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Investors flock to Venture Capital and earn poor returns because they’re fixated on the kind of astounding returns generated by a Facebook rather than understanding the high risks associated with it
Venture capitalists (VCs) hardly make tonnes of money, except one or two cases of great successes. Not everyone predicts the next Facebook or Google. Statistics show that venture capitalists hardly create much wealth as a whole, much less return the original amount to investors. Kaufman Foundation, an institution that invests in venture capital, that less cash has been returned to investors than has been invested in VC since 1997 and only 20 out of 100 venture capital handily outperforming the market by more than three percentage points. Moreover, half of these were created prior to 1995. Read it here.
A reason for the failure of VCs to outperform market can be squarely blamed on an investor’s poor financial literacy, or lack of it, when investing in a venture capital fund. It is important to understand where savings are going and how the firm managing your savings will utilise it. Unfortunately, investors are ignorant of the basics of VC and their average track record. They invest because they’re fixated on the kind of astounding returns generated by a Facebook rather than understanding the high risks associated with it. What if Facebook had failed? What would have happened to the initial funds invested? Some of these questions are rarely asked, let alone answered. The Kauffman Foundation study says, “Our research shows that LPs regularly accept the risks of investing in a “black box” of VC firm economics. It is common for institutional investors to make investments in VC funds without requiring information about general partner (GP) compensation, carry structure, ownership, and firm-level income, expenses, or profits. The “black box” in this context refers to the unknown parameters of a VC firm. Much like its hedge fund counterparts which make scant disclosures to their investors, the VCs are opaque in structure, disclosures and such.
Even intelligent investors are conned into investing by VCs as latter sell the idea of “J Curve” a fancy investment jargon and metric that makes VCs look tempting to invest. Shaped like the letter J, venture capitalists hard-sell the idea by starting that the biggest profits come at the end of the investment period, usually 5-10 years. Usually, the returns will be negative during the initial years as money is spent on developing an idea before it becomes a product or services ripe enough for market wherein the profits are huge. However, this was all an eyewash! According to Kaufman Foundation, instead, it found out that its VC portfolio resembles an ‘n’ curve, where the internal rate of return (IRR) peaks once VC has raised enough funds to move to the next fund or create a brand new fund. It said, “The ‘n-curve’ we found in our portfolio suggests that many VCs have moved from professional risk-taking and investing to professional fundraising.” The whole incentive behind this is that most VCs are always in search of many ideas, often most of them failing, until they hit the jackpot, which is hard to come by, if statistics mentioned earlier is anything to go by.
One of the ways to demystify VC is to do the ‘homework’. Without doing proper due diligence on VCs, one cannot be sure of their performance. Investment managers must make all the efforts to ensure that information is gathered vis-a-vis consultation with VC partners and the companies they’ve invested in it. It is hard work, but it is the only way to ensure that savings goes into the right hands. Of course, the other alternative is to pray that regulators mandate VC to disclose everything (which is unlikely ever going to happen—whether in America or rest of the world).
Another solution is to have a metric by which one can measure and compare VC performance. This is much like comparing any HDFC Bank mutual fund to the NSE Nifty stock market index. The study suggests taking a benchmark while acknowledges certain limitations by stating, “despite some statistical limitations, [public market equivalent] (PME ) is the most informative measure of VC fund performance. “ The reason for the limitation is that not all publicly traded small-cap companies behave the same way as early-stage start ups that VCs invest in. However, using a small-cap benchmark is the closest approximate measure and could be used as a proxy for VC performance. This could enable a fund manager to see where VCs stand vis-a-vis other investment classes.
At the end of the day, it is the investor’s responsibility to ensure that financial literacy prevails and thorough homework is done before an investment is made, keeping in cognizance of risk involved. At the moment, the odds of finding the next ‘Facebook’ (or for that matter Google or Microsoft) are slim or next to none and heavily stacked against the investor and venture capitalist. An investor, according to the study, would be far better off investing in a basket of small-cap equity shares or a small-cap index fund that tracks publicly listed small-cap companies.