Analysis

Is This the End of Israeli Venture Capital (And Maybe the Startup Nation) as We Know It?

Veteran VC funds are closing, executives are being replaced or looking for work, and U.S. funds might be readying to abandon Israel altogether. The whole model may be broken

An employee works at a laptop computer at the Jerusalem Venture Partners JVP Media Labs, situated in the JVP Media Quarter in Jerusalem, Israel, on Wednesday, Oct. 21 , 2015.
Rina Castelnuovo/Bloomberg

“The venture capital funds Gemini, Evergreen and Genesis have closed, at the Magma fund there’s a conflict between the partners, executives at JVP are looking for work and Pitango is dealing with allegations of sexual harassment by one of the partners,” says a leading source in the Israeli venture capital funds industry.

“In their stead, new funds such as North 83, which already has several exits under its belt, are coming to the fore. The main problem is that the foreign funds are far more dominant in Israel at present than the local ones,” said the source.

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This description, which was echoed by other industry executives in various versions, attests to the fact that Israel’s venture capital industry has reached a turning point after almost two decades of little or no change. That spells an industry that will be completely different from the one we know today, a shift that will change the way local startups raise money and finance their operations.

For those in the know regarding the events of the past two years, none of this is new. But the basic questions remain unanswered: Why didn’t the veteran Israeli venture capital funds succeed in creating a next generation and maintain their standing? Why are the best startups choosing to raise money from American rather than Israeli funds? Why are Israeli institutional investors — the investment houses that manage the public’s pension funds and long-term savings — uneager to invest in venture capital funds in general and Israeli funds in particular?

Why has fundraising by new funds declined so greatly, both in terms of the number of funds and in the amount of money? And finally, will these dramatic changes in the venture capital industry have an adverse effect on the startup sector, which serves as an economic engine for the entire Israeli economy?

Here are seven facts and insights about the Israeli venture capital industry, as of summer 2018.

Everything begins with returns

At first glance we might have thought that the vicissitudes of Israel’s venture capital funds are a result of personal stories. But the root is almost always financial, and the numbers show that over the past 10 years many Israeli funds were unable to provide investors with a significant return on their investment, certainly not enough to justify the almost total absence of liquidity for their money.

Because they are private firms, the funds can keep data on their returns and other metrics close to their chest, but the numbers that have emerged from academic studies and from the industry leave no room for doubt. A study of global venture capital returns conducted about two years ago by Prof. Steven Kaplan of the University of Chicago, according to an anonymous database originating with the funds themselves, indicated that the industry earns an average of only 1% to 2% above the stock market.

Last September Kaplan told TheMarker that for the funds that started out before 1998 “there was a wonderful period, and afterwards the returns were poor.” He added that since 2006 they have enjoyed better returns, with an excess return of 1.1% to 1.2% a year above the stock market. Among the venture capital funds, the large and well known ones continue to profit.

In the venture capital industry it is customary to rank funds by quartiles, according to performance. The goal is to reach the first, or top, quartile of funds, whose returns are among the 25% best in the industry. Top-quarter funds can raise more money and establish follow-on funds; Funds in the lower tiers sometimes leave the business altogether.

The problem is that many of the veteran Israeli funds were unable to find a way into the top 25% and therefore were unable, or found it very difficult to continue.

A vicious cycle

The best startups, those with a good chance of creating a hugely profitable exit for the investors, prefer to raise money from the large U.S. venture capital funds, usually ones in the top 25% or even top 10%. The good startups look for the good funds because the fund’s reputation will reflect back on them. In addition, the top funds have useful connections with the global high-tech industry. The top venture capital funds grant a seal of approval.

The result is that a handful of funds, most of them American, benefit from attractive and promising investment opportunities (in the industry this is called a deal flow) whereas the rest of the funds are left to back less promising firms. This is a system that enables the American funds to benefit from high returns and to maintain the lead in the rankings and conversely makes it difficult for Israeli funds.

The ego trap

These problem of U.S. competition is made worse by the problematic relations between the partners in Israeli venture capital funds, in particular between the founding partners and the rising stars of the next generation. The latter do much of the real work in managing the fund and, of course, want but not necessarily get more of the profits.

And sometimes it’s just personal. In the venture capital market they like to tell the story of the Magma Venture Partners that earned impressive returns by investing in companies such as Waze but the two founding partners — Yahal Zilka and Modi Rosen — couldn’t get along.

At Jerusalem Venture Partners, the return of founding partner Erel Margalit after a stint in politics dismayed many of the partners who had been running the show in the years he was away.

The new generation

In the vacuum left by the veteran funds, new ones such as TLV, 83North, Aleph and the Israeli arm of the U.S. fund Bessemer have arisen. These are medium-sized funds that typically raised $100 million to $250 million — less than the historic big rounds of the veteran funds but more than their most recent fundraising rounds. The new funds have the most interesting portfolios and have had some of the most successful exits in recent years, too.

Ironically, the new funds have an easier time raising capital. Because startups take time to realize their potential and returns on venture capital are measured in years, the older funds often find themselves weighed down by their poor performance while new funds with no portfolio at all get a grace period of a few years to prove themselves.

The gamble on the young and untried instead of the tried and true often turns out to be a smart one. As Kaplan explained, the returns on first-time funds XX??(a typical venture capital managing raises several in succession over a period of yearsXX?) tend to be higher — perhaps younger managers are hungrier. The industry is abuzz with talk now of managers, some of them from U.S. funds that have ceased operations in Israel, that are busy launching new management companies and raising capital for their own funds.

Yes deposit, no return

Traditionally, Israeli venture capital funds have raised money from financial investors, mainly from abroad, whose only concern is what kind of return they will make and in diversifying their portfolio. More recently, however, money has been flowing into venture capital funds from other, surprising sources: Chinese investors, Russian oligarchs and even billionaires from Kazakhstan. They all want a return on their investments, but they often have other motivations that are no less important.

What they want is access — to industry, technology and key people in Israel. To get this they want the funds to in effect become an arm of their operations in Israel. When the funds fail to attract capital from traditional financial investors, this new class of investor steps in. In some cases, their capital comes with strings attached, suggesting question marks surrounding the source of the money. Even so, some venture capital funds go along.

The Americans are leaving

Far from being any slowdown in fundraising by Israeli startups, the pace in last year has accelerated, with $5.2 billion raised, according to IVC Research. But not all the news is good. Most of that money came from American and other foreign venture capital funds and corporate investors while Israel investment continues to shrink.

One bit of evidence for the trend is the merger between the Israeli arms of the U.S. venture capital funds Marker LLC and Innovation Endeavors, the latter controlled by Alphabet Chairman Eric Schmidt. Schmidt wanted to concentrate management of the fund in the U.S. and is cutting back its Israeli operations.

Even worse, many people in the industry say the biggest U.S. venture capital funds, such as Bessemer, Lightspeed and Norwest, could leave Israel altogether even if the performance of their Israeli portfolios hasn’t been bad, simply because the opportunities in the Israeli market are too small for them.

“It’s a matter of size. When you have a chance to invest in a company like Snap everything else looks small,” says one veteran fund manager, referring to the company that owns Snapchat and went public at a $16 billion valuation. Sequoia Capital has already closed its Israel office for that reason.

Is the system broken?

Many say yes. They point to the poor returns of venture capital versus the stock market and the fact that many institutional investors have reduced their private equity holdings, including venture capital. In Israel, institutions like the provident and pension funds and insurance companies, make virtually no investments in venture capital even though they live in Startup Nation.

The answer is pretty straightforward: Institutional investment managers have come to the conclusion that if they can’t invest in the best venture capital funds, it’s better not to invest in them at all. Given the current situation, that seems pretty logical.