Is the level of Venture Capital investment a Lead or Lag indicator of growth?

The NVCA has released a couple of press release this week on the state of the VC industry

The first is a one pager on VC investment in the Internet Industry. The highlights of this Press Release are…

  • 2,051. The number of Internet-specific companies that received VC funding in the last 5 years.
  • $22.9 billion. The amount of venture dollars invested in Internet-specific companies in the last 5 years.
  • 328. Number of venture-backed Internet-specific companies that have IPO’d in the last 20 years.

The interesting part being that the first 2 key points about the ongoing level of investment are based on a 5 year time line while the exit returns are based on a 20 year timeline. All of which suggests the VC Industry hasn’t achieved that much an ROI from its Internet portfolio over the past 5 years.

The other press release was the 2011 industry forecast. The highlight of this length presentation of industry stats was the news that 82% of VC’s are anticipating an increase in investment in the Consumer Internet sector.

All of which is not a surprise given the level of investor excitement around the SoMe flagships Facebook and Twitter.

In the past we have analysed just how good the VC industry is at picking winners. What we haven’t examined why the VC’s struggle to pick winners.

I suspect its because VC investment is a lag indicator of innovation in the US economy rather than a lead indicator. This is because of the time it takes to generate investor awareness in the opportunity, raise the funds and then allocate those funds to suitable opportunities.

This inherent delay in the fund-raising cycle simply means that VC don’t actually fund innovation but they do provide the fuel that amplifies the Boom:Bust nature innovation cycle.

To demonstrate this idea I have taken the NVCA’s Investment and Fundraising Data for the past 15 years and mashed them together into a single chart to illustrate the lag between investors putting new funds into the VC pool and the time it takes for VCs to get those funds working on behalf of the investors.

NVCA Investment Data 1995-2010

The first thing you’ll notice by looking at the chart is during the Dot Com Boom

  • The bulk of the funding arrived at the end of the boom rather than at the beginning where the real growth opportunity was for investors.
  • While the level of funds invested grew by a factor of 10 the number of investments being made only increased by a factor of 4.

Post Dot com boom we discover that

  • The balance of the uninvested funds from the boom supported the industry for the 3 year period following the crash.
  • Confidence in the industry’s ability to pick winners didn’t return until after the Google IPO.
  • Again the bulk of the investment funds became available some 5 years after the original opportunity presented itself.
  • Since the GCF and the general downturn the industry has survived on the funding growth of 2005-2007 generated by the “Google” factor.
  • The chart suggests industry can only sustain itself for a 3 year period before new investor funds are needed to reinvigorate the market. This is why confidence in the revolutionary “Facebook” Factor and the continued strong growth in SoMe sector is such a key part of the VC story today.

NVCA Data vs. Growth in GDP 1995-2010

If we add the growth in US GDP to the NCVA data we discover that, if anything, the VC’s act as something of a dampener to the raw boom-bust extremities of investor sentiment. However the graph clearly shows us that the growth in VC investment isn’t counter cyclical as one would expect from an investor experienced in seeding innovation but correlates with the market’s boom bust cycles.

This suggests that VC industry are in the business of profiting from the late growth opportunities in the Innovation Cycle rather than seeding the Innovation Cycle. After all the history of the MobCon shows us that the majority of investors contributing funds to the VC industry warm to the opportunity late in the investment cycle. This then is probably the reason why the VC market has such a problematic history in picking winners. It isn’t so much about their ability to identify and seed innovation early in the innovation cycle that is in question but their focus on funding innovation trends late in the market cycle. That’s why when VC get involved we tend to see a flood of innovative Me2 in particular market segment rather than a diverse spread of innovative start-ups across a wide range of sectors.

What this chart also suggests is the bulk of the investor funds for the SoMe and Mobile Apps boom should hit the market between now and 2015 – Certainly this is what the VC market appear to be banking its strategic outlook on – and that’s why so many high-profile VC’s are busy raising funds to create new SoMe portfolios (e.g. Kleiner Perkins $250 Million sFund).

Announcements like these may declare to the market SoMe is going to be hot but the reality is SoMe is already red-hot. Just like the Mobile App Market and that’s why I would suggest that the level of VC investment is a lag indicator – rather than a lead indicator – on the growth potential of the US Economy.

[Update 4-5-2012] This pattern is even easier to identify if we isolate the year on year change in VC investment against the annual change of the rate of growth in GDP.

Year on year change in VC investemnt vs growth in GDP

GDP chart sources: US Growth in GDP 1990-2010, thoughtofferings and US Output Data

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