Venture Capital Needs to Downsize or It Will Continue to Stagnate

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.

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 York–based 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 haven’t been plowed over, says Raucci.

The Kauffman Foundation’s 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 what’s broken in the investment model,” says Harold Bradley, the Kauffman Foundation’s 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 can’t get through. New York’s Milestone Venture Partners’ Fund II (MVP II) has been among the best in the industry, big or small. MVP II’s 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 II’s 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 II’s 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 hasn’t got a succession plan in place and hasn’t 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.