End of Bubble 2.0?

Sitting in Silicon Valley, it's easy to see how we might be in Bubble 2.0. Unlike the boom of the late 90s, this is a private affair, with sky high valuations and marginal businesses being funded by Angels, VCs, and individuals in private exchanges, whereas Bubble 1.0 was all about excessively high valuations in the public markets.

The Angel phenomenon is interesting, as there is a clearly social dimension to it. Those who made money in the first boom can get invited to cool cocktail parties if they invest in "it" companies even if they aren't starting "it" companies any more themselves. The Social Proof that runs Angel List and gets recycled through TechCrunch and Arrington is kind of like the Gartner/Forrester mill that populated hockey-stick graphs in spreadsheets across corporate America.

And like Bubble 1.0, there are real technological changes that support what's happening this time around -- the social graph is new, mobile is new, cloud computing is new, costs have fallen dramatically, etc. All true. All may not justify the valuations. So I'm not questioning the technology, I'm questioning the financing.

There was an important article announcing that Calpers is pulling out of VC:

The nation’s largest public pension fund, CalPERS, appears likely to slash its investments in venture capital in what could be a blow to this still recovering asset class... The California money manager’s new strategy, which it has discussed before, appears tied to flagging returns from its existing investments and concerns that taking a large enough stake in future funds is nearly impossible. CalPERS, with $239 billion in assets, needs to hold significant positions in new securities for them to have an impact on the bottom line... The pension fund this year has about $2.1 billion in venture capital assets, or 6% of a $34 billion private-equity portfolio that includes buyout, distressed debt and mezzanine funds. The new plan, which will be debated at an investment committee meeting on Aug. 13, would cut that allocation to less than 1%... The pension fund cites several reasons for the proposed move, “One is that venture has been the most disappointing asset class over the past 10 years as far as returns,” says Joe Dear, CalPERS’s chief investment officer. “Second, it’s very difficult for a large fund like CalPERS to gain access to the best venture partners in the size that makes a difference to our performance.”

A buddy of mine in the industry had some very interesting insights which I will share below (redacted appropriately):

This is clearly the right move for Calpers. Hopefully other big funds will follow suit. At those sizes you just can't move the needle and it is a really hard space to make money. A lot of brain damage for  less than 1 percent of your total portfolio. Even if you are wildly successful with 50% returns, you only increase your total return by less than 0.5 percent. You can't be wildly successful putting the dollars to work of Calpers because despite best efforts, you end up being the benchmark. They probably have about 30-50 VC funds to get $2 B invested. Big prestigious endowments can't get enough capacity even at their more modest sizes. Calpers move portends well for those who stay and do smart VC investing as the competition in capital raising rounds goes down and valuations are more reasonable.

There is still too much capital in VC which is a very small capital constrained niche of the investing world. $10 B a year would probably be enough capital, but we are still running at over $20 B / year raised. There is still pain to be had and more big money needs to be shaken out.

The problem with VC is people came up with risk and return expectations from historical data. They decided to allocate X% without regard for how much they could get into the best funds. They then just started investing in VC as an asset class with $s way to big for the best managers to absorb. To fill allocations they had to give money to lower quality managers in the name of chasing a historic risk and return which is only available on a limited pool of capital. As a result returns really suffered - they would have even without the spectacular implosion of the tech boom. The same thing is happening in hedge funds at the moment on an even more spectacular scale. At least money into VCs got spent in the real economy in ping pong tables and jobs.

Now that the public markets have said "no" to bubble valuations, and Calpers is saying "no" as well, will we see the private bubble pop?