Bubble bubble, are VCs in trouble?

Venture funds raised a mere $2.7 billion during the second quarter this year, and the industry trade association is sounding the alarm about a shrinking number of funds. According to the National Venture Capital Association, 32 venture firms raised money during the quarter, with one firm — Accel Partners — raising half of the total for the quarter in two funds. What does it mean for the industry when the diversity of funds decrease?

For the year, venture capital fundraising during the first half of 2011 totaled $10.2 billion from 76 funds, a 67-percent increase by dollars compared to the first half of 2010, but a 15-percent decrease by number of funds. Ironically, in 2009 most industry watchers were concerned the industry had gotten too large on a dollar basis, calling for funds to raise between about $13 billion to $15 billion a year, when now, the concern is about the industry needing to get larger — at least when it comes to the number of players.

“The fact that the number of firms raising money successfully remains at such low levels confirms an ongoing contraction of the venture capital industry, which will serve well those funds that can obtain commitments – but that group is becoming more and more narrow,” said Mark Heesen, president of the NVCA. “While a smaller venture industry will intuitively produce higher returns, it is critical that the mix of funds remain geographically diverse and cover a broad base of industries if we expect to contribute to economic growth and innovation at the levels we have historically. For that reason, we would like to see more funds raise money in the second half of the year.”

While we’ve covered the need for the venture capital industry to shrink, we haven’t really taken a look at what it means should the industry become dominated by existing and older funds. In general, (successful) older funds raise more money since limited partners want to continue investing in success. And there’s pressure for venture firms to continue raising the amount under management to support a growing infrastructure of people who help run the firm while the partners are out investing.

But since much of today’s investments seem to focus on smaller deals at the early stage rounds, it can make it difficult for partners at these large funds to justify spending time on an investment that’s such a small percentage of the firm’s portfolio. Sometimes the larger firms spin out or create dedicated funds for smaller efforts, such as mobile focused funds, but I wonder if this trend means the older and larger firms will be limited to competing for deals at the later stage, and pushing up valuations. Of course, as long as there are hot IPOs that’s not a problem, but when that stops, where will that leave the funds whose portfolios are focused on expensive later-stage deals? Or are they competing here, because they can, and because when everyone in the market is partying hard, it doesn’t make economic sense to sit out?

While I’m not sure I really buy the diversity card that Heesen is trying to play (in general, VCs are about as diverse as a herd of cloned sheep) I do think the rise of larger, older funds could have unforeseen consequences for startups trying to raise money once they graduate from seed and angel rounds. And I think there may be unforeseen consequences for the industry overall if it runs too far out of balance.