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Will the Credit Crisis Hurt Venture Capital?

credit crisis and venture capital [1] Recently, there has been some discussion of whether the credit crisis is helping or hurting venture capitalists.

The argument that it is helping holds that the credit crisis has made returns from venture capital investments more favorable than returns from other types of private equity. The high returns to private equity in the past few years were driven by inexpensive credit so taking away that cheap credit has brought private equity returns back into line with other investments.

Maybe. But I’m not so sure that the credit crisis is helping venture capitalists. There are several reasons to think not.

1. Exit through M&A: The main exit route for venture capitalists is through acquisition of the start-ups they fund. While some acquirers of start-ups use cash to buy companies, others use their stock or raise debt to fund acquisitions. With the stock markets in turmoil, it’s harder for companies to purchase other companies with stock (which might drop in value). And with credit getting more expensive, borrowing to purchase companies is getting more costly. So at the margin, there are probably fewer buyers of VC-backed start-ups and those buyers who remain are likely to pay less for companies, lowering VCs’ returns.

2. IPO Drought: In a recent survey of 660 VCs conducted by the National Venture Capital Association (PDF), 64 percent attributed the IPO drought, at least in part, to the credit crunch/mortgage crisis. IPOs are less in demand if investors’ appetite for risk decreases, as it appears to have done recently. They are also less attractive if the stock market is falling or gyrating all over the place, as it has been.

In addition, it’s hard to take companies public if the investment banks that do the IPOs can’t focus on normal business because they are consumed with going under or getting bought out. If the credit crisis is adversely affecting the IPO market, then VCs are losing their most attractive exit route, lowering their returns.

3. VC Firm Operations: Some venture capital firms themselves are getting hit by the credit crisis. The private equity firms that do both venture capital and leveraged buyouts are getting hit because the disappearance of cheap credit has hurt the leveraged buyout market. At companies where leveraged buyouts are a much bigger part of their operations than venture capital, the investors could face enough problems that they start exiting the market.

Venture capitalists also raise money from limited partners. While some argue that those investors will shift their asset allocation toward venture capital in their search for higher returns, an alternative scenario is that some of those limited partners, like pension funds, will lose so much money from their other investments that they will have to cut back on all their investments, including those allocated to venture capital.

4. Portfolio company performance: The companies in which VCs invest could be adversely affected by the credit crisis. A slowdown in the real economy that results from the credit crisis would hurt young companies’ efforts to sell new products and services. Also new high growth companies need debt, and if lines of credit and debt financing aren’t available to them, that could hurt their performance. Finally, the portfolio companies need to manage their own cash, and there have been some reports that they have put that money into Auction Rate Securities (ARS) rather than into checking accounts. The problems in the ARS market have kept some startups from getting to their own cash.

Maybe VCs are escaping the credit crisis unscathed. But I think there are several reasons why they won’t in the long run.

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About the Author: Scott Shane [2] is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of eight books, including Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By; Finding Fertile Ground: Identifying Extraordinary Opportunities for New Ventures; Technology Strategy for Managers and Entrepreneurs; and From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company.