Liquidity drought could save venture capital

(breakingviews.com) -- California's current three-year water shortage is visible all across its increasingly parched, brown landscape. Silicon Valley-based venture capitalists are facing another kind of drought entirely.

Liquidity for VC-backed companies has dried up according to new data from Dow Jones VentureSource. The inability of firms to turn their investments into cash is endangering all but the most well-connected. Oddly enough it may save the fading VC industry.

VC-backed liquidity totaled $2.8 billion last quarter, despite three initial public offerings -- the first in nine months. That's because the quarter saw the fewest mergers and acquisitions since 1999 and the median value of deals fell by nearly half. The headline figure was down over 80% from 2007, which produced $14.6 billion in VC-backed liquidity.

In fact, most VC firms haven't seen a single sizable exit since the dotcom bubble. This makes raising fresh capital nearly impossible -- except for the most well-connected players.

Indeed, a strong brand name means more when times are tough. Case in point: former Netscape founder Marc Andreessen just finished raising $300 million for a new firm. His Silicon Valley chops certainly helped. He was recommended to potential investors by other top shops like Kleiner Perkins, and can count technology luminaries Peter Thiel, of PayPal fame, and LinkedIn chief Reid Hoffman as investors.

True, $300 million isn't a huge commitment. But it reflects the new realities of the VC industry. Entrepreneurs can now start web businesses for less than $50,000, so nimble funds that make a smattering of investments will likely do better than concentrated big guns.

And less money is a good sign for the industry, which was choked by a surfeit of cash for a decade. As a result, returns lagged as fierce competition forced firms to offer overly-favorable terms and pour money into lackluster ideas. The best performing fund vintage of the past decade was from 2002, and it returned a paltry 5.7%, according to Cambridge Associates.

A smaller set of preeminent firms may mean that the industry's survivors will actually have some spoils to feast on. And that's something that VC hasn't seen for a while. The current drought may prove to be more blessing than plague.