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Bill Gurley wrote an excellent post yesterday on what is happening to the venture capital industry.  His “punch line” is that:

…as these large institutions [LPs] adjust their portfolios and potentially abandon these more aggressive strategies, the amount of overall capital committed to alternative assets will undoubtedly shrink. As this happens, the VC industry will shrink in kind. How much will it go down? It is very hard to say. It would not be surprising for many of these funds to cut their allocation in the category in half, and as a result, it shouldn’t be surprising for the VC industry to get cut in half also.

From a top down perspective, this analysis is spot on.

There is another side to this story at play here as well, and it is captured in Fred Wilson’s post on craigslist yesterday.  Fred writes:

I do not believe we should criticize a company that operates like this. We should learn from it. Of all the Internet companies out there, the one that serves as the most iconic for our firm is craigslist, not Google. We dream of funding a company that can be worth a billion dollars with only 30 employees. We’ve never done it and I don’t know if we ever will. But we are going to try again and again and again.

Fred’s perspective here is widely shared in the current VC community.  And as traditional tech VCs increasingly focus on capital efficient models, where controlling spend becomes as important as ramping revenue, there is a definitional shrinking in the capital required to fund the sector (assuming some fixed capacity of investments per investor).  Even more so, as I commented on Fred’s post, companies like craigslist may not even need or want VC investment, further shrinking the capital required.  The craigslist’s of the world may be the unicorns of the venture capital industry.  Either way, this is a meaningful departure from the capital intensive telecom and infrastructure investing of the 90s.

What we have here is both a top down contraction as LPs change their risk profiles and allocations to illiquid assets as well as a bottoms up move towards capital efficiency further compressing requirements for venture capital.

So the shrink is on from both sides, which as both Fred and Bill agree, is probably a good thing for the long-term health of the industry.  Expect to see fewer, smaller funds, smaller rounds and greater returns.  Let’s hope so.