Top venture capitalist says his industry will shrink by 50 percent

Noted venture capitalist Bill Gurley of Benchmark Capital speculated this week, on his blog "Above the Crowd," about the near-term future of his industry. In short, it is not very bright. Gurley outlines why he thinks the sector is headed for a catastrophic but much needed contraction on the order of 50 percent. This is particularly bad for the ranks of marginal VCs who have enjoyed drawing hefty salaries for managing funds that now appear worthless.

But the contraction will be very good for the future of the VC segment. Says Gurley, "We have seen over and over again how excess capital can lead to crowded emerging markets with as many as five to six VC-backed competitors. Reducing this to two to three players will result in less cutthroat behavior and much healthier returns for all companies and entrepreneurs in the market."

His rationale, however, is somewhat different from that of other observers, who have noted that returns on venture capital are way down from peaks reached during the dot-com bubble and the relatively frothy six-year aftermath. Gurley believes that the biggest culprit in the VC winnowing is a dramatic reduction in VC investments by large institutional investors.

Such investors had dramatically upped the percentage of their portfolios dedicated to so-called alternative assets (meaning things that can't be readily traded, such as hedge funds, venture capital, private equity and real estate). Now, those investors, which include many leading pension funds and university endowments, are forced to correct in the other direction as their portfolios are top-heavy on these alternative investments and light on stocks and bonds that can be easily traded -- precisely when demand for cash is rising.

What's more, Gurley points out, many of these institutional investors committed large sums of future cash to investments in venture capital, leveraged buyout and private equity funds. Those future commitments make it nearly impossible for an institutional investor to enter into any new venture capital commitments. Which is why VC funds trying to raise new rounds are having a very tough time.

Gurley is a little late to this party. Econoblogger Paul Kedrosky published a paper for the Kauffman Foundation outlining a similar argument for a 50 percent decline in the total size of the venture capital industry last June. And Union Square Ventures' Fred Wilson made an argument for a much diminished VC industry in May of 2009.

Further, Gurley does seem to sugar-coat the issue a bit in one key sense. The venture capital crash has been so vicious that many large institutions appear to have been left with a very bitter taste regarding promised sweet rewards that never materialized. Witness this brutal commentary by Harold Bradley of the Kauffman Foundation on why the economics of the typical venture capital fund structure primarily makes sense for the venture capitalists themselves.

This might be an instructive issue for Gurley and other venture capitalists to address -- why they are getting paid 2 percent of the fund asset base and 20 percent of profits in a glutted industry when perhaps a more rational structure might be closer to .5 percent and 15 percent of profits.

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