Venture capital, which suffered mightily when the dot-com bubble burst, might at first blush seem to have some protection against the current recession. After all, with a five-plus year investment horizon, venture capital wouldn't seem to be particularly vulnerable to the ebbs and flows of the economy, especially since technology companies didn't cause this recession as they did the last one. But in fact, VC firms are getting battered, with VC investment plunging to a 12-year low and the number of new funds hitting a five-year low. Most troubling, VC performance is down, with returns declining significantly across all time horizons but 20 years, according to the National Venture Capital Association, or NVCA. With a great deal of navel gazing and some handwringing, VCs have been asking themselves, "Is the damage collateral, or is the venture capital model inherently broken?"

The double whammy of two recessions in under a decade has been devastating for many VCs and the limited partners that invest in them.

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"As one LP told me, he has been investing in great venture firms for a decade and has not yet made any money," says Stuart Ellman, the co-founder of RRE Ventures LLC, a New York firm founded 15 years ago. "Therefore the model must be broken."

Ellman, who has spent a lot of time talking with RRE's LPs, divides them into three categories: those who are committed to VC and have a long-term approach, those who don't know whether they will have the capital to continue to invest in VC after the crash and those who "are constantly debating where they should allocate money within private equity, whether it should be in LBOs, growth capital, distressed or venture capital," says Ellman.

"These people, for the most part, are skeptical and believe that the venture model is broken."

Ellman and other VCs counter that rather than being broken, venture capital is a highly specialized investment tool that should be wielded only by a small number of managers who have proven themselves adept at using it.

"Returns for venture capital from 1995 to 2000 were so phenomenally good that the asset class attracted massive amounts of new capital, new players and lots of me-too activity," says Ellman. "As in all such episodes throughout history, this influx caused previously good returns to become concomitantly bad. Since the party ended, the VC industry has been slowly unwinding its way out of this overpopulation."

The slimming down of the VC industry is already under way. While by some counts there are thousands, if you consider only the ones that have made an investment in the last year, only several hundred are active.

Earlier this spring, Dan Primack, the founder of Thomson Reuters Private Equity Hub, coined the term "VC walking dead" to characterize firms that are officially in business, with enough cash to support existing investments but not enough to add companies. Some observers say hundreds of venture capital firms fit the description.

The macroeconomic factor that has hurt VCs the most is the nearly frozen initial public offerings market and its negative effect on mergers and acquisitions. There were no VC-backed IPOs in the fourth quarter of last year or the first quarter of this year, although the second quarter has been slightly more promising, with successful offerings from VC-backed Bridgepoint Education Inc. in April and OpenTable Inc. and SolarWinds Inc. in May.

"Without liquidity events, the asset class of venture capital is in dire jeopardy," warns Adeo Ressi, best known for starting TheFunded.com, which invites entrepreneurs to share their experiences with VCs under the cloak of anonymity. "By the end of 2010, the vast majority of funds will be out of business," says Ressi.

"Exits are the No. 1 concern for venture capitalists," says Mark Heesen, president of the NVCA. "Venture capital is all about returns, and VCs haven't been able to deliver returns to their LPs."

Fred Wilson, the co-founder of New York's Union Square Ventures, has been studying the history of VC returns and writing about "The Venture Capital Math Problem" on his popular "A VC" blog lately. Wilson has plenty of historical perspective. In 1996, he co-founded Flatiron Partners, which invested in 59 Internet companies by the time the bubble burst in 2000. Some of them, such as StarMedia, crashed and burned, while others, such as comScore Inc., are thriving today.

Flatiron stopped making investments and went into maintenance mode in late 2000 after its sole backer, J.P. Morgan Chase & Co., reined it in.

The math problem is "part of a fundamental question about venture capital," says Wilson. "What is a reasonable rate of return that one should expect for a broad-based portfolio fund?"

"Venture capital is different from being in public stocks," he says. "With public stocks, you can take your money out whenever you want. You can't do that with venture capital. Your money is locked up for 10 years -- or more."

Using data from Thomson VentureXpert, Wilson calculates that 10-year returns for VC firms as a class are between 5% and 10%, compared with the S&P, which is -5% for the same period. "Is a 10% excess return enough to incent a rational investor to part with their money for an extended period of time?" Wilson asks. "Maybe. It really depends on who the investor is. But it certainly is not a slam dunk in my mind."

The tricky part for an LP is choosing a fund that will outperform the average. "In any period of time, such as the early wave of biotech or the PC or enterprise software or communications equipment, there are 15 to 20 firms that nail that wave," says Wilson. "But everybody else is going to be left with the crumbs."

And those crumbs, Wilson warns, may not be worth venture capital's "illiquidity premium."

Even if an LP thinks it can identify the top-performing VC firms at a given point in time, it may not be able to invest in them. There are more LPs who would like to invest in Silicon Valley's venerated Sequoia Capital, for example, than the firm's funds can handle.

"I think 'back to the future' is the answer to most of the VC asset class problems," concludes Wilson. "Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals and smaller exits."

Union Square Ventures invests between $275,000 and $6 million throughout the life of a startup. Its portfolio is filled with social media companies that need relatively little capital to deliver products and services, such as Twitter Inc., the microblogging service based in San Francisco.

If Twitter and other Web 2.0 companies, most of which have not figured out how to make money, remind some of the dot-com era, Wilson is not among them.

"Most companies back then had million-dollar-a-month burn rates," he says. "Today, Union Square's portfolio companies are spending $50,000 to $70,000 a month or $600,000 to $700,000 for the whole year."

In fact, it takes tech startups so little money to get up and running these days that some entrepreneurs are beginning to question the need for venture capital. Charlie O'Donnell, the co-founder and CEO of Path101 Inc., a career development site based in New York, used to work for Union Square as an analyst, and Wilson is an angel investor in Path101.

"People would tell me, 'Oh, you're lucky that you used to work for a venture fund because you understand what they want,' " O'Donnell wrote in a blog recently.

"In hindsight, I don't know about that. I might have been better off not knowing that VC existed, aiming for profits from the beginning -- and then just being nicely surprised if some dude shows up at my door with a few million in cash asking to buy a minority stake in my business."

If entrepreneurs learn to get along without VCs, that might indeed be the death of venture capital.