Now the issues have been laid out in the open. In the second quarter, both venture capital firm fundraising and funding for startups fell sharply, according to industry reports. Funding to VC firms collapsed 82 percent from a year ago as investments in startups dropped 49 percent. In short, the whole system is awry. Just how bad is the problem?

Venture capitalists received $1.9 billion from limited partners in the second quarter of 2009. Even when the economy was faltering in 2008, the venture community had collected $9.3 billion, according to Thomson Reuters and the NVCA. It’s hit the lowest point since 1996, and one thing can’t be ignored: The recession is hammering the VC industry. Those that have raised new funds in the past year may well focus on their work, but those that haven’t and are under performing LP expectations may soon question their ability to survive in the industry.

For the past year, most limited partners, the firms that fund venture capitalists, have at one point or another turned doubtful about their involvement in the venture sector, whose returns have fallen slightly below the S&P’s 10-year average. Apart from a handful of IPOs last quarter, some of them quite successful, few major liquidity events or acquisitions have occurred, leaving little room for enthusiasm. Checks have been few and far between for the endowments or pension funds, the oldest and most loyal Sand Hill Road backers. Even universities such as Harvard, Princeton, and Stanford have quietly conducted internal studies and decided to shed some of their portfolios, signaling their dissatisfaction for the partners they want to remove.

There are other factors at work as well. With the public markets in shambles, most major endowments, foundations, and pension funds have had to account for the losses in their holdings. These audits have showed they were overweight in losses from the venture sector when compared to the declines of their other investments. Worse, a lack of payments has created a liquidity mismatch wherein more money goes out than comes in. Even Harvard has been forced to scramble and borrow $1 billion from JP Morgan amid the crisis in order to fulfill its commitment to the university’s operations. Of course, not all institutions are confronting liquidity issues. Joe Dear, the newly appointed CIO at CalPers, quieted rumors last week by revealing the details of the pension fund’s contributions, which have so far exceeded the withdrawals of more than 1.3 million California employees.

No matter how one crunches the data on how much money LPs have granted to venture capital as an asset class, this reads like the battle of Waterloo, where Napoleon lost the French empire. This last quarter, only 25 funds have received money in the United States compared to a steady stream of over 80 beneficiaries that successfully went to the well in the past. The damage shows in all subsegments as new funds – 11 since January – and amounts raised stumble. What’s more startling is the decline in existing funds securing new money from LPs: For the second quarter of 2009, that’s 17 versus 59 in the same quarter a year ago and 69 in the second quarter of 2007. That’s four-times fewer firms getting re-funded. The writing is on the wall for VCs: If the trend continues, the roughly 1,000 global firms that deployed capital in 2005 will not manage to continue their activity beyond 2011. Some LPs, interviewed or contacted recently by the Red Herring, confide that maybe 250 to 300 firms might survive beyond that period.

For the first time in decades, a strong secondary market has been reactivated on a global basis. Vultures are circling the best deals. Venture capital firms have dissected the rich 3i startup portfolio and acquired the best pieces during the first quarter, most of them in Europe, and many other portfolios are being carved out. Industry insiders and LPs are telling Red Herring that some of the leading funds that have kept enough cash are paying no more than 30 cents on the dollar for valuable IP and assets with companies fetching $50 million in revenues for 2008. This represents quite a steal and a significant realignment for startups themselves. As usual in venture capital, the last round wins it all.

It comes as little surprise that venture capitalists have felt reluctant to pursue additional early stage investments and even to participate in follow-on rounds. The $3.9 billion that they shelled out in the second quarter of 2009 for startups pales in comparison to the same period of 2006-2008, when it peaked at over $7 billion. The number of deals has plummeted by over 12 percent in all categories and the amount of series B, C, and D as well. VC selectivity has reached new heights, and they are leaving behind some companies in dire need, which have paradoxically complied with their business plans’ projections. In spite of the NVCA's shrewd attempts to spotlight the situation, the numbers exposed by the PwC reports are overall quite abysmal. Without biotech and cleantech, investments would have fallen even lower, at levels not seen in almost fifteen years.

At the bottom of the food chain, entrepreneurs are drastically squeezed. Not only is the recession slowing down the purchasing process in large and medium-size companies, which are loath to take risks at this juncture, but also the financial backers, LPs, are dragging their feet. Startup valuations are freefalling, and founders are excited when it remains on par with their last funding. Needless to say, budgets are tight or reduced in most cases, and 2009 will be remembered as a frugal year.

Everyone agrees that the 82 percent drop in funds raised by venture capitalists from limited partners mirrors the decrease for entrepreneurs and is accelerating a consolidation that is both wished for and feared by limited partners. On one hand, these LPs expect to see better returns with less VCs in the industry. On the other, there is no telling if the survivors will ever bring back the storied 3x returns and above that were commonplace in the go-go years of the late nineties. That’s because much still depends not only on the exit markets opening up, but just as importantly on when it might occur, because IRR relies on the timing of the paycheck restituted to limited partners.

The next six months will most likely see less than $12 billion invested in startups in 2009, a large drop from the 2008 data of $28 billion, according to PwC. It looks as if the sector has gone back to 1995-1998 levels, a recession that few could have predicted just a few weeks ago. At the same time, with less than $10 billion of additional dry powder and downsized funds, fewer VC are going to compete in the marketplace and some well-know partnerships will have to adjust their size immediately and anticipate to seek other job opportunities. Entrepreneurs will have to absorb the diet pill and do more with less capital. This coming quarter should be remembered as the turning point for the whole sector.

Alex Vieux,
CEO and Publisher, Red Herring