Tuesday, May 08, 2012

The truth about venture capital

The excerpt below is from the Kauffman Foundation's report on venture investing. I'd like to see a similar report for hedge and private equity funds. If you believe in efficient markets and rational sophisticated investors (i.e., pension funds, endowments, the super wealthy), you have to explain why they continue to invest in underperforming asset classes and pay exorbitant fees. My explanation is that apes are not smart. Alpha is hard to detect and it's easier to believe a story (narrative sales pitch) than the numbers (esp. if the numbers are hard to obtain or require a bit of brainpower to interpret). Financial services are incorrectly priced, both by sophisticated investors, and by society. Via Ben Lorica.

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, longterm 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. ...
See earlier post How to run a hedge fund.


Ben Lorica said...

Re: Hedge Funds

Simon Lack's recent book, the Hedge Fund Mirage touches on similar issues. If you look at the profits generated by Hedge Fund industry, most of it has gone to insiders: see here for details.


SLD82 said...

Suppose you are a public pension fund manager. From an actuarial
POV, you need a return >10% for inflows
to exceed outflows over the long term. Statistically, you understand this is
impossible considering the amount of money you are managing and the fact that the S&P doesn't exceed 8% over the longterm.   You
understand that given the magnitude of your investment and the long time
horizon, it basically comes down to risk v. reward on the efficient frontier.  Given this information, do you: 
a) Recommend that pension benefits be curtailed, at
which point you will be a political scapegoat? 
b) Recommend that pension contributions increase,
at which point you will be a political scapegoat? 
c) Play dumb, kick the can, and wait for a political
crisis at which point the fund will be reigned in from actuarial la-la land and
you will have likely moved on to a different job?

At the end of the day, it is easier for a fund manager to
fail conventionally than to fail unconventially, especially when the average investor
has no concept of statistics. As long as HF’s, private equity, and VC are considered “smart” investments, financially illiterate baby-boomers will insist fund managers invest in them.  

uair01 said...

Thanks for posting this. Ideas that go against conventional thinking are always welcome!

David said...


LaurentMelchiorTellier said...


"You put Lloyd Blankfein in pound-me-in-the-ass prison for one six-month term, and all this bullshit would stop."

MtMoru said...

"Never was so much paid by so many for so little."


Returns or even returns adjusted for risk aren't the right measure. If hedge funds really are hedge funds and if VC and private equity funds are poorly correlated or negatively correlated with other assets then diversification makes them worthwhile. Still any business which doesn't compete on price is a fraud.

Financial services in general are overpriced, and even when investment banks are actually doing something rather than stealing they collect rent, to use LY's term. Right now loss ratios in P&C are only 50%.

LondonYoung said...

All it takes to collect a little rent (or avoid paying too much) is to know 8th grade algebra  

On hedge funds - Steve, why not take one of the indices of hedge funds that covers funds which are open to new investment and not survivor biased (there are a few such indices, lemme know if you can't find one).  Then calculate its beta and alpha with respect to any broad equity index.  (Warning, this require algebra.)

And, just a side note, bonds have outperformed stocks under just about any measure over the last 30 years - how often were we told that that wasn't gonna happen.  And if you meet someone who says "ah, but that is over, interest rates can't keep going down forever!", then ask them which has done better in the 20 years that Japan has followed a zero rate policy - stocks or bonds?

RKU1 said...

Given the extremely high returns this decade of several VC-funded companies such as Google and Facebook, this really is a remarkably damning portrait of the entire overall VC industry.  Not totally unexpected to me...

Venture Capital Partners said...

Awesome . Keep sharing . :))

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