Venture Friction

Last week, Fred Wilson of Flatiron Partners asked the question many in the Valley are repeating these days: how much is too much for the venture industry? He concludes that, like most markets, the private equity space will ultimately reach equilibrium around "just enough" as the amount of money invested in venture funds decreases to an amount that the industry could reasonably invest:

I think all markets are self correcting. LPs aren't stupid. They will overfund a market for a while, but if returns suffer long enough, they'll cut back and wait until returns come back. That is exactly what has happened in the venture business. Very little money was raised in the past three years. In fact, when you factor in all the money that the big VC firms have given back, it could well be that no net money has come into the venture business since 2000. This has made the business healthy again.

I wish I were as optimistic as Fred. The number of big billion dollar funds continues to grow and I think in hindsight, the last three years will be more about the hangover of the bubble than any longer-term correction.

Friction, as both economists and physicists will tell you, is where idealized models meet real world realities. In economic terms, the more friction in a market, the longer the time scale for it to reach equilibrium. In some markets, that's a good thing -- too much efficiency can cause as much trouble as too little. But the venture industry features (among others) 10-year funds with little secondary market liquidity, no real-time price info, wildly volatile (and historically phenomenal) returns calculated over very long time frames and a substantial oversupply of dollars trying to get in against a large number of incumbent LPs who have no interest in giving up their seats at the table.

That's a lot of friction. And it will be a long time before the venture industry reaches anything close to a new equilibrium point.