Previously, venture capital as an asset class has been critically discussed by Jochen and Alex in their respective blogs excitingcommerce.de and kassenzone.de.
Source: http://www.excitingcommerce.de/2012/09/vcs-und-die-hohe-wahrscheinlichkeit-des-unwahrscheinlichen.html and http://www.kassenzone.de/2012/09/12/venture-capital-funktioniert-nicht/
In his last blog Alex already hinted that I am working on a more detailed analysis of the subject. Why do I find this interesting? Well, after having worked in the PE and VC industry I always wondered how it would feel to change sides – become an entrepreneur and learn the nuts and bolts of daily operational challenges. It has been very interesting and I am tempted to claim that “professional” VCs who have been in banking or consulting all their lives and therefore represent the favorite MBA trained elite that joins VC/PE firms on a junior level – know next to nothing except how to draw pretty slides, talk in “investor” slang at fancy conferences and run after hypes like a crazy bunch of headless chickens. This is clearly an exaggerated view but overall the question remains if venture capital is an asset class with a future. The question is, if the more experienced senior staff has the ability to find deals and make investments that are profitable. In addition, I am wondering if only a select few sometime „get lucky“ or if this is a sustainable industry with a risk/reward ration that should be attractive to investors.
In addition, Germany has seen a significant increase in venture capital through the Berlin „hype“. Now, with the entire industry under fire it becomes extremely interesting to see how the industry is going to develop. Even more importantly I am certain that these new analysis will have an impact on the rapidly developing European start-up environment.
Based on a range of studies it has become clear that the venture capital industry in general simply sucks at being investors and even more importantly sucks as an investment vehicle for their Limited Partners (“LPs”). Returns of venture capital as an asset class are simply not sufficient to continuously attract new capital.
How bad are returns?
The Kauffman Foundation, a highly reputable Limited Partner in many venture capital firms, has published the following facts based on their significant, long-standing venture capital investment history.
“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.”
There are also other articles and reports that are based on the Kauffmann analysis and the inability of venture firms to raise new funds. Limited Partners have finally woken up to the reality that blindly investing in larger and larger venture capital funds no longer makes sense. Why is that? As Fred Wilson states in a recent MIT technology review interview:
“Because the returns haven’t been very good in the venture capital industry for a long time. I think if you talk to the investors in venture capital partnerships, they’ll tell you that they’re very much on the fence on venture capital, and if venture capital continues to put up mediocre returns, they’re not going to stick with it forever.”
At the moment Berlin delivers a wonderful live case study to prove my point. The current hype, number of horrible investments and general herd behavior of investors in Europe’s new venture capital “capital”. Where are the actuals businesses that are supposed to generate lasting returns in the current “hype-cycle”? Where are the returns, exists or just simply lasting value creation? A small elite group of investors such as the Samwer Brothers are highly successful but from my impression the overall industry does not generate lasting value.
The Kauffmann report goes on to argue that actually LPs should re-evaluate their investment behavior and focus on other key value drivers within the VC industry.
- “Invest in VC funds of less than $400 million with a history of consistently high public market equivalent (PME) performance, and in which GPs commit at least 5 percent of capital;
- Invest directly in a small portfolio of new companies, without being saddled by high fees and carry;
- Co-invest in later-round deals side-by-side with seasoned investors;
- Move a portion of capital invested in VC into the public markets. There are not enough strong VC investors with above-market returns to absorb even our limited investment capital.”
The Kauffmann report also has an interesting title:
“MET THE ENEMY… AND HE IS US” – Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience“.
They consider the problem the be the LPs – they need to change their asset allocation in order to substantially alter industry behavior and subsequently the return rate for the industry as a whole.
The previously listed investment recommendations are only one side of the equation. I think that there is a general consensus that due to the lack of returns and the issues outlined by the Kauffmann Foundation the VC industry will change.
Therefore, there are a lot of questions that remain:
What are the implications for start-ups? What consequences does this bring for VC funds, which have fully invested their current capital? Will prices for start-ups significantly change?
Excellent Analysis Nils, thanks for sharing!