The report, recommended to us by our member Jan Andresen and written by Diane Mulcahy, Bill Weeks and Harold S. Bradley, is trying to find the responsible for the fact that during the past 10 years, venture capital funds didn’t manage to outperform public stock markets and for 15 years have provided poor long-term returns, in spite of high-profile successes like LinkedIn, Facebook, Google or Groupon.
The industry speculates that the first to blame is the venture capital model, which is considered “broken”, yet the conclusion of the Kauffman Foundation’s report is that the limited partner investment model is the one to be blamed for the poor performance of the majority of the large venture capital funds.
Mulcahy’s, Weeks’ and Bradley’s hypothesis is supported by the research they had done on the portfolio made of 100 venture capital funds. During their investigation, the authors discovered that 62% of analyzed funds didn’t manage to beat the returns of the public markets and only 20% of the venture capital funds were able to generate returns that outperform public stock markets by more than 3% on a yearly basis, (50% of which were founded before 1995).
Here are some of the main issues that can be “fixed” according to the authors:
In order to explore the problems of the venture capital model, the authors decided to “follow the money”. So they had a good look at the limited partners “meeting room” and they emphasized the role of investment committees and trustees in the decision making process in terms of allocating the capital, which, based on Kauffman Foundation’s research, often make limited partners invest in large funds that don’t manage to generate impressive returns, they also tend to misjudge the investments or make investment decisions relying only (in most cases) on internal rate of return measures that according to authors are often misleading.
Fees and Expenses
The other practice pointed out and analyzed in the report is the “2 and 20” structure according to which large venture capital funds charge the limited partners 2% management fee on committed capital and 20% profit-sharing. The authors suggest that with this model the venture capitals are not being paid based on their performance but rather to raise bigger funds, regardless if later on they generate return on investment. One of the report’s assumptions is that the large venture capitals funds barely manage to return investor money after all fees are paid.
The Lack of Venture Capital Due Diligence
Another interesting aspect revealed in the paper is that very often limited partners do not require detailed information about ownership, expenses, profits, cash flows etc. of the venture capital, information which is essential to understanding company’s financial health. Remarkably enough, the same information is being required by the general partners themselves from the companies they consider investing in.
(Too) Long Life of a Fund
The authors claim that most of the venture capital funds exist more than 10 years; despite the fact that they are structured to invest for the first 5 years and then return all capital during the next 10 years, it barely happens nowadays. Now most of the funds require at least 12 to 15 years to be able to exit or liquidate all investments and complete its life. This trend is very expensive from the limited partners’ point of view as they frequently have to pay the additional management fees based on the value of the portfolio.
Large Funds Have Been Victims of Their Size
Kauffman Foundation shows in the report examples of the venture capital funds in their portfolio with a capital of more than $500 million that didn’t managed to generate more than twice the invested capital. In fact, their empirical work shows that 51% of funds larger than $250 million did not return the capital to the investors (after fees); on the contrary, smaller venture capital funds are able to return more than twice invested capital in more than 30% of the cases.
General Partners vs. Limited Partners Alignment
In the limited partners investment model, only 1% of the capital committed comes from the GP, whereas the remaining 99% comes from the limited partners, according to Diane Mulcahy, it helps “to build funds, not the companies” and as the report suggests, is one of the reasons why Kauffman Foundation’s venture capital portfolio has been underperforming.
The authors of the report share their recommendations for the actions that need to be taken in order to “fix” the limited partners model, which they consider “broken”. They say that the allocations to venture capital previously set and approved by the investment committees are the main reason why the limited partners’ model does not work and they strongly recommend to bring this practice to an end. In addition, they suggest that limited partners should call for the information on venture capital firm economics in order to get committee approval. They should demand more transparency in order to be able to evaluate the venture capital funds’ and general partners’ performance. The authors rejected the “2 and 20” model and recommend the “pay for performance” structure, where limited partners and venture capital firms “agree on a compensation structure that pays fees based on a firm budget, sharing profit only after investors get back their investment plus a preferred return.” They also mentioned that in order to measure the performance of a fund, the venture capital firms need to use Public Market Equivalent (PME) as benchmark and reject other markers, such as vintage year, internal rate of return or gross returns.
Kauffman Foundation’s 51-page report has been based on their 20 year experience in investing in venture capital. The authors say they have “learned the lesson” and now with a new approach aim to turn Foundation's portfolio performance from “disappointing” to satisfying.
Based on "We Have Met the enemy ... And He Is Us" paper published in May 2012. To read the entire report click here.