How venture capital is broken

By Felix Salmon
May 7, 2012

I read quite a lot of papers about finance and investing, but I can’t remember the last time I came across a 52-page paper which I simply devoured, avidly, reading every word, and even following the footnotes. But such is the latest publication from the Kauffman Foundation, a truly wonderful report on the foundation’s own experiences in the world of venture-capital investing. This is required reading for all institutional investors with any kind of exposure to VC, and I sincerely hope that it succeeds, at least at the margin, in forcing those institutional investors to behave a bit more like investors, and a bit less like chumps being bullied into throwing millions of dollars into a series of opaque black boxes delivering decidedly subpar returns.

The Kauffman Foundation was created to encourage entrepreneurship; its endowment currently stands at some $1.83 billion. Of that, $249 million is invested in VC and growth equity funds; the foundation has been investing in VCs for 20 years now. As a rich, long-term institutional investor devoted to the cause of early-stage companies, the Kauffman Foundation is — or should be — pretty much the perfect LP as far as VC funds are concerned. And indeed, over the years, it has invested in 100 such funds, and therefore now has a spectacular real-world backward-looking dataset of VC returns from an LP perspective.

This is the kind of dataset that money, literally, can’t buy: VC funds’ investment agreements have such tight confidentiality clauses that Kauffman and other institutional investors would never be allowed to share this information with anybody else. But by anonymizing their data, and by self-critically coming clean on their own returns from venture capital, Kauffman’s investors have managed to put together a detailed and compelling report with a very simple conclusion: venture capital is not much of an asset class, and insofar as it is an asset class, it’s very, very broken.

Over the past 20 years, net of fees, Kauffman has been paid out 1.31 times, on average, the amount that it invested in any given fund — well below the standard “venture rate of return” of twice committed capital. The payout is meant to come after no more than 10 years, but the 10-year figure is honored mainly in the breach: Kauffman alone has 23 funds more than 10 years old, and eight funds more than 15 years old. One fund, at age 19, still retains more than 20% of the capital that Kauffman committed way back in 1992.

Here’s the bigger picture: the total amount returned by all of Kauffman’s funds. The red line is at that 1.31x average multiple:

returns.tiff

This is very much a short-head, long-tail dataset, with the short head having high returns and the long tail being decidedly disappointing. What’s more, the really high returns in this chart — the ones which achieve that “venture rate of return” of 2x committed capital — come exclusively from funds with less than $500 million committed: something which is very rare among top-tier VCs these days. What’s more, most of them also come from funds raised before 1995. If VC funds were good investments once upon a time, they’re not any more:

vintages.tiff

In reality, VC returns have been dismal for the past 15 years:

During the twelve-year period from 1997 to 2009, there have been only five vintage years in which median VC funds generated IRRs that returned investor capital, let alone doubled it. It’s notable that these poor returns have persisted through several market cycles: the Internet boom and bust, the recovery, and the financial crisis… In eight of the past twelve vintage years, the typical VC fund generated a negative IRR, and for the other four years, barely eked out a positive return.

I’m all in favor of investment strategies which display low-volatility returns, but only when those returns are actually positive; in reality, according to this report, the average VC fund returns less money to investors than they invested in the first place.

The Kauffman report makes a very strong case that the best way to look at VC returns is to benchmark them against a liquid public stock index: they like the Russell 2000 small-cap index. If you do that, you get a chart which looks a bit like this. The x-axis is PME, or public market equivalent: if a fund is lower than 1, as most of these are, then you would have been better off just investing in the Russell 2000. And while there are certainly funds which massively outperformed that index, in order to get that kind of performance you really need to invest your money before 1995, to take full advantage of the dot-com bubble.

pme.tiff

Given the high fees and the illiquidity and the inherent risks of venture-capital investing (the Russell 2000 can’t go to zero, a venture fund can), it’s reasonable to expect a venture fund to return at least 3% per year over and above the Russell 2000. Using that metric, 78% of the funds that Kauffman invested in have failed. And remember that Kauffman has more access to the top-tier firms than most VC investors.

But the really interesting thing about the Kauffman paper is that it doesn’t blame the VCs for this underperformance. Instead, it pins the blame squarely on the LPs — the investors who irrationally invest money with VCs.

The first thing they do is have a “VC bucket”, which then turns them into “bucket fillers”. VCs love bucket fillers, because an LP with a bucket is an LP with no ability to invest in something better instead, like the Russell 2000.

GPs we interviewed are very aware of “bucket filling” behavior, and said LPs with VC mandates act like the money is “burning a hole in their pockets.” They just need to spend it. Institutional investors governed by mandates presumably attempt to get into the ten to twenty top-tier VC funds; but if they can’t, they’re left to choose from second- and third-tier funds—a strategy that nearly guarantees returns unlikely to exceed a low-cost, liquid, small cap public index.

If you look at the performance of VC funds during the golden years of 1986-1999, it turns out that once you strip out the top-performing 29 funds, the rest — more than 500 — collectively invested $160 billion, and managed to return $85 billion to investors. If you can’t get into one of the best funds — and everybody knows which funds those are — then there’s really no point investing in venture capital at all. But what happens is that some investment board looks at VC returns inclusive of the best funds’ returns, and then mandate a certain investment in VC which assumes they’ll have some kind of access to those top-tier funds. And that’s an extremely dangerous assumption to make, because most of the time it won’t be true.

The second thing that LPs do is that they pay VCs to raise lots of money, rather than pay them for returns. Most of the income in the VC industry comes from the 2 bit of 2-and-20, rather than the 20 bit. Which means, as the report puts it, that “while a select group of VCs remain focused on delivering great investment performance to their investors, too many are compensated like highly-paid asset managers.”

As such, these GPs have every incentive to exaggerate early-year returns in their funds, despite the fact that the whole point of the way the funds are structured is to allow long-term investments which don’t pay off until many years down the line. Here’s the most astonishing chart from the report:

curve.tiff

What you’re looking at here is the self-reported returns from all 100 of the Kauffman foundation’s funds, plotted on a time zero axis. In theory, if you believe the VC industry’s hype, the returns should look a bit like the green line: negative in early years, as you make investments which won’t pay off for a long time, and then positive by year 10.

In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. (The blue line shows total fund returns, while the red line shows returns net of fees — the money which actually goes to LPs.) Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves.

If GPs were incentivized mainly by their 20% performance fee, then you’d expect something like the green line, or at the very least you’d expect the performance to rise over time, as the fund’s illiquidity premium manifested itself. If GPs were incentivized mainly by their 2% management fee, however, then you’d expect something much more like the real-world red and blue lines, where performance figures are used more to raise new funds than to make money.

Here’s how the report explains GP math:

Data from the Foundation’s portfolio indicate that the median time to the first capital call of a subsequent fund is 26.6 months. As a thought experiment, assume a VC partnership raises a $250 million fund. Early in year three, exhibiting early positive IRRs, the firm raises a subsequent $350 million fund. Demand for Fund III remains strong, and the GPs raise another $500 million fund later in year five. Each new fund adds a fresh income stream to the residual fees older funds continue to generate over the ten-year life. Without visibility into the firm financials, LPs don’t see the total cumulative management fees the firm receives, and, more importantly, don’t know where those fees go. In this theoretical example, a moderately successful VC firm raises three smaller-sized funds within the investment period of the first fund; and the operating income climbs to more than $19 million by year five. Our experience would indicate that VCs may somewhat increase fixed costs like additional staff with subsequent funds, but in most cases expand very conservatively.

The Kauffman foundation has lots of bright ideas about how this misalignment of incentives could be fixed: for instance, investors in VC funds could ask for much more transparency on the costs of running those funds, pay a budget-based management fee instead, and then pay a performance fee which rises sharply when the fund genuinely outperforms the public markets. For instance, it could be 20% when the public markets are outperformed by 3%, 25% if the outperformance is 5%, and 30% if the outperformance is 7%.

Ian Charles ran an intriguing experiment in 2008, when he asked LPs how much of a performance fee they would be willing to pay to get into a top-performing, $250 million fund. He got bids as high as 72.5%, and a market-clearing level of 42.5%. Clearly it’s possible, in theory, for top VCs to charge much higher performance fees than they’re charging right now, and some of them are OK with budget-based management fees, too.

But here’s the weird thing: it’s the LPs, much more than the VCs, who are averse to any change on the compensation front. Investors, it turns out, are extremely conservative, and don’t want change even if it’s in their best interest.

One startling fact from the report explains why that might be the case:

Our own casual review of institutional private equity investors reveals median job tenure of around three years. There is much turnover at the LP investor level, which creates little incentive for any one investor to fight hard on behalf of their institution for better economic terms, especially if they are not getting paid for that outcome and views such behavior as harmful to industry ‘relationships,’ which the investor likely will find beneficial in landing their next job.

What this says to me is that the VC industry, as a whole, is being incredibly successful at extracting rents from dumb institutional investors. These investors wouldn’t dream of investing in a public company where there was no transparency as to basic questions like how much money the principals were being paid, but they happily invest in venture capital funds where the founders cream off so much of the income that younger top performers end up leaving the firm. And in general, VCs are incredibly good at playing fear off against greed: would-be investors really want massive VC returns, and they really don’t want to be left out in the cold. Even Kauffman does that: “We have chosen to stand down on terms,” they write, “when faced with an investment decision in a top-tier fund.”

The big picture, here, is that an enormous number of institutional investors are still chasing VC returns which haven’t really existed in the industry since the mid-90s. So long as all that money is chasing a relatively small number of opportunities, and especially now that valuations for early-stage tech companies are going through the roof, the chances that the average LP will make any money at all in VC are slim indeed. Venture capital is sexy, and it makes a lot of money for GPs. But investors need to take a very hard look at the asset class, and ask whether it’s worth it from an LP perspective. After reading this report, they should probably conclude that it isn’t.

22 comments

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There is a reason that Volker said that the only valuable innovation in finance in the past few decades was the creation of the ATM.

Posted by Matthew_Saroff | Report as abusive

Doesn’t that first chart look an awful lot like the same chart from various forms of show business investment: movies, TV shows, plays? Or baseball–a rare grand slam, and a lot more strikeouts and ground-outs?

Posted by dellbell | Report as abusive

@Matthew_Saroff: The concept behind venture capital – outside investors taking an equity stake in order to fund the growth of a business – is far older than the last few decades. It at least goes back to European joint stock companies funding merchant trips in the 16th century, and potentially longer ago than that depending on how much of a stickler one wants to be about the form of corporate organization.

The problem these charts expose is that venture investing is driven by a quite small number of winners. It’s not surprising that dollars flowing to more and more venture funds results in diminishing returns, particularly since almost all of the dollars are funneled into a couple of sectors (IT and healthcare), with an emphasis on companies who are targeting large market opportunities with a game-changing, disruptive innovation. There are only so many such companies that are going to be successful in any given time frame.

This point would be even clearer if someone could prepare a chart like the first chart but showing returns by company as opposed to fund. You’d almost certainly find that a relatively small number of venture-backed companies – less than 20 per decade – account for over 100% of net venture returns during the period. That’s not to say that other individual companies may not generate positive returns – some do – but that on a net basis the losers greatly outnumber the winners after excluding the Googles, Ciscos, eBays, and Facebooks of the world, and that’s the underlying reason why venture returns look so bad outside of the top funds.

Posted by realist50 | Report as abusive

Yes, it is, I’ve met a guy who got into Digital at the beginning. (Wife’s maiden name is Slumberger)

But venture capitalists are not the same as venture capital funds.

It is the use of an intermediary to do due dilligence, without the transperency associated with, for example, mutual funds, which is the innovation.

I have a rule, which I call “Saroff’s Rule” (http://40yrs.blogspot.com/search/label/ Saroff%27s%20Rule) which states, “If a financial transaction is complex enough to require that a news organization use a cartoon to explain it, its purpose is to deceive.”

VC funds seem straightforward enough, but when you get into the weeds, and try to figure out how they REALLY operate, it’s cartoon time.

Posted by Matthew_Saroff | Report as abusive

A question, should I change the rule from, “Its purpose”, to “It’s true purpose”.

Also, how should it apply to puppet shows? (http://40yrs.blogspot.com/2010/04/corol lary-to-saroffs-rule.html)

Posted by Matthew_Saroff | Report as abusive

These results are in line with a recent paper by Harris, Jenkinson, and Kaplan, for details see:

http://www.verisi.com/resources/buyout-v s-venture-capital.htm

Investment Multiple: Outside of a few exceptional *vintage* years in the 1990′s Venture Capital hasn’t produced decent investment multiples

Public Market Equivalent: “Buyouts underperformed the S&P 500 in 6 out of 29 vintage years, while Venture Capital underperformed the S&P 500 in 16 out of 29 vintage years.”

Posted by datascientist | Report as abusive

Success fees encourage higher risks to be taken. VC Funds are already risky, but providing an incentive to make them more so doesn’t make sense to most investors – although the attraction to the managers of the potentially enormous fees is clear to all.

Suggesting success fees have anything to with the interests of the investors is nonsense – unless there is a similar negative failure fee for underperformance.

Posted by FifthDecade | Report as abusive

To: Matthew_Saroff

Re: How should Saroff’s Rule apply to puppet shows?

Set an example: Seek venture capital to launch a vaguely described start-up whose mission is to be the world leader among companies that mediate all their interactions through robots, automata, puppets, Magic 8-Balls and vintage telephone answering machines from the 1980s.

Instead of brochures, web pages, charts or text in any format, make presentations solely by traveling puppet shows restricted to medieval technologies and standards of hygiene. Puppeteers will operate on the assumption that audiences hold medieval concepts of the world.

Golden Opportunity Potential: Kick off the campaign in Tampa during the upcoming Republican National Convention.

Posted by TobyONottoby | Report as abusive

@TobyONottoby:
Dylan Ratigan used puppets to explain the banksters. (http://40yrs.blogspot.com/2010/04/corol lary-to-saroffs-rule.html)

Posted by Matthew_Saroff | Report as abusive

Another observation: there are a very small number of high fliers in this game, and they really, really outperformed the rest. I suspect that this level of dispersion isn’t present in equity mutual funds.

I also suspect that people tend to anchor on the eye-popping returns, and convince themselves that they can select the funds that’ll outperform. Kaufmann is showing that that’s not really feasible at this point in the VC asset class. I know that some folks think they can pick good active mutual funds, and I know that Felix doesn’t think that’s possible; I disagree with him here in some respects, but this paper really shows that investors really have to be aware of how their cognitive limitations limit their capacity to maximize their own returns.

Posted by weiwentg | Report as abusive

“You may rely on it.”

“At the sound of the tone, insert one 2-euro coin, tuck your head between your knees, and kiss your Hayek goodbye.”

“Witch!”

Posted by TobyONottoby | Report as abusive

An interesting, but extremely superficial paper. I have both been an entrepreneur going for venture capital and done diligence on 18 potential deals. My view of the VC world is from the trenches where the value gets created.

In general, no group compares for arrogant, self-assured, willful ignorance like the decision makers in Venture Capital. Focus on numbers, inattention to detail, lack of interest and understanding of what is really being invested in is the rule, not the exception. The ‘bright young men’ are mostly not very damn bright. They are manipulative, slick and (as the report alludes to) understanding of cronyism’s road to their own paydays.

The VC industry operates as a lemming horde. The algorithm is that if something is successful or looks good (i.e. a ‘sector’ gets identified) that everybody and their rabbit will invest in it. This guarantees poor returns for venture capital as a whole. It makes no sense to back 12 different companies in an area where at most 2 or 3 can survive, to say nothing of prosper. Large institutional investors can and do screw themselves this way when the left hand doesn’t know or care what the right hand is doing.

And yet – the big returns are generally made in places that aren’t identified. Something new or that is done differently. Apple and Microsoft did that. Every VC gives lip service to finding the next one. But in my experience, not a one, ever, has been willing to consider investing outside the well-trampled mudpits in which their cronies stumble around.

From what I’ve seen, the difference between how venture capital is allocated and a blind baboon playing whack-a-mole is this. In the case of venture capital, if the blind baboon hits a mole (and kills it) then all the other blind baboons come running to whack at the same hole, hitting each other, the winning baboon, breaking their mallets and turning the freshly killed mole into a thin stain spread wetly on the ground.

There is not a lack of viable business ideas. Not at all. But there is a lack of ability to recognize such, or to even give a damn – really – if the idea is good. Sorry – but that’s the report from the trenches back to the dim bulb half-wits upstairs.

What I got out of reading this report was clarification of the social algorithm of the problem in venture capital. It’s cronyism, a de facto cabal that seeks to rip off the top-teir firms. Pretty simple to see why it works that way.

Posted by BrPH | Report as abusive

The real problem here is that the established rules of marketing don’t really work–particularly for small companies… When VCs apply these rules to companies they fund, the companies fail, and these failures are what constrain returns for institutional investors. –Jude Hammerle

Posted by JudeHammerle | Report as abusive

Brilliant. Wondering if anyone has seen a similar analysis for PE funds?

Posted by MattDil | Report as abusive

the Kauffman report is excellent but it doesn’t tell us anything we didn’t already know. the VC asset class is not a good fit for institutional investors who want to put $10s of millions to work in each and every fund. if the institutions left the business, the best VCs would be raising $200mm fund and the worst would be raising $20mm funds. we’d be back to the way the business looked when I got into it in the mid 80s.

the one quibble i have with Kauffman’s suggestions is the focus on terms. while they are a problem, they aren’t the core problem. good managers earn their fees. the problem is that there aren’t many good managers in the VC business.

Posted by fredwilson | Report as abusive

I agree that VC returns have sucked in the last decade but their theory on the “n” curve is flat out wrong. The reason for the n curve is because most of the funds were 1999-2000 vintage funds …. go look at what the NASDAQ did after 2000.

Posted by MarkJro | Report as abusive

Wow, what a great article. Thanks for taking the time to explain it all out. Loved it!

Posted by Bryko | Report as abusive

Wow, what a great article. Thanks for taking the time to explain it all out. Loved it!

Posted by Bryko | Report as abusive

JP Morgan was given a free hand on Bears deal by the federal government when the financial crisis started. When I was in an employee of Investment bank of JP Morgan, they were doing midnight changes of numbers during the crisis years of 2007-2009. JP Morgan got a $35 billion check from federal government to play their books. They call in the middle of the night when I was told to change the numbers in the trading database directly to cook the books. Since then I am sure they are continuing to cheat the financial world as usual on a daily basis. Finally a day dawned on them to eat their own medicine.

Posted by Former_employee | Report as abusive

The trend was on its boom in 1996, but then it decreases. The basic reason could be that people believe on equity investment. They just use to float stocks in the market to get some funds. http;//investmentfinancialmanagement.blo gspot.com

Posted by JuliaJones | Report as abusive

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