The high volatility of the venture capital industry is well documented. This volatility manifests itself in a number of ways: the funds flowing to venture capital firms, the investments firms make in portfolio companies, and the financial performance of portfolio companies and venture capital firms (Gompers and Lerner, 2004). Much of this volatility appears to be tied to valuations in public equity markets. An increase in IPO valuations leads venture capital firms to raise more funds (Gompers and Lerner, 1998b; Jeng and Wells, 2000), an effect that is particularly strong among younger venture capital firms (Kaplan and Schoar, 2005). Moreover, returns of venture capital funds appear to be highly correlated with the returns on the market as a whole (Cochrane, 2005; Kaplan and Schoar, 2005; Ljundqvist and Richardson, 2003).
Many industry observers (see, for instance, Gupta, 2000) argue that the volatility of the venture capital industry is a symptom of overreaction by venture capitalists and entrepreneurs to perceived investment opportunities. These swings result in periods in which too many competing companies are funded, followed by ones in which not enough companies have access to capital. The boom of 1998-2000 provides an extreme illustration of these problems. Funding during these years grew dramatically—in real terms, the financing level in 2000 was more than 30 times the level in 1991—and was concentrated in two areas: Internet and telecommunication investments, which accounted for 39% and 17% of all venture disbursements in 1999.
Considerable sums were devoted to supporting very similar firms: e.g., nine dueling Internet pet food suppliers and close to two dozen companies that undertook the extremely capital-intensive process of building second cable networks in residential communities were funded. Meanwhile, many apparently promising areas such as advanced materials, energy technologies, and micro manufacturing languished unfunded as venture capitalists raced to focus on the most visible and popular investment areas.
This alleged overreaction may have its roots in the behavioral biases of venture capitalists who irrationally associate past investment successes with future investment opportunities. Or it may stem from venture capitalists who feel compelled to follow the herd out of concern for the reputation consequences of being contrarians (Scharfstein and Stein, 1990). Indeed, in 1999, even private equity firms with investment mandates to invest in leveraged buyouts felt compelled to back Internet startups.
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Venture Capital Investment Cycles: The Impact of Public Markets
