Venture C(r)apital: Myth And Reality
Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years. As The Kauffman Foundations finds, from its 20-year history, investment committees and trustees should shoulder blame for the broken LP investment model, as they have created the conditions for the chronic misallocation of capital (no doubt driven by the failure of 'hope' over experience). All is not lost to the money-pumping narrative-followers though as five myths are destroyed and five recommendations made that may help LPs allocate and follow-through more effectively.
It’s become a bit of a sport among venture capital (VC) insiders and observers to assert that the venture capital model is broken. Industry returns data show that VC returns haven’t beaten the public market for most of the past decade, and the industry hasn’t returned the cash invested since 1997, certainly a compelling sign that something must be wrong. It’s so easy to point the finger of blame directly at VCs—there are too many of them, they’re raising too much cash, they’re sitting on too much cash, they’re investing too much cash, they’re taking home too much cash...
We believe that to really understand and constructively address what’s ‘broken’ in VC, we need to follow the money. And the money trail leads right to the LP boardroom, where investment committees oversee venture capital investing.
- Assumption 1: ‘Top-Quartile’ and ‘Vintage-Year’ performance reporting is, at best, not fully informative, and is, at worst, misleading.
- Assumption 2: The average VC fund barely manages to return investor capital after all fees are paid.
- Assumption 3: VC mandates do not produce “VC returns” that exceed a public equity benchmark by 3 percent to 5 percent per year.
- Assumption 4: The life of a VC fund is frequently longer than ten years. VC funds are structured to invest capital for five years and to return all capital within ten years, but we see a large percentage of our fund lives extending to twelve to fifteen years.
- Assumption 5: Big VC funds fail to deliver big returns. We have no funds in our portfolio that raised more than $500 million and returned more than two times our invested capital after fees.
The following recommendations constitute the most important actions that investment committees can take to repair the broken LP investment model:
- Recommendation 1: Abolish VC Mandates: The allocations to VC that investment committees set and approve are a primary reason LPs keep investing in VC despite its persistent underperformance since the late 1990s. Returns data is very clear: it doesn’t make sense to invest in anything but a tiny group of ten or twenty top-performing VC funds. Fund of funds, which layer fees on top of underperformance, are rarely an effective solution. In the absence of access to top VC funds, institutional investors may need to accept that investing in small cap public equities is better for long-term investment returns than investing in second- or third-tier VC funds.
- Recommendation 2: Reject the Assumption of a J-Curve: The data we present indicate that the “J-curve” is an empirically elusive outcome in venture capital investing. A surprising number of funds show early positive returns that peak before or during fundraising for their next fund. We see no evidence that the J-curve is a consistent VC phenomenon or that it predicts later performance of a fund. Committees should be wary of J-curve-based defenses of VC investing.
- Recommendation 3: Eliminate the Black Box of VC Firm Economics: Institutional investors aren’t paid for taking on the additional risk of investing in VC firms with ‘black box’ economics. Investment committees can stop accepting that risk by requiring consultants and their investment staffs to acquire and present information on VC firm economics, including compensation, carry structure, GP commitment, and management company terms and performance, in order to obtain investment committee approval.
- Recommendation 4: Pay for Performance: The current market standard 2 percent management fee and 20 percent profit-sharing structure (“2 and 20”) pays VCs more for raising bigger funds and, in many cases, allows them to lock in high levels of fee-based personal income regardless of fund performance. Creating and negotiating a compensation structure that pays fees based on a firm budget, and shares profits only after investors receive their capital back plus a preferred return, would mean LPs pay VCs for doing what they say they will—generating excess returns above the public market.
- Recommendation 5: Measure VC Fund Performance Using a Public Market Equivalent (PME): Evaluate VC fund performance by modeling a fund’s cash flows in comparable indexes of publicly traded common stocks. We use the small capitalization Russell 2000 as a benchmark as we believe it better reflects the higher price volatility, higher beta, and higher sensitivity of small companies to economic cycles than the large capitalization S&P 500 index does. Adopt PME as a consistent standard for VC performance reporting, similar to the Global Investment Performance Standards.3 Require consultants or investment staff to present PMEs as part of any investment decision. Reject performance marketing narratives that anchor on internal rate of return (IRR), top quartile, vintage year, or gross returns.
From the myth of the J-Curve to the reality of mis-aligned compensation structures along with a plethora of intermediaries who 'need to get paid' even as LPs force money to work in ever-increasingly crazy investment narratives... it seems the liquidity of central banks has been washing ashore in many places for much of the last decade enabling a dismal level of mal-investment (cognitively dismissed by every investor who dreams of the next Facebook)
Full Kauffman paper below:
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