Capital Flows and You

For almost five years now the Bay Area has been on an economic tear. While the rest of the world tried to sort itself out from the aftermath of the housing market collapse, tech companies thrived. There have been some tremendous advances in technology in that period, and massive shifts in technology. The tech industry in general, and Bay Area companies in particular, seem to be a world apart. There is very little examination of what causes this, and we suspect many would be uncomfortable with the reality.

We are still too close to the first Internet Bubble of the 1990’s, and the housing Bubble that followed. As a result, people rarely talk about this exceptionalism. But make no mistake, there is an unspoken sentiment among people in the tech community that somehow we have developed a superior economic model. You can see this in the evangelism of start-up communities, and the tech blogs’ efforts to push this ‘model’ in other parts of the world.

If anyone ever spoke of this, the argument would probably run something like this:

The tech industry has embraced entrepreneurialism and acceptance of risk-taking. The concentration of technical talent in the Bay Area has created a cluster of expertise which builds on itself. And improvements in one area help feed innovation in others.


At this point, you can cue talk of new paradigms or economic orders, and then just cut and paste any Fast Company or Wired article from 1997 to 2000.

It is tempting to believe this. There was always something a bit unreal about the Bay Area in 2010. Except for a few dark months, property values never really fell. Unemployment was constantly low, and now there is a perennial shortage of labor. Ninety miles away, in Central Valley towns like Modesto foreclosures were rampant. Stockton went bankrupt. None of that seemed to really touch the Bay.

We are big fans of the tech industry, and want to believe that there is something ‘different’ about it. But really, we think much of the past few years can be explained by some basic economic fundamentals. When capital is cheap, it is easy to create economic activity.

And capital is cheap in the Bay Area. There has probably never been an easier time to raise venture financing. You may not be able to raise money to create a social game, or a photo-filter app, but for plenty of other business plans there are interested investors.

For all the talk of “Series A” crunches and the need for change in the Venture community, there is still an immense amount of venture capital sloshing around out there. VC’s have money, so they are willing to invest.

This is not a bad thing, at least it is not entirely bad. All that money has gone to building some great, important businesses and fuelling all kinds of advances. And while some sectors are seeing an excess of fundings (I’m looking at you mobile advertising), for a variety of reasons, this round of investing has been largely productive.

The real question is how long can this go on for? This is where we start to hit reality.

To understand the source of all this easy capital, we need to take a step back and look at the wider economy. The latest wave of momentum in tech funding really kicked off in the middle of 2009. At that point, the financial crisis had already ebbed, Lehman had fallen almost a year before. The panic subsided because of massive government intervention. This story is well known, but less understood is the affect this intervention had on the stock and bond markets. For years now, the financial markets were largely driven by government policy. The markets rose and fell largely on the words of Central Bankers and Ministers of Finance.

This was terrible for people who get paid to make investments. It did not matter if you were the world’s best stock picker. Or if you spent months researching which companies were good and which were not. The stocks of both went up or down by the same amount depending entirely on government fiat. In market parlance, everything had a correlation of one.

Aside from a few macro funds, most hedge funds were stuck, going through several years of very modest returns. Stock mutual funds offered even more modest returns, but Limited Partners (LPs), Institutional investors and other people with money still wanted returns. To find those returns, they started to look at alternative asset classes in which to invest. Emerging markets did well. Commodities did too. And you can probably guess what else did well – venture funds. For the past five years, it has been surprisingly easy for Venture Capitalists to raise funds from LPs.

We tried to find some evidence of this. The graph below is by no means scientific, but makes a reasonable proxy. In the chart, we compared quarterly inflows to Exchange-Traded stock funds (in blue) with the number of venture fundings that quarter. The data is not perfect, we used ETFs, but mutual fund data would have been better. And our Venture funding number comes from Crunchbase, which is good but not perfect. Still, the picture is pretty clear. Over the past several years, the number of fundings has grown, while the flow of funds to public equities was low or declined. And while the two trends used to be in sync, they are now increasingly divergent.

 VC flow data
Source: Crunchbase and Factset


There is a lot more going on here. We spoke with a top-tier Venture investor recently. And from his point of view, it is by no means easy to raise funds from LPs. His view was that many of the smaller funds are having a very hard time raising capital and are quietly scaling back or shutting down. But the larger funds, or those with some outsize hits (e.g. early investments in Facebook) were able to raise huge funds.

So our view is that there is still a lot of venture funding out there, but there are now some signs that the correlations in the stock market are changing. The Fed has clearly begun to back off its monetary policies (to the extent that anything about the Fed is clear). We believe that for a short period, probably months, monetary policies will still drive the stock market, but that the effect will taper off. After that, we should start to see improving risk/reward trade-offs from equity funds and improving differentiation for hedge funds. This will not lead to a sudden, sharp end to venture fundings, but it will likely bring about further consolidation. When was the last time you heard about a billion dollar VC fund getting raised?

The good news in all this is that for later-stage private companies, improving stock market conditions will likely mean the IPO window remains open. For earlier stage companies, the outlook is less clear. This may be a good time for them to stock up on your capital reserves.

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