 2007 (acknowledging some significant blips).

If the recent crisis has caused institutional money managers to rethink the allocation scheme of their portfolios this does not bode well for the venture industry in the long run. While it is possible for some alternative assets to shift toward a model that provide shorter terms liquidity options for LP’s, the venture industry is dedicated to investing in ideas that must be developed and commercialized. The most valuable resource we can offer an entrepreneur is time, making our investments inherently illiquid and therefore vulnerable to such a shift in thinking by limited partners. A shift in allocation will imply a shrinking of the industry, initially resulting in a healthy trimming of the fat, but without the expected recovery as the economy begins to expand. This could result in an industry with an un-stabilized market size of less than the $15B a year that Bill describes. At a much smaller scale, the industry misses many opportunities and cannot generate the required returns or support the vibrant ecosystem of innovation required for success on both sides of the funding table.

In the limit, a declining level of investment, due to shifts in LP portfolio allocation will result in limited innovation and declining returns leading to extinction for the venture industry and the innovative companies we support. Contrast this with a contraction in absolute dollars that is part of the broader business cycle followed by growth driven by the strongest investors and entrepreneurs and it becomes obvious [to me :)] why allocation percentages matter more than absolute dollars in this industry.