Opinion

James Saft

SAFT ON WEALTH: Much ventured, little gained

May 10, 2012

May 10 (Reuters) – Venture capital investors put their money
down with dreams of backing the next Facebook, but the reality
involves high fees and much disappointment.

A new study by the Kauffman Foundation, an entrepreneurship
charity and a heavy and long-time backer of venture capital,
makes disturbing reading oo.gl/eAp9E, 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 $249 million 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
percent 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 percent
annually on the value of the funds plus 20 percent 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 percent 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 percent 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 $500 million 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 $20 billion 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.

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