Tuesday, May 8, 2012

How can we explain the incredible shrinking venture capital industry

How can we explain the incredible shrinking venture capital industry and the disappearance of many venture funds before our very eyes? In an article, “How Venture Capital is Broken,” Felix Salmon of Reuters recommends a new Kauffman Foundation study.

“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,” says Salmon.  “ But such is the latest publication from the Kauffman Foundation, 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.”

As we angel group members know well, The Kauffman Foundation, created to encourage entrepreneurship, has contributed significantly to the development of the angel community and to the formation of the Angel Capital Association. Apparently, its endowment currently stands at $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,” says Salmon.

“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.”

If the charts in this document would reproduce properly in this blog format I’d introduce them right here, but instead I’d recommend clicking through.

It appears to me that over the very long term, those few angels I know who maintain rigorous records and share them  have earned returns  far exceeding the numbers in this report. I’ll have to refresh my memory, but I recall that George Schwenk of the Breakfast Club and the late Luis Villalobos of the Tech Coast Angels both generated long term net returns exceeding twenty-nine per cent.

You can find the complete report here.

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