Last week year-end 2009 US venture capital performance figures were made available by Cambridge Associates (venture capital returns are reported on a quarter lag – even longer when it’s year-end). Despite improving in the fourth quarter, returns over all major time periods were pretty lackluster save for the 15 and 20-year returns which still include the tech bubble. The 10-year return, the period given the most attention because it the same length as the life of most venture funds, dropped into negative territory. What’s more is that the net to LP returns for every vintage year since 1998, except for 2003, is negative. This to me stood out as the most discerning stat –it means that average investor lost money in venture pretty much every year since 1998. Yes, top quartile managers have done better, posting positive returns with IRRs in the 2-6% range – but single-digit IRRs for venture capital still cannot be justified, especially when when you factor in the illiquidity premium.
There’s no reason to be shocked by the return figures however, since they were somewhat predictable. Plus, the lag in returns makes the year-end numbers look worse than they really are because we’ve seen the public markets improve significantly since the start of the year. You can expect the venture capital index to rise in the neighborhood of 3-5% when first quarter returns are made available– improving as a result of the public markets as well as heightened liquidity. Still, the forthcoming return increases will not go far in improving the overall picture of venture over the past decade. This means venture investments will be tough to sell to limited partners, which will invariably lead to an attrition of funds and firms and eventually lower levels of capital being deployed.
Lower levels of capital deployment, however, is almost exactly what the industry needs. Remember I mentioned 2003 being the only positive vintage year median? Well it also happened the year with one of the lowest fundraising and investment levels. Also, even though it does not make perfect sense, looking back at the returns over the last decade, imagine if only the top 50% of funds/firms were in existence – the median figures I mentioned would represent the low, and the top quartile the median. Real top quartile returns then would most likely have been in the double digits – more than acceptable. While we should always be forward-looking, we can’t ignore the fact that the past has shown a smaller group of better mangers results in a healthier industry and better returns.
And if we want to be forward looking, there are plenty of reasons for investors to keep faith in venture and continue making commitments:
- You have a contrarian play at hand;
- Innovation, the lifeblood of venture, continues unobstructed;
- There’s the diversification case -venture proved to be an extremely valuable diversifier for institutional portfolios during the recession;
- Lastly we’re finally seeing a thawing of the exit markets and the return of liquidity through IPOs and M&A activity, especially by tech giants who have huge sums of cash on hand.
These changes should result in successful vintage year 2009 and 2010 funds, but when coupled with sustained lower levels of investment, should also bode well for the future of the industry. Gaps in funding from institutional investors will be filled by novel ways for entrepreneurs to raise funding. Examples include crowdfunding site like Profounder, and more basic funding platforms such as Kickstarter. These sources of capital fill niches that traditional venture had for the large part had gotten too big for, but fewer dollars flowing into startups means VCs will (and have already started to) move back down to earlier stage deals, which also historically happen to deliver the best returns. Looking back at overall venture performance isn't pretty, but keep in mind that past performance is rarely an indication of what’s to come. The venture industry is undergoing a transformation and performance for the next few years is primed to transform as well.