The Investment Outlook Sours

But some financial experts believe that the economic crisis could also create new opportunities.

No one knows what's coming next in the great financial crisis of 2008. Deep and lasting recession? Or temporary economic chaos followed by miraculous recovery? The financial upheaval has already soured the atmosphere for venture capital and innovation, as total investment this year looks set to fall for the first time since 2003. But some economists and financial experts believe that there is no need for gloom in the longer term. They even suggest that if the fallout leads to better-regulated capital markets, it could establish a healthier environment for innovation in the future.

Credit: Technology Review

Even so, in the near term, things could get worse for venture firms. "The current crisis doesn't directly involve venture-capital funds, but it affects them indirectly," says economist Andrew Lo, a professor at MIT's Laboratory for Financial Engineering. "As credit is withdrawn from the global economy, we're going to see less capital available for all purposes, including venture capital."

Indeed, the latest quarterly survey of Silicon Valley venture capitalists, published by Mark Cannice, a professor at the University of San Francisco (USF) and founder of the USF Entrepreneurship Program, highlights the bleak mood among VCs. Asked to rate their confidence regarding the next 18 months on a scale of one to five (five being the most confident), the average score was 2.89, the lowest since Cannice began his surveys in 2004.

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This dour outlook will put strains on fund activities, experts say, probably wiping out some firms, while forcing others to be more cautious and focused on investments likely to bring short-term paybacks. So the most immediate consequences of the crisis, experts think, will be on venture-capital firms' abilities to raise money, and on their decisions on how to invest it. New venture groups thinking about raising money for entirely new funds may indeed find it very difficult until the financial environment settles down, says Joe Hadzima, a senior lecturer at the MIT Sloan School of Management. Furthermore, the general economic uncertainty and the shortage of free capital may discourage some investors from putting money into existing VC funds, as they will likely tie up investments for several years.

But this will impact different funds in different ways, as each fund tries to meet the capital calls of their portfolio companies. The "big name" funds, Hadzima points out, tend to have large and stable limited partners such as educational endowments, foundations, or pension funds, which have already allocated money to meet capital calls. Smaller firms may not be so well situated. "Some smaller venture firms may have problems if some of their limited partners are individuals who have seen the value of their investments go down and don't have much liquidity," he says.