The venture capital business model is broken, says the Kauffman Foundation. And the only fix may be to return to the past — to small, focused funds that are local in nature and creative in their strategy.

Venture capital funds are simply not delivering, experts now argue. The ten-year returns for venture funds ending June 30, 2012 averaged 5.3 percent, compared to 6.0 percent for the Dow Jones Industrial Average and 7.2 percent for the Nasdaq Composite, reports Cambridge Associates, which tracks alternative asset performance. For an asset class in which managers get a 2 percent management fee and 20 percent of the profits and the capital is locked up for as much as ten years, the returns are unacceptable, Kauffman and others say. Compared to other alternative assets such as hedge funds and private equity funds, venture capital returns often are a poor third.

In its report “We Have Met the Enemy ... And He is Us,” the Kansas City–based Kauffman Foundation, with more than 20 years of experience investing in nearly 100 venture capital funds, says venture capitalists have oversold their importance and value. After a comprehensive analysis of its own portfolio, Kauffman found a persistent pattern of inflated early returns that were then used to raise subsequent funds. The analysis also showed the poor historical performance of funds with more than $500 million in committed capital.

They point out that the risk has gone out of venture capital. The staple of legendary venture capitalists such as Arthur Rock, Georges Doriot and John Doerr was built on investing in companies such as Apple, Digital Equipment and Amazon — companies exploring the frontiers of change, companies too complex for spreadsheets to predict. Today, “we have discarded a century of can-do ambition built on rapid advances in technology and replaced it with a cautiousness far too satisfied with incremental improvements,” wrote Paypal founder Peter Thiel and former world chess champion Garry Kasparov in a recent editorial in the Financial Times.

Another criticism is that venture capital funds are too big. The institutional investors that give venture capitalists their money are too complacent and too undemanding. And the rewards totally out of sync with performance. The entire incentive system is off-kilter, says New York investment banker Joe Cohen, who as the managing partner of Cowen & Co. in the 1980s and 1990s helped take many venture-backed companies. When the large funds can routinely take in 2 percent fees for just raising money — the bigger the fund the greater the fees — there is little incentive to actually perform, says Cohen.