Socially acceptable

The US venture capital market has been sending investors something of a mixed message since the first quarter of 2010.

Last April, the 10-year returns for venture dipped into negative figures for the first time in history, according to Thomson Reuters’ US Private Equity Performance Index. The long-term data point put a taint on the venture industry, already perceived to be a risky asset class and the least loved among many investors.

At the end of the year, however, interest in the sector was up as activity levels rose: venture capitalists invested $21.8 billion in 3,277 deals in the US, a 19 percent increase in value and a 12 percent rise in deal volume over 2009, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association (NVCA). The spike in investments marked the first annual increase for US venture capital since 2007.

Fundraising, meanwhile, has remained sluggish, with just $12.5 billion raised last year, compared to $16.3 billion in 2009, according to Reuters and the NVCA. While US venture capital funds raised more than $7 billion in the first quarter of 2010, a 76 percent increase over the same period last year, nearly half that amount went to two of the industry’s most dominant players: Bessemer Venture Partners, which raised $1.6 billion for its eighth fund, and Sequoia Capital, which according to a regulatory filing had raised $1.36 billion for its “Sequoia Capital 2010” fund.

“In a quarter where you have a couple of the large funds come through, the numbers switch around and it doesn’t mean very much for a quarterly trend,” says Kelly DePonte, partner at placement and advisory firm Probitas Partners. “I wouldn’t look at that number and conclude very much one way or the other.”

Social buzz

While few venture-backed initial public offerings in the past 18 months have made headlines for returning outsized profits, skyrocketing private market valuations for social media companies – an investment in Facebook by Goldman Sachs in January valued the social networking giant at $50 billion – have commanded investors’ attention around the world. At press time, professional networking site LinkedIn had also just revealed IPO plans valuing that company at nearly $4 billion, while voice-over-internet protocol business Skype was sold to Microsoft for $8.5 billion.

All three companies, of course, have venture and private equity backers standing to make substantial returns on investment – and they are not just the investors who came in during early funding rounds.

Secondary share transactions for private companies whose user bases continue to grow exponentially, such as LinkedIn, Twitter, Groupon and Zynga, in January 2011 alone exceeded the total investment dollar volume for all of 2010.

“Our view has always been that secondaries will become a fundamental part of the venture ecosystem,” says Sam Schwerin, managing partner at direct secondaries VC firm Millennium Technology Value Partners. “All of a sudden, in the last 12 months, that thesis is really resonating.”

While Millennium is particularly keen on social media, having invested in both Facebook and Twitter, Schwerin says one of the most interesting questions facing the industry is how deeply social media will impact the real creation of value. “Is it just the top tier companies, is it the second tier companies [or] is it the entire industry [that will create value for shareholders]?”

Other venture firms that have heavily backed social media companies include Kleiner Perkins Caufield Byers, which recently raised a $250 million fund dedicated to the sector; online and digital media investor Spark Capital, which owns stakes in Twitter and Tumblr; and Andreessen Horowitz, which exited Skype alongside Silver Lake Partners and the Canada Pension Plan Investment Board in May.

While some of these firms have had incredible success backing social media and technology companies (witness the 3x-plus returns the $8.5 billion Skype deal delivered to investors), others are wondering whether the focus on the sector is creating another venture capital bubble destined to burst.

Mark Heesen, president of the NVCA, doesn’t think so. While social media is clearly a hot topic and of particular interest to venture capitalists, the numbers don’t reflect that an inordinate amount of dollars are going into a very narrow sub-sector, according to Heesen.

“The last bubble was when we invested $100 billion in one year,” he says. “It’s not like you’re seeing a huge number of ‘me too’ types of companies being funded as well, so I see this as a very different environment.”

While no official figure for the amount invested in social media through primary and secondary transactions in 2010 has been agreed upon, one venture capitalist put the total for the year at approximately $10 billion.

“In terms of what we are now seeing it's more a new media bubble than a tech bubble because the stratospheric valuations are limited to that sector compared to 10 years ago when everybody's valuations went up,” Anthony Miller, managing partner at TechMarketViews.com, recently told CNBC.com.

Still, many VCs, such as New York-based Lux Capital Management, worry about jumping on the bandwagon and avoid the media and internet sectors altogether. “From our perspective, it’s a lot more compelling to be in the areas where crowds are not,” says co-founder and managing partner Peter Hébert.

Arun George, a technology analyst at Altium Securities, told CNBC that he expected private equity firms to make good returns on their early investments in social media companies, but that it would take two years or so  to see whether or not the sector would create value for other shareholders down the line. “It is still in the hype cycle and will stay there until some of these companies start IPOs and then we will see what these companies are making and what they are expecting,” George told the news channel. “That's when disappointment will set in and that's when the fatigue will set in.”

Changing shape

While the venture industry as a whole may not be on the brink of another bubble, it is undergoing what many feel was long overdue consolidation and manager shake-out.

“Firms that may have had recognised brand names and be considered part of the establishment are slowly – and in many cases a little more quickly – going away or breaking up,” Hébert says. “A lot of the firms that most people might recognise just because of their historical performance have been unable to continue that same track record and probably will be feeding ground to a number of newer emerging firms that have a differentiated strategy”. 

That’s a prospect that has some limited partners excited.  “Venture capital in the past 10 years hasn’t performed as well … now we’re seeing a rationalisation of the venture capital market,” Christine  Pastore, the head of private equity for New Jersey’s $72 billion state pension system, said during an investment council meeting in March. “It’s an opportune time to come into the venture capital market when those top quartile managers are going to outperform. The amount of money going to those managers is less and they’ll be able to attract top-tier entrepreneurs.”

As to whether or not the greatest opportunity lies with firms investing in social media, the jury remains out. When it comes to identifying venture capital’s next breakout sector, picking a winner is extremely difficult, says Mark Cannice, professor of business at University of San Francisco. Cannice has been gathering data on venture capital since 2004, and says that only the market can decide whether social media or another industry end up being the next transformative event for the asset class.“It always seems to surprise us, and my guess is it will again,” he says.

“Somewhere someone is cooking something up, and we won’t know it until it’s passed us by.”