Alternative Investment
Venture capitalists make big money, right? Wrong

A Kaufman Foundation research has found out that investment in venture capital is a bad idea as it has not beaten the American markets since the late 1990s. Worse, investors have got back less cash than they have put in

Facebook has been the most sought-after investment story of the decade, with its recent high-flying (if highly controversial) initial public offering (IPO) generating millions of dollars for its founders and the investment firms that invested vis-a-vis venture capital (VC). The success story of Facebook has prompted investors, institutions and the general public to truly believe that VC produces superior returns, over and above market returns. However, a recent research study, conducted by Kaufman Foundation, an institution that invests in VCs, found out that VC is broken and has indeed produced inferior returns. Here are some of the findings:
 

  • Companies like Facebook, Zynga, Groupon, etc have merely been outliers. The study stated that VC returns haven’t significantly outperformed the public market (it has used American benchmarks) since the late 1990s.
     
  • Since 1997, less cash has been returned to investors than has been invested in VC.
     
  • Given its opaque structure and nature, VC is a losing proposition with only one-fifth of 100 funds beating the public market by more 3% (with half of these incorporated prior to 1995!).
     

In other words, VC is just not worth your time, unless you want to gamble all your chips, hoping that the VC they invest in will be able to find the ‘next’ Facebook.
 

VC is a form of investment vehicle that concentrates on start-ups and early stage investing. They invest in companies that have no prior track record. They invest in ideas and act as incubators to those ideas and use the funds to hire talent and infrastructure to grow ideas into reality. Facebook, Google, Yahoo!, Flipkart are some examples of companies that grew out of VC backing. Typically, they invest in a growing a firm for a few years, sometimes ranging from 3-10 years, depending on the idea, and cash out during the IPO.
 

One reason that investors (or institutions/investment firms) believe in VC as an asset class is because of a well-known behavioural bias known as narrative fallacy. The media has sold countless success, albeit sensationalist, stories to the investment public who, more often than not, fall for it and believe in it strongly. A lot of investment funds (which in turn invest in VCs) have mandates set up by a bunch of brilliant Ivy League graduates, armed with PhDs and MBA degrees which state that some percentage of the corpus must be invested in VC (a mandate is more of a rule than anything else). These mandates are created despite the abysmal track record of VCs. The study clearly states this startling statistic: 62 out of 100 VC funds failed to exceed returns available from the public markets, after fees and carry were paid. This leads us to another key issue for underperformance—high fees.
 

One of the solutions Kaufman Foundation has suggested is to, obviously, abolish needless mandates or rigidly defined rules and, instead, have flexible mandates to invest anywhere, so VCs can be avoided at all costs. It is important for the investment public (and institutions) to know the ratio of failure to success and it isn’t looking good at the moment. The media, however, doesn’t write about horrid stories of funds gone bust because, ironically, in the investment world, pessimism doesn’t sell.

Touching upon the issue of high fees, most investment funds operate on an incentive structure known as “2-20” (2% of corpus as fees and 20 percent of profits) which puts the onus on funds raising rather than searching for profitable opportunities. Regardless of fund performance, the fund manager collects his 2% fees. The larger the funds collected the deeper will the fund managers’ pocket be. Moreover, most the funds collected go into high risk VC (partly can be attributed to mandates). Hence, there is no regard to management of funds or allocating it in efficient investment channels nor is there any effort to find the next ‘Facebook’.
 

The study stated, “The most significant misalignment occurs because limited partners (LPs) don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2% management fee on committed capital and a 20% profit-sharing structure (known as “2- 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.”
 

One of the solutions recommended by Kaufman Foundation is to pay for performance. In other words, change the way VC managers are incentivised and rewarded in such a way they will be more focussed on fund management and identifying investment ideas instead. It even suggested following a ‘European’ style where investment money is actually returned once a hurdle is achieved. This puts far more clarity on investment and actually might entice investors to put money.

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COMMENTS

Colin Sprague

4 years ago

The new way to play VC is by providing services for stock instead of cash. In this manner a service provider gets shares of an emerging company pre-IPO and only has time that is at risk. In the end, they will make money and it's then just a matter of how much, which will depend on the success of the IPO. These deals are quite frequent and easily found at Stock4Services.com.

Will the RBI and IRDA dump their principles and follow the FM’s diktat?

Finance minister P Chidambaram wants a slew of changes which will mean getting the banking and insurance regulators to do what he says. Can he? The FM’s other moves, too, may not have many takers

The finance ministry has come out with a slew of changes to jolt the slumping life insurance business. Here are the proposals and the reality on the ground:
 

Tax incentive for pension products and service tax easing – Apart from NPS (National Pension Scheme), pension plans may get a separate limit of Rs20,000, which will be over the above the 80C limit of Rs1 lakh. Today, premium paid towards pension products (80CCC) fall in the same bucket of 80C, unlike in the past when it had its own exemption limit of Rs10,000.
 

Reduction in service tax on first-year regular premium as well as single-premium policies is also proposed.
 

What it really means: Taxation related amendments will need approval from the Central Board of Direct Taxes (CBDT) and Central Board of Excise and Customs (CBEC). The FM may be able to get this done but tax benefits may not lead to more pension products since insurance companies do not want to launch guaranteed return products. And the public is not interested in buying a variable return product even if it is tax-free.
 

Opening bancassurance – Banks may be allowed to set up broking arms to sell products from multiple insurance companies. This will put the onus on banks to have properly trained personnel that can possibly reduce mis-selling.
 

What it really means: This move from the finance ministry trashes the Insurance Regulatory and Development Authority’s (IRDA) draft guidelines on the complicated zonal tie-up to partially open bancassurance. Currently, IRDA allows a bank to sell the products of only one insurer. Moreover, the Reserve Bank of India (RBI) is not in favour of allowing banks to set up broking arms as their performance will affect the balance sheet of the bank itself, which will not be in the interest of depositors.
 

Moneylife is of the opinion that making banks accountable has not been successful till now and going for an open architecture can further complicate the matter. It remains to be seen whether the FM can hammer the RBI and IRDA to agree to his ideas so quickly. Both are headed by seasoned officers of the Indian Administrative Service who have their own ideas.
 

Use-and-file escape route The FM wants to make it easier for insurance companies to launch new products. Under the existing “file and use” procedure, approval of the filed product is needed before launching it in the market. The finance ministry wants “use and file” for standard products. IRDA will prepare a list of standard products that qualify for the “use and file” system which entails allowing the insurer to market the product if there is no regulatory objection within 15 days. IRDA will also draw up guidelines so all products can be cleared within a period of 30 days.
 

What it really means: Moneylife view is that the proposed change empowers the insurance company more than what may be desirable. Insurance products, except pure term plans, are complex for customers and hence coming up with standard products list is prone to error. In the past, IRDA had to ban products like Universal Life Plan (ULP) which it had approved. IRDA is still debating for a long time if it needs to ban highest NAV products. “Use and file” is good for insurance companies, not consumers. The pressure on IRDA to approve products within 30 days seems unrealistic. Instead of listening to the industry, the finance ministry should find out the reasons for delay in product approval by IRDA.
 

Remove the differences between traditional products and ULIPs - Today the commission on traditional products is 30%-40% of first year premium while that on ULIPs is half of that or lower. The FM has talked of rationalising it.
 

What it really means: If the arbitrage between traditional and ULIP products is removed, it will mean a big fall in the sales of traditional products. The commission itself was driving the sales after regulatory changes in ULIP after September 2010. LIC has seen a complete reversal in its portfolio. Traditional product business is 80% and ULIP 20% when it used to be 80% ULIP and 20% traditional before September 2010 ULIP changes. Moneylife feels that this is good news for consumers. There could be resistance from insurance companies on this contentious issue.
 

Investment norms – The FM has promised to allow debt investment of up to 12.5% of investments in products rated lower than AAA (the highest credit rating).
 

What it really means: Nothing. The LIC may be ‘persuaded’ to invest in lower grade debt instruments but private insurers will continue to follow their risk-control measures.

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COMMENTS

Dayananda Kamath k

4 years ago

india was fortunate enough that last time chidambaram wanted to follow the southeast asian policiies as commerce minister and was fully prepared to impliment it to import the south east asian crisis into india. luckily the southeast asian crisis brokeout and his policy was not implimented. even though his election petition is pending since last 3and half years in courts he is preparing to strike back to sell india by his policies. may be he has been

Narayanan

4 years ago

Bankers who do other than banking is a sure way to get into trouble. It also does not provide level playing field for agents/brokers. As of to day the bankers are selling the policy only by arm twisting the borrowers at the time of lending. The competition of India should look in to this. Some times insurance companies by pass the intermediaries. This is also unethical practice.

Some of the insurance companies are trying to y pass the agents/brokers who get them the business in the renewal business by asking the customers on-line renewal if they want to place the business directly.

DB DESAI

4 years ago

Individidual agents should be allowed to multi company insurance products in life and general like they sell multi amc products in mutual funds. Upfront commission should be 2% net of all taxes, deductions etc. Insurers and fund companies should be banned to launch promotional schemes to boost sales and some mechanism must be there to concentrate on numbers like no. of policies, no. of sips etc. and a system to recognize genuine sellers, advisors should be established. If commission on Insurance is reduced to 2% 99% of misselling will automatically stop. Those who need pension will eventually buy NPS this this the stand taken by PFRDA then why insurance companies cant take such a stand. Real thing is this is only a discussion of intellectuals and experts etc. but actually in practice everybody wants money by whatever means. Otherwise why govt. should give different incentives to boost sales of insurance and why should rather they not identify the people who are ready to sell insurance for insurance and happy to do this at just 2% of commmission?

Sea piracy: India to deploy armed commandos onboard vessels

The CISF commandos will travel with the vessels in the Indian Ocean region up to the tip of Somalia, which is prone to piracy incidents, and then re-board an incoming vessel to get back to their base in India

 
New Delhi: Indian merchant vessels plying in piracy-infested waters will soon have armed security of commandos from Central Industrial Security Force (CISF) as the government has begun framing rules of engagement for this contingent, reports PTI.
 
The Centre has given a green signal to the paramilitary force to train about 100 of its troops with the Navy's Special Forces squad, called Marine Commandos (MARCOS), to undertake long-haul deployment and amphibious operations in the high seas.
 
Sources privy to the development said the Union Law Ministry, in consultation with the Home Ministry, is finalising the Standard Operating Procedures for these squads which will deployed onboard ships and would be equipped with specialised long range weapons.
 
"The rules of engagement as notified under the international maritime laws are being looked into and will be prepared before the first CISF squads are deployed onboard these vessels," they said.
 
The squads are expected to be deployed by this year-end, they added.
 
The CISF squads will travel with the vessels in the Indian Ocean region up to the tip of Somalia, which is prone to piracy incidents, and then re-board an incoming vessel to get back to their base in India.
 
A five-member security detachment including a commander will be deployed onboard these ships.
 
At present several vessels, sailing with Indian flags, are relying on security agencies employing foreign nationals in piracy-infested waters.
 

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