Venture capital harms your wealth

October 9, 2009

The promise was certainly seductive: Lock up your money with me for five years and I’ll give you double-digit annual returns.

For years, that was an accurate equation for venture capital. From 1981 to 1998, there were ups and downs, but the 10-year return generally hovered around 20 per cent, well above most other asset classes. That return came at a price of course. It was illiquid and there was no secondary market. And there was a further catch. Most potential investors were excluded: Venture funds were relatively modest in size, there weren’t very many of them and they were picky about whose money they’d take for their limited partners.

The dotcom boom changed all of that. Venture capitalists became business magazine stars, new funds sprouted up all over, and established firms with a decent track record were suddenly able to raise nine- and ten-figure funds.

The 20 per cent mark began to look pallid. In 1999 the U.S. venture industry was boasting five-year returns of nearly 50 percent, as a flood of IPO’s provided swift and lucrative exits. The end-to-end return, net of fees, expenses and carried interest, for the year ended March, 2000, was 310 per cent.

Alas, that was then. New York VC Fred Wilson, principal of Union Square Ventures, reckons average returns over the last 10 years are in the range of 6 to 8 percent. Aggregate industry figures are still flattered by the anni mirabili of the dot com era, and the staggering venture bonanza of the Google IPO for a handful of elite firms. But when 1999 drops out of the 10-year calculation average returns will slump to the low single figures or negative.

The returns have shrunk, yet the industry hasn’t contracted all that much. According to data from Thomson Reuters, in 2008 there were 882 existing venture capital firms with $197.3 billion under management. That represents an increase from the go-go year of 1998, when there were 624 firms with $92 billion under management.

Venture investments have been ticking along at a fairly constant rate as well. There were two astoundingly anomalous years — 1999 and 2000 — when US venture investment was $52 billion and $102 billion. After the dotcom crash, that slumped to $39 billion in 2001 and all the way down to $19 billion in 2003. Last year’s $28 billion was down from 2007’s $30 billion, but before 1999 the biggest year in the industry’s history, 1998, had seen just over $20 billion invested.

Returns have slumped and lucrative exits are vanishingly rare. Only six venture-backed companies went public in the US last year. Earlier this year, the National Venture Capital Association launched a never-going-to-happen plan to increase the number of sub-$50 million IPOs.

Given all this, why do investors continue to back venture funds? After all, $28 billion went into VC funds last year. I asked Wilson, who is one of the more publicly skeptical VCs. “If you get into a good fund, you can still get 30 to 40 per cent,” he said. “That’s what keeps the LPs interested.”

Everyone believes they are investing in the children of Lake Wobegon, who are all above average. But institutional investors won’t play the fool for long and the response from potential LPs is bound to get stonier for all but the most accomplished funds. So what, if anything, will save venture capital?

There will need to be fewer, smaller funds, making smaller bets with their investors’ money. Fewer exits won’t be such a problem, because fewer exits will be needed. It will be something that looks, in fact, a lot like the VC world pre-dotcom. That will be a wholly good thing, for venture capital, for investors and for entrepreneurs.

A smaller industry will have fewer hangers on who invest with the latest trend, and there will be less dumb money buoying poorly formed, unrealistic dreams.


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