|Source: Cambridge Associates|
Despite the Irish Government's desire to attract US venture capital (VC) firms to Ireland and high-profile successes, including Google and LinkedIn, and the forthcoming Twitter IPO (initial public offering), returns in the US market have been dismal over 20 years. In addition the vaunted J-curve - - an illustration of the common view, that while VC funds lose money early on, returns surge later - - is a myth. Venture capital is the exception as a funding source for startups. More US VC-backed new companies fail than succeed, and since 1999 VC funds have barely broken even while historically, according to Kauffman Foundation, America's leading entrepreneurship think-tank, less than 1% of US companies have raised capital from VCs, and the VC industry is contracting. But less venture capital does not mean less startup capital since non-VC sources of funding, such as angel capital, are growing.
According to Cambridge Associates, in the 10 years to March 31, 2013, annual returns of the main stock indices outperformed VC funds. See chart above and here [pdf].
In July 2010, Brian Cowen, then taoiseach, announced at the New York Stock Exchange a $500m Innovation Fund Ireland for Irish tech companies with half to be subscribed by international investors, in particular VCs and half coming from a public pension fund.
The private investors did not materialise and in the intervening period, the Irish Government itself has actually given up to $200m to 3 international VC firms to invest and the Silicon Valley Bank may have got up to $100m. One of the VCs opened an office in Dublin in 2011.
In Ireland, local VC funds invest in companies employing about 9,000 people and investments are commonly made with Enterprise Ireland, the public agency for indigenous exporters.
Richard Bruton, jobs minister, in March 2012 launched a new fund to again try to attract US VC companies and in an RTÉ interview expressed more optimism about VCs than America's leading entrepreneurship think-tank:
The '2012 NVCA Yearbook,' which is produced by Thomson Reuters and focuses on the US market, says that for every 100 business plans that come to a venture capital firm for funding, usually only 10 or so get a serious look, and only one ends up being funded.
Some 76% of tech companies acquired in 2012 had not raised institutional investment (VC/PE -private equity) prior to acquisition.
The Kauffman Foundation, which invests some of its endowment in VC firms, has published a research study, 'We Have Met the Enemy … And He is Us,' [pdf] that is based on a comprehensive analysis of the foundation's more than 20 years of experience investing in nearly 100 VC funds. It illustrates a persistent pattern of inflated early returns in funds that may be used to raise subsequent funds and shows the poor historical performance of funds with more than $500m in committed capital.
The foundation currently has $249m of its $1.83bn portfolio allocated to venture.
The research found that of the almost 100 VC funds, including what it says are some of the most notable and exclusive names (confidentiality agreements barred it from naming them), only 20 of them beat a public-market equivalent by more than 3% annually, and half of those started investing before 1995.
Interviews with fund managers and limited partners also suggest that many institutional investors commonly maintain inadequate fiduciary oversight and are anchored to narrative fallacies about the benefits of venture capital as an investment class.
The authors call upon institutional investment committees to require deeper due diligence of VC investments and more rigorous data analysis of VC portfolio performance relative to the public markets. The authors also urge limited partner investors to charge more for providing capital to risk assets by insisting on preferred investment returns before sharing profits with general partners - - as is often the practice with buyout and growth investment firms.
"Investments in venture capital funds should be measured against the naïve alternative investment - - publicly traded small company stocks," said Diane Mulcahy, director of private equity at the Kauffman Foundation and the paper's lead author.
The authors also recommend that foundations, endowments and corporate and state pension funds negotiate investment terms that better align their interests as limited partners with those of the general partners in which they invest. The report suggests potentially troubling asymmetries between the information required by venture capital funds from portfolio companies and the information they are required to provide to limited partners of the funds.
The foundation found that the most significant excess returns earned from venture capital occurred in funds raised prior to 1996, and those funds averaged $96m in committed capital. Many of those successful funds led managers to raise successively larger funds; which significantly eroded returns and maximized general partner profits through fee-based income at the expense of limited partner success.
"The result is that institutional investors end up paying general partners - - who typically commit only 1% of partner dollars to a new fund while LPs (limited partners) commit the remaining 99% - - quite handsomely to build funds, not build companies," said Mulcahy.
"We believe LPs have a responsibility to fix what's broken in the investment model, and that starts with better information and budget approval rights," added Bradley. "Some insiders cry that not enough venture money is being steered to early-stage companies - - but with six times the capital invested every year this decade than was invested in the entire decade of the 1980s, too much capital is the problem and LPs are not charging enough for that capital."
The report goes on to outline a series of steps the Kauffman Foundation itself will take to correct its approach to venture capital investing. Mulcahy, who manages the Foundation's VC portfolio, said: "We are changing our investment behaviour based on this data; going forward, we expect to be much more selective and disciplined investors in only a handful of VC funds."
It said it will invest in venture funds of less than $400m whose partners have consistently shown they can outperform public markets and who commit at least 5% of the fund’s capital. It also plans to do more direct investing to avoid paying management fees and sharing profits with VCs. And, it plans to shift money from venture capital to the public markets.
- Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3% annually, and half of those began investing prior to 1995;
- The majority of funds: sixty-two out of 100, failed to exceed returns available from the public markets, after fees and carry were paid;
- There is not consistent evidence of a J-curve in venture investing since 1997; the typical Kauffman Foundation venture fund reported peak internal rates of return (IRRs) and investment multiples early in a fund's life (while still in the typical sixty-month investment period), followed by serial fundraising in month twenty-seven;
- Only four of thirty venture capital funds with committed capital of more than $400m delivered returns better than those available from a publicly traded small cap common stock index;
- Of eighty-eight venture funds in our sample, sixty-six failed to deliver expected venture rates of return in the first twenty-seven months (prior to serial fundraises). The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with sixty-nine funds (78%) that did not achieve returns sufficient to reward us for patient, expensive, long-term investing.
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