The Triumph of Hope over Experience

Reports supporting the poor performance of the venture capital industry are queuing up. The most recent report (May 2012) from the Ewing Marion Kaufmann Foundation is no news, but scary reading:

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.

The Kauffman Foundation found that in their own portfolio …

Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing prior to 1995.

The majority of funds—sixty-two out of 100—failed to exceed returns available from the public markets, after fees and carry were paid.

There is not consistent evidence of a J-curve in venture investing since 1997; the typical Kauffman Foundation venture fund reported peak internal rates of return (IRRs) and investment multiples early in a fund’s life (while still in the typical sixty-month investment period), followed by serial fundraising in month twenty-seven.

Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index.

Of eighty-eight venture funds in our sample, sixty-six failed to deliver expected venture rates of return in the first twenty-seven months (prior to serial fundraises). The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with sixty-nine funds (78 percent) that did not achieve returns sufficient to reward us for patient, expensive, long- term investing.

Still more nettlesome problems for investors were found:

The average VC fund fails to return investor capital after fees.

Many VC funds last longer than ten years—up to fifteen years or more. We have eight VC funds in our portfolio that are more than fifteen years old.

Investors  are  afraid  to  contest  GP  terms  for  fear  of  “rocking  the  boat”  with   General Partners who use scarcity and limited access as marketing strategies.

The typical GP commits only 1 percent of partner dollars to a new fund while LPs commit 99 percent. These economics insulate GPs from personal income effects of poor fund returns and encourages them to focus on generating short-term, high  IRRs  by  “flipping”  companies  rather  than  committing to long-term, scale growth of a startup.

See related blogs: Are venture capitalists paying or living the venture, Why governments don’t get startups

Source: We have met the enemy … and he is us