Venture Capital Syndicate Activity Should Rise

In 1959, Fairchild Semiconductor, the first commercial integrated circuit producer, became the world’s first venture-funded firm. Today, over half a trillion dollars of venture deals are closed each year. Through these deals, our society has seen some of its most disruptive businesses emerge at a rate never before seen by humanity. Though the liquidity crisis bruised the venture capital industry, its constituents are rapidly adapting to the new economic reality. A combination of increased regulatory scrutiny and a tightening availability of buyout credit will increase the population of small venture capital firms and with it the rate of venture syndicate activity.

Leveraged buy-out firms, which use leverage, or borrowed money, to purchase relatively mature, usually privately held companies, pose a system risk via their heavy use of leverage. These firms acquire a controlling interest in undervalued targets with low debt and stable cash flows. On their own, these investments would produce unattractive returns. To compensate, buyout firms purchase a small amount of the company with cash and then borrow money, secured by the target’s assets, to purchase the rest of it; the debt is serviced by the target’s cash flows. This leverage amplifies the investment’s returns, generating a highly lucrative albeit risky yield. Yet, by involving systemically crucial lenders, the buyout firms inadvertently attracted regulatory attention, which is now pushing to require all private equity firms, currently unregulated, to register with the SEC.

Venture capital, technically a type of private equity, invests in early stage, high growth ventures, usually by means of a convertible preferred instrument. VC funding accelerates the pace of global innovation by providing critical seed and growth funding to revolutionary companies. These companies are far too risky to get funding from traditional lenders; as a result, they tend to carry extremely high organic rates of return (and rates of failure). Due to this and a myriad of other factors, pure VC firms don’t tend to engage in leverage. It follows that VC firms do not pose a systemic risk to the macroeconomic infrastructure. Thus, near the beginning of this month, the Private Fund Investment Advisers Registration Act of 2009, requiring the registration of all PE firms, buyout and otherwise--including VC--with the SEC, was amended to exclude VC firms. Though the delineation between buyout firms and VC has not been explicitly stipulated, it can be assumed from the systemic risk argument that it will likely be based on whether or not a firm engages in explicit leverage.

According to a 2009 study by the Private Equity Jobs Digest, approximately 22% of private equity firms classify themselves as a combination of buyout and venture capital. With a 2009 report by International Financial Services London estimating 2008 North American PE fundraising at $288B, this constitutes approximately $63B in funds undecided between buyout and venture capital. As the costs of compliance, including registration, filing and litigation, often manifest as fixed costs - compliance costs are usually allocated to a fixed department or outsourced via fixed contracts – the increased regulation will be a greater burden on small firms than on large ones. Hybrid VC-buyout firms are usually VC firms migrating into the buyout space; they can be expected to be small by buyout standards. In addition, the liquidity crisis has made it increasingly difficult for small buyout firms to gain access to credit. Over the next 5 years the small VC firm should make a strong comeback.

The influx of small VC firms will encourage a greater amount of syndicate activity around venture deals. Due to the high default risk intrinsic to venture capital, fund managers prefer not to hold too much of their capital in a single venture. A trend over the past decade has been to syndicate venture deals. Syndicated venture funding is the process by which a group of VC firms invest in a deal, the point being to diversify each fund’s exposure to the investment. It is particularly popular with smaller firms, who are able to achieve diversification beyond what they could independently attain. As the number of small VC firms rises, syndicate activity should increase as well.

Small venture capital firms provide value to the industry by pursuing specialty market niches often ignored by the larger firms. Their size affords them greater agility and the ability to pioneer new investment flavours. Via syndication, small firms are able to combine their innovative insight with the capital of fellow funds, capitalizing ventures that wouldn’t otherwise find funding from larger VCs (and certainly not via traditional avenues). Thus, due to the increase in small VC firms and syndicate activity, one can expect an explosion in the markets and industries that have access to venture capital.