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Moneylife » Investing » Alternative Investment » Venture capitalists make big money, right? Wrong

Venture capitalists make big money, right? Wrong

Moneylife Digital Team | 02/10/2012 06:28 PM | 

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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1 Comment
Colin Sprague

Colin Sprague 2 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.

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