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
In its report We Have Met the Enemy ... And He is
Us, the Kansas Citybased 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
For the industry to produce competitive returns the asset
class has to shrink, says the Kauffman Foundation. And Cohen
and others believe that institutional investors who invest in
venture capital need to bring the compensation of venture funds
and venture capitalists in line with their actual performance.
Reducing the size of the pool will probably reduce the number
of companies that will receive financing, but it will boost the
return on capital, says Robert Raucci, an institutional
investor himself and a managing partner of Newlight Partners, a
New Yorkbased asset manager.
Raucci believes that the basic tenets of venture capital are
intact and that the asset class still is one of the few ways to
finance a culture of risk and innovation. But the concentration
of capital geographically and thematically has
inflated prices to the point that it is difficult to deliver
profit consistently to investors. The opportunities are lie
aboard, or looking at areas within the U.S. that havent
been plowed over, says Raucci.
The Kauffman Foundations biggest criticism is leveled
at institutional investors themselves. Institutional investors
such as endowments and pension funds have distanced themselves
from the task of selecting venture capital by relying on data
crunchers such as Cambridge Associates and fund-of-funds to
make the selections. The process has become bureaucratic and
has been taken over by quants, with the emphasis on investing
in big funds and neglecting outliers, especially innovative and
creative small funds.
We believe LPs have a responsibility to fix
whats broken in the investment model, says Harold
Bradley, the Kauffman Foundations chief investment
officer. Some insiders cry that not enough venture money is
being steered to early-stage companies, he adds. But
until limited partners become more sensitive to small funds and
understand how to accurately rate their potential, the
misallocation will continue.
Many small funds, in spite of their track record, say they
simply cant get through. New Yorks Milestone
Venture Partners Fund II (MVP II) has been among the best
in the industry, big or small. MVP IIs internal rate of
return was 16.9 percent, compared to the -0.33 percent median
return for 2001 funds as reported by Cambridge Associates. More
important, MVP IIs performance against a public market
equivalent (PME) as proposed by Kaufman has been extraordinary.
Against the Russell 2000, an index of small cap companies,
which showed a gain of about 4 percent, MVP IIs returns,
net of all fees, were in excess of 17 percent.
Still, Milestone has had a difficult time reaching the
pension funds and endowments. For many institutional
investors we are too small a fund, explains Goodman.
Others continue to insist that Milestone hasnt got a
succession plan in place and hasnt a reliable deal flow.
Many others simply fail to understand the value of the
Milestone portfolio and its potential. Adds Goodman, We
believe that the opportunities for venture investors to finance
young information technology companies with great growth
potential have never been better.
Milestone is experimenting with new models of developing and
financing digital health companies. It recently joined the New
York Digital Health Accelerator (NYDHA), a collaboration of New
York area healthcare companies, providers and service
organizations to fund early stage digital health ideas. The
accelerator selects and finances projects for nine months,
during which time the projects receive direct access to
customers and feedback from the nearly two dozen healthcare
provider organizations that are in New York. At the end of nine
months the projects will be considered for additional venture
financing by funds such as Milestone.