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Sunday, 21 September 2014

Much ventured, little gained

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Venture capital investors put their money down with dreams of backing the next Facebook, but the reality involves high fees and much disappointment.

James Saft, Reuters Columnist

A new study by the Kauffman Foundation, an entrepreneurship charity and a heavy and long-time backer of venture capital, makes disturbing reading, detailing 20 years of disappointment, a failure by venture capital firms to deliver and of the foundation itself to take the needed steps to protect its own interests.

Kauffman, which has US$249m in venture capital, is providing insights which, because of tight disclosure agreements, are almost impossible to obtain elsewhere.

The message is that most of the foundations, pension plans and high net worth investors who back venture capital would be better off trying their luck in public equity markets, which may make investors feel a bit less hip but the returns of which venture capital struggles to beat.

Over its 20-year experience, just 20 of Kauffman’s 100 venture funds beat a public market benchmark by more than 3% annually, a generally accepted target for VCs, and most of those are funds which started before 1995. Well over half – 62 of 100 – actually failed to beat public markets after fees.

As well, returns are concentrated in a very few top performing funds, but those did not tend to be among the largest funds.

Venture capital operates on the famous 2/20 system, under which investors pay the venture capital manager 2% annually on the value of the funds plus 20% of the takings when investments are ultimately sold. This protocol, which in an industry dedicated to innovation hasn’t actually changed in decades, actually gives VC managers perverse incentives.

For example, Kauffman’s funds are showing very positive returns much earlier in their life cycle than they in theory should, given that they are supposed to make long-term investments that pay off well down the road. Peak returns tend to come sometime in a given fund’s second year, rather than five or six years down the road. It is not at all surprising, however, when you factor in that funds usually do second round capital raises in their second year, often for much more than the initial commitment. It’s very handy for a VC to have a good record just as you are going out marketing, but perhaps it is a bit harder to find a good home for all those new funds raised.

Like other businesses, VC firms enjoy economies of scale and therefore it’s in their interest to rack up funds, all of which guarantee them at least a 2% annual fee. Kauffman rightly advocates negotiating a cost-based fee based on operating expenses.

Not just Kauffman

It is, of course, possible that Kauffman is simply not very good at its job as an investor in venture capital funds. That’s not supported by industry-wide data from Cambridge Associates, which found that between 1997 and 2009 there have only been five years in which funds raised that year generated enough of a return to actually return investor capital, much less beat public markets by 3% to 5% a year.

So why are returns so poor, and why has the trend been so dismal over the past decade and more?

In part, it is because the industry has grown more quickly than has the supply of good investments and capable managers. There was a lot more low-hanging fruit in the fabled early days of venture capital than there is today.

“When you get an above-average return in any class of assets, money floods in until it drives returns down to normal, and that’s what I think happened,” legendary venture investor Bill Hambricht said at a February event at Kauffman.

Whereas US$500m a year flowed to venture capital between 1985 and 1995, over the last 15 years the industry has had to find a place to park about US$20bn a year. That puts enormous pressure of managers to find investments, a pressure that seems to be driving poor returns.

All in it has to be counted a market failure. The law of supply and demand seems to apply to investments but not to the fees managers charge. Kauffman is right to lay the blame for this on investors, who have not done a good job fighting their own quarter.

That’s because, like wedding dress shops, the venture capital industry is selling hope. No one likes to buy cut–rate hope, even though that is what so many get in return for their full-price money.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. To email him: jamessaft@jamessaft.com )


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