Lessons from Twenty Years of Investments in VC Funds

[Guest hellsten]

“WE HAVE 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:

http://www.kauffman.org/~/media/kauffman_org/research%20reports%20and%20covers/2012/05/we%20have%20met%20the%20enemy%20and%20he%20is%20us(1).pdf

 

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 investment team analyzed our twenty-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership “brands” and concluded that the Limited Partner (LP) investment model is broken. Limited Partners—foundations, endowments, and state pension fund—invest too much capital in underperforming venture capital funds on frequently mis-aligned terms. Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias. We found in our own portfolio that:

- 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.

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.

 

Understanding the costs and long-term investment results of VC fund investing reveals still more nettlesome problems for investors:

- 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.

 

The Kauffman Foundation’s approach to venture capital investing in the future will be to:

- 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.

[Guest longinvestor]

Thanks for posting. Very revealing indeed. The combination of the LP's hope of superfast return of capital, looking for a double (or more) feeds the killer instinct of feasting on other-people's- money of the GP.

 

The dominant theme emerging from the broken capital allocation schemes of all hues during recent times is the fee structure. It's-the-fee-stupid. Nowhere else but in the world of finance does the world pay fees for hope. The world of finance has a nice thing going for themselves.

[stahleyp]

I agree with long. I'd be interesting if the SEC (or something else) came out with some type of clawback rule - that the fee would be returned (or a certain percentage) if a certain benchmark or return expectation wasn't met. The fund (hedge, mutual or VC) could set up certain rules to reduce behavioral basis (3-5+ year lockup) and as a result if they do a poor job, they make very little or nothing.

 

I'd imagine that would be incredibly disruptive for the investment industry.

[topofeaturellc]

I don't think its totally fees with VC's - its just a horrible asset class.  Even if you took fees out returns are still bad.

 

The other thing that's amazing is that the reason why the name brand guys outperform if you look at the data is that they get offered a cheaper price to invest at.

 

So it ends up being something like : coin comes up heads a few times, now guaranteed even if you are a market performer to outperform your peers by like 20%.

 

Its crazy. I just had to stop talking about business with my friends who are in VC funded bizzes.

[cubsfan]

Hellsten - nice paper, thanks for posting.

[PatientCheetah]

Like most things in tech, the strong tends to get stronger and the weak tends to get weaker. Each year, there are only so many revolutionary companies, causing return distribution to resemble power law. There is very little reason to invest in VC unless you can get into the top funds. They have the best deal flow and best reputation. Similarly, the most promising entrepreneurs are attracted to the top VCs for the same reasons.

[ni-co]

I don't think its totally fees with VC's - its just a horrible asset class.  Even if you took fees out returns are still bad.

 

The other thing that's amazing is that the reason why the name brand guys outperform if you look at the data is that they get offered a cheaper price to invest at.

 

Totally agree. It all comes back to the price you pay. As Howard Marks says: "What matters most is not what you invest in, but when and at what price. There is no such thing as a good or bad investment idea per se."

 

VC has the kind of attention and glamour factor that drives up the prices and that you shouldn't like as an investor – in this way it's very similar to most IPOs.

[randomep]

 

.... 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.....

 

Yet more confirmation of WEB ideas.....

[Guest longinvestor]

I don't think its totally fees with VC's - its just a horrible asset class.  Even if you took fees out returns are still bad.

 

The other thing that's amazing is that the reason why the name brand guys outperform if you look at the data is that they get offered a cheaper price to invest at.

 

So it ends up being something like : coin comes up heads a few times, now guaranteed even if you are a market performer to outperform your peers by like 20%.

 

Its crazy. I just had to stop talking about business with my friends who are in VC funded bizzes.

 

I'd like to rephrase so, "No matter what the performance is or what a bad asset class it is, the fees get collected and first. The worry over performance comes later and it is solely the LP's worry".  So it is mostly about the fee and OPM. The article points out that the LP's put up 99% of the capital.