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| In Calamity's Wake |
Virtual Overhang
Eileen P. Gunn
04/01/2004
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With the economy improving and cash-strapped entrepreneurs willing to sell
stakes in their companies on generous terms, venture capital firms would like to
start fresh. More than half of the firms surveyed in December by VentureOne, a
San Francisco firm that tracks the venture capital industry, hope to start
raising fresh money in 2004. Only a handful did any fund-raising over the
past two years, and in a normal market, they count on starting a new fund about
every three years. Still, the idea of new fund-raising may surprise those of us
who have read about the “overhang”—the huge amount of committed capital
supposedly sitting on the sidelines waiting to be invested.
Venture
Economics put this figure at about $56 billion last year—a number that has been
widely quoted in the trade press. But Paul Gompers and Josh Lerner, two finance
professors at Harvard Business School, believe the overhang is far smaller than
most suspect. Their rationale: Between 1995 and 2002, venture capital firms
raised roughly $44 billion more than they invested. But when one accounts for
the money these firms “gave back” from recent funds ($5 billion), the value of
future management fees ($17 billion), and the money they are keeping in reserves
for additional rounds of financing ($18 billion), that surplus shrinks to a
little more than $4 billion.
Additionally, according to VentureOne and Ernst
& Young, venture capital firms invested more than they raised in both 2002
and 2003, indicating that whatever overhang does exist is steadily being worked
out. “The overhang is really overstated as a problem, especially when you
consider how much money is spoken for in terms of follow-on investments,” Lerner
argues.
Indeed, Intersouth Partners, a seed-stage fund in Research Triangle
Park, N.C., closed a new fund in 2003, and actually raised more than it had in
its previous fund ($205 million, versus $170 million in 2000). According to
general partner Dennis Dougherty, this ensures Intersouth can fully participate
in as many follow-on rounds as its companies require (otherwise it could be
diluted out by venture capital firms that can invest more, or be forced to
accept a lower valuation than it thinks a company deserves—which in the end
hurts our returns as investors).
Lerner worries that individuals and
institutional investors may now have too much pent-up demand for private equity
investments. “What does concern me is all the money on the sidelines waiting to
come back in,” he says. “It creates a sort of virtual overhang. When venture
capital firms start fund-raising again, there are lots of people who want to
come back in—institutions, pensions, overseas investors.” Despite firms’ efforts
to retreat from the megafunds they raised a few years ago and reimpose
discipline on their fund-raising, “this latent demand makes me worry we could
have another bubble,” he says.
 Back to main article: "In Calamity's Wake"
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