Why the Smart VCs Are Boarding their Jets

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private-jetI started my career as a finance reporter covering wonky subjects like banks, bonds and agribusiness. I ended up in Silicon Valley covering tech, because it was the late 1990s, and I was doing what finance reporters are supposed to do: Follow the money. I’ve since realized if you want to cover startups well, it’s more complicated than that: You have to distill between the pioneer money and the lemming money. By the time the lemming money is investing, the story has been told, and the pioneers have already picked their bets.

There are a few ways to do this. One is to poll the smarter VCs, but frequently they don’t want to share their secrets. Another is to look at relative increases in the percentage of capital going to different sectors. For instance, in the mid-2000s, sectors like Web 2.0 and clean tech weren’t getting the most venture capital, but they were getting the biggest percentage of increases in funding before Facebook was gracing every magazine cover and John Doerr was weeping over the environment at TED. A third way is to look at how the money shifts in a downturn. When a bubble bursts do formerly hot sectors turn into wastelands?

One reason I knew Silicon Valley would rise again after the 2000 crash was that it always does. Another was that the percentage of capital going to Valley companies increased, as VCs pulled closer to home and stopped speculating in more nouveau tech hot beds around the U.S. and overseas markets. But the exact opposite is happening this time around. According to new numbers by Dow Jones VentureSource, venture capital investment fell in the United States last year but rose in China, India and Israel despite increased economic and political turmoil in those regions; despite the human desire to nest in bad times; and despite the fact that so far VCs have struggled to get much in the way of returns from billions poured into India and China.

That should tell us something.

Sure, more money is still invested in the U.S.: But all three of my litmus tests support the theory that the pioneer money isn’t pulling back from overseas speculation in the wake of troubled times for the industry. The smart money is doubling down on emerging markets. Investing in unknown entrepreneurs in emerging markets is scary. But there’s a greater fear in venture capital these days: Where is the next new frontier to make big money?

We think of a VC’s job as investing in high tech—but really, it’s about investing in high growth. Doubling or tripling your money is great, but venture capital is at heart a home run business. And most of the sectors where VCs have traditionally gotten the biggest home runs have simply matured: Chips, computers, software, telecom, Internet. Sure, there’s still opportunity in the Web, software and even hardware—look at Facebook, Salesforce.com, and NComputing—but these are increasingly one-off and many of the most promising ventures sell before they get to home run levels.

There continues to be opportunities in biotech, too, but drug discovery takes a lot of money and a lot of time. Instead of swinging for the fences building the next Genentech, most VCs are content to find a novel drug candidate and license it to big pharma. That’s more a base hit than a home run. As for clean tech, the market is huge, but uncertainties around the science, government cooperation and expense of building a new alternative energy industry cast big doubts on just how lucrative returns will be.

Compare that to places like India, China and even Central Africa where incomes are rising, populations are growing and nearly everything is a growth industry. Trucking, logistics, coffee shops—and yes, some Internet and tech companies too. Sure, it’s fraught with its own risk, whether it’s ethical quandaries of whether to bribe public officials, language and cultural barriers, immature capital markets or just the grind of investing halfway around the world. But venture investors are supposed to take risk. They are supposed to be pioneers. If it were easy, there wouldn’t be the promise of 10x returns.

Venture capital judges itself on a ten-year cycle, and the riches of 1999 are about to fall off the index. The industry as a whole is in danger of performing about at the level of the S&P 500 or below. If it wants to survive, it’s time for a reboot: Get back to boutique, the way smart seed funds have done, or figure out global. Only a few firms will thrive in between.

Interestingly, the trend is happening at the same time the rank and file in the Valley seems to be coming down with a disturbing case of xenophobia. One of BusinessWeek’s most commented stories this week was about H-1B Visa fraud, and frankly, there were a lot of offensive anti-Asian views throughout the thread. Similarly, when I was on KQED’s Forum last month talking about layoffs in the Valley, a good many people called in angry that they’d been laid off while foreign-born engineers kept their jobs.

I know losing a job is scary, but a lot of the value of Silicon Valley has been built by people from other countries. Put another way: You had your job (and stock options) at companies like Google and PayPal because of foreign-born founders who came to the Valley and were able to thrive. We’d do well as a region to continue to invest in the smartest people from around the world, whether they’re coming to us or—gasp— we have to get on a plane and go to them. I believe the Valley will remain the hub of innovation, but for that to be the case, that hub needs to have far longer spokes.

Ten years after following the money brought me to Silicon Valley, increasingly following the smart money is taking me halfway around the world.

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