The Kauffman Foundation has released a new paper about the state of its own considerable historic investment in venture capital funds. The title, "We Have Met the Enemy...and He Is Us," says it all about the key revelation: that as an investor, Kauffman has made a terrible, terrible mistake putting money into VC. The foundation, which is endowed to the tune of $1.85 billion, is blaming itself for the sorry state of its VC returns, which have fallen off significantly from their 1990s highs. And it's demanding changes in the way that investors approach VC:
The data we’ve reviewed in this paper demonstrate that VCs are good capitalists. They act in ways that are consistent with maximizing their economic profits. [Investors] seem to be less-good capitalists, because they repeatedly fail to negotiate key economic terms that have a significant impact on their investment returns.
At Reuters, Felix Salmon is all over this. He's been building a case against the VC business — as well as its preferred method of investment exit, the blockbuster IPO — for some time now. Felix makes a lot of excellent points in a very long and densely reasoned post, culminating with this:
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.
This is largely true and beginning to affect the way that "Limited Partners" (the "LP") relate to "General Partners ("GP"). LPs are the pension funds, foundations, and universities that have been using VC as an alternative investment category, to obtain higher returns than they can get from stocks, bonds, and other traditional asset classes. They're under pressure to do this because many of them have set elevated return targets in order to remain solvent. What they can't get from traditional investments they hope to garner from VC, private equity, and so on. Unfortunately, they're discovering that this isn't the panacea they might have hoped.
GPs are the folks who run the VC firms. They get paid on a model that typically earns them a 2 percent management fee and a 20 percent stake on investment returns. So much of the criticism of VC that has emerged of late focuses on the cost of being in these funds in the first place, as well as their poor performance over the past decade.
However, the Kauffman paper is somewhat at pains to not just blame itself, revelatory though that may be, but to also blame...very large VC funds. Kauffman doesn't name names in its own portfolio, but as Felix notes, we all know who they are. And one of the conclusions we should draw from the paper isn't that VC is entirely broken, but that the model of big LPs investing with big GPs is broken — and is probably best characterized as a dysfunctional, almost codependent relationship, with LPs engaged in delusions about the future based on aging memories of VC home-runs.
Meanwhile, smaller VC funds have performed relatively better in the Kauffman portfolio. In fact, a good rule of thumb for the foundation is to actively avoid funds larger than $500 million (this would include every large name-brand fund in Silicon Valley and most leading funds in other regions):
We discussed above how VC allocations or mandates can create pressure among LPs to invest in whatever funds they can access. Many good small funds are closed to new investors, and institutional investors with large balance sheets cannot move the performance needle without large allocations if they choose to invest in VC. This creates pressure to invest in big funds, even if the expected returns are lower, and makes very long odds for large institutional investors trying to win the VC investing game. In our own portfolio, we found that we earned an investment multiple of two times our invested capital only from venture funds whose commitment size was less than $500 million; not a single fund that exceeded that capital raise earned more than twice the invested capital after fees.
The upshot, according to Kauffman, is that size matters. This is from the press release for the paper:
The Foundation found that the most significant excess returns earned from venture capital occurred in funds raised prior to 1996, and those funds averaged $96 million in committed capital. Many of those successful funds led managers to raise successively larger funds; which significantly eroded returns and maximized general partner profits through fee-based income at the expense of limited partner success.
And this is from the paper itself:
The institutionalization of venture capital investing has led inevitably to the growth in fund size. Endowments and foundations were early investors in a category deemed too risky for large corporate and state pension funds. The excess returns of VC funds from the mid-to-late 1990s induced more risk-averse investors to jump in—right about the time that the Internet bubble was about to burst. Today we see that enormous funds fail to generate excess returns, and fee-based economics misalign the interests between GPs and LPs, and create an environment for VCs to act like high-fee asset managers instead of nimble backers of high-risk, high-return entrepreneurial companies.
In my own conversations with VCs, this is anecdotally borne out. I'm not talking to Marc Andreessen; I'm dealing with incubators, angels, and sub-$100-million funds in L.A., many of which aren't entirely concentrated on big bets in the consumer Web space. In fact, some of the VCs I've spoken with have indicated that larger funds are actually doing something that the Kauffman authors imply in the paper: the big guys are acting as intermediaries between their LPs and more "nimble" backers — very early stage funds — by coming in on investments identified by angels, forming part of the syndicate. In effect, the $500-plus funds are quasi-LPs. Overpaid money managers running what amount to funds-of-better-funds-than-their-funds, rather than innovation-seeking missiles.
So it's not really fair to insist that the VC business is broken, or that all VCs are swindling their LPs out of money by promising returns based on past performance that never show up, then stretching out the fund life beyond ten years to extract more fees. What's happening is that the VC landscape is transforming, but not exactly in radical fashion.
Smaller funds, incubators, angels, and even crowdfunders like Kickstarter (although I'm skeptical about crowdfunding's true impact beyond advertising) are filling the earnings void left behind by the growth of big, underperforming funds. If this reminds you of anything, it should be the birth of VC itself. The business originally sought to fund entrepreneurs who were undertaking risky startups in the context of a postwar technology revolution that itself had low long-term risk. If you could handle the early heat, VC was really a long-term bet on a sure thing — that society would become much more reliant on electronic technology, information, computing, and so on.
I'm glad that Felix has put forward an uncompromising verdict on VC. He's not holding back, as his recent Wired piece on IPOs and a subsequent withering analysis of a Wired profile of Andreessen prove. But I also think he's tarring VC with a far too broad a brush. I've objected to this a couple of times already. But Felix has his teeth in the debate, so I expect to get the opportunity to object many more times.