Wednesday, April 25, 2012

Venture capital is sucking (your money)

Many of America's tech startups are funded by venture capital. But why on earth would any venture capitalist invest in a risky, unproven new company with a risky, unproven new technology? Answer: High risk goes hand in hand with high returns. Most of the new companies will fail, but the ones who succeed will be huge, more than making up for all the failures. 

Well, that's the theory anyway. If venture capital is taking all that risk and not making stellar returns, then something is severely broken.  

Friday's finance seminar here at UMich was by Steven Kaplan of the University of Chicago's Booth Business School, who presented a paper he's writing with Robert Harris and Tim Jenkinson entitled "Private Equity: What Do We Know?". In this context, the term "private equity" refers both to buyout firms (i.e. what we normally call "private equity") and venture capital firms. The paper is all about measuring the returns that these industries have earned in recent decades.

Most of the talk focused on the buyout industry; only in the last few minutes did Kaplan actually get to talk about VC. But when he did, what I saw made my eyes bug out! Here is the key picture from the paper:

The different lines represent not different VC firms, but different data sources - each line is the average across all VC firms studied. On the x-axis we have "vintage" year, which is the year a firm started investing. On the y-axis we have the Private Market Equivalent ratio, which is a measure of how well funds did relative to the S&P 500 (a PME of greater than 1 means that a fund beat the S&P). Thus, if a line is at PME=2.5 at 1995, it means that, on average, VC firms that started investing in 1995 made 2.5 times the return of U.S. public stocks in general.

So what happened was that before the dot-com bubble burst in 2000, VCs did amazingly well. In the decade since, they've done slightly worse than the S&P 500 - in other words, they've done so poorly that you'd have been  better off buying Ye Olde Vanguard 500. And when you factor in risk, the comparison isn't even close; venture capital has a beta of well over 1, meaning that VCs are exposed to more aggregate risk than an index fund.

In other words, since the end of the dot-com bubble, venture capital has proven to be a sucker's bet. 

Now, you can respond by saying "OK, sure, but that's only one decade. What we really care about are longer-term returns." And maybe that's right. Maybe VC returns will eventually bounce back, justifying this long fallow period. BUT, whether poor VC performance in the 2000s was structural or random is something we won't be able to know for a long long time - not until we've gathered a statistically large sample of VC performance. By that time, you and I will probably be retired or dead. 

In the meantime, all we can do is guess. And dang it, but that graph sure looks like a structural break to me.  Something looks like it broke the VC business model after the dot-com crash. Maybe the new tech bubble (Facebook, etc.) will pump those returns back up, but there have been some big IPOs and some big acquisitions in Tech Bubble 2.0, and VC returns haven't really bounced back yet, so I'd be cautious. What's more, I'm starting to read about a slump in venture funding...

Could this be the (temporary) end of the VC industry? If so, is it a harbinger of technological stagnation, or simply the passing of a financial fad?

(Oh, one more thing. Kaplan et al. find that buyout firms, in contrast to VCs, have consistently beat the market over the last three decades or so. Maybe that has something to do with that enormous tax break they get for buying up firms, loading the firms up with debt, and then paying themselves a dividend while leaving the firm to die...)

Update: An anonymous commenter suggests that a few VC firms manage to consistently beat the market. It turns out she's right (at least as of 2005). This paper, also by Steve Kaplan, shows that VC firm performance is persistent; those firms that make good returns in one period are likely to make good returns in the next period. VC firm performance also appears to be highly skewed - a few firms are making most of the money. Together, these two facts suggest that there are a few really skilled VCs out there who invest successfully year after year, and a large number of truly abysmal VC firms that drag the total return way down. This begs the question of who is throwing money at all these awful VC firms when there are proven winners out there! One possibility is that the "winner" firms limit the amount of capital they are willing to accept; they know that there is a limited number of good projects, and that if they get too big they won't be able to keep returns high. This means that if an investor wants to invest in VC, she may simply not be able to give her money to one of the "winner" firms. This explanation would be bad news for proponents of market efficiency, but would be consistent with the picture of overall stagnation in the VC-funded part of the tech industry, since the driver of low returns would still be the limited number of good new tech ventures.

Update 2: Peter Thiel explains some reasons why a lot of VC funds fail.

Update 3: More reasons the VC model is broken.

Update 4: Here's a Felix Salmon blog post saying essentially the same thing as this post, except with many more charts, graphs, and explanations.


  1. To what extent do you think this phenomenon is based on outliers, or things that we can't forecast? Even if the years are "on average" worse off doesn't mean there isn't the potential for outliers to completely skew your data. This kind of "tail benefit" seems especially pertinent in a field like technological innovation, which is inherently unpredictable.

  2. Anonymous12:00 PM

    The answer is easy: Huge number of new B and C rated VC's flooded the market like locusts in the dot com boom, their lingering following the bust has dragged overall returns for the class into the dirt. The top VC firms who were the ONLY VC firms that mattered before the run up, are still generating >40% IRRs fund after fund. The structural break you observe is the arrival of a swarm of VC amateurs with massive amounts of capital that has diluted total returns for the class. Thats all.

    1. I think is Anonymous is right. You need to be really careful about what is being plotted on the x axis and you need to explain when the returns that are plotted on the y axis were earned. (New venture capital might still be a suckers bet.)

    2. You need to be really careful about what is being plotted on the x axis

      It's when the fund started investing money. I explained that.

      you need to explain when the returns that are plotted on the y axis were earned

      For "realized" investments, the returns are annualized over the life of the investment. For as-yet-unrealized investments, current market prices are used.

    3. Noah

      OK. So far so good. Now suppose that it takes say 10 years for a venture capital investment to pay off with an IPO. In that case you would expect the later entrants to show lower lifetime realized returns because their investments are not ready for an IPO yet.

    4. New idea: Why don't you read the paper and see how they deal with this issue? ;)

    5. I can justify taking a few minutes to read your blog. I have a harder time justifying reading a fifty page paper.

    6. Anonymous2:59 AM

      "The structural break you observe is the arrival of a swarm of VC amateurs with massive amounts of capital that has diluted total returns for the class."

      Um, yeah. I thought everyone knew this. I call it the Guy Kawasaki effect.

      Same thing applies to hedge funds. The ones that are worth investing in won't take your money.

    7. Anonymous2:17 PM

      Actually, hedge funds are worse. They, like VC don't beat the market on average, but the performance of top firms is not persistent. So winners make money, but you can't predict winners, and most of that money is going to be eaten in fees anyways.

    8. Yep.

      Topic for a future post... :)

  3. This is very much in keeping with results from public market investments - higher volatility investments have not outperformed lower volatility investments over the medium/long term history of markets.

    Some evidence:

    Larger survey:

  4. Yeah, I'd guess the same as @9:00 - doesn't this look like a classic case of profits leading to new firms entering the field bringing profits to 0?

  5. Wait a second. Anonymous and Adam are saying different thing. Anon says that the successful VC firms from before the dot-com bubble are still making good returns and that only new entrants are sucking. Adam says that new entrants have driven profits to 0, which should also be true of pre-bubble firms. See? Different! If Anon is right, you can still make excess returns just by choosing old-vintage VCs. If Adam is right, even that will no longer work. If Anon is right, private equity markets are not efficient; if Adam is right, they are.

    Big difference.

    1. Follow-up: After doing a bit more research, I'm tentatively convinced that Anon is right and Adam is wrong...what we're seeing is not efficient markets in action, since winners continue to win.

      But the implication is that the winners (who can be identified from past performance) only accept a limited amount of investment capital. Thus, the low overall return still indicates a lack of good investment opportunities, despite the presence of persistent winners (see the Update in the original post).

    2. Anonymous1:18 PM

      I think part of why the winners are still winning and the new ones are not is based of several things:
      1) success in silicon valley still is often predicated on who you know/meet. otherwise, why would it matter who you got your money from. These are the people that can introduce you to the right people to help you grow. That's why the same people keep turning up again and again.

      2) Maybe the supply of human capital of those who truly understand the business is severely

      I wonder if the best VC's are actually the best marketer/managers for their investments

      I think also perhaps the left side of the chart shows early players winning big based upon asymetry of information that later entrants (i.e. dumb money) don't have and won't get. The big winner VC names and some Angels have been caught colluding in the bay area and there is a certain amount of good old boys club to it. Perhaps they can't prevent other capital from coming in, but they can certainly prevent the access to human capital (i.e. knowledge).

      Finally, this has become more case of too much money chasing too little yield which is happening across the investment spectrum.

      -elam bend

  6. Anonymous5:55 PM

    Is it certain that we don't just have more complete information about VC firms post-2000? Is it possible that there's a winner's bias going on previous to 2000 that is inflating those numbers?

    1. Explain how the winner's bias would work...

    2. Anonymous12:02 PM

      There are simply no (or limited) records from the VC firms that went belly up. I don't know anything about how well the VC market is tracked, but it's got to have gotten easier as the Internet has matured. If this were true, VC's may have always had a few competent players and many incompetent ones.

  7. The S&P 500 hasn't done very well since 2000; certainly it has had worse-than-average performance (at least if you measure the average in time series terms). When a beta=1 asset does worse than average, we should expect beta>1 assets to do much worse than average, so it shouldn't be surprising that venture capital has performed badly. In fact, we should be impressed that it has done almost as well as the S&P 500. If there's an asset class that nearly equals the S&P 500 in bad times and outperforms it in good times, that would be a pretty impressive asset class.

    1. Sure, but that's the case in which the structural break is illusory.

    2. Also, note that the S&P has been fairly volatile since 2000 (just look at a picture!), while venture returns have not. That suggests that the high beta is being driven by the 90s bubble. And it also suggests that there really is a structural break.

  8. Anonymous9:50 AM

    I have a second hand contact at Sequoia Capital. Next time I see him I will ask what the son-in-law, a principal, says about how they are doing. I do know they are mostly looking for business in India and China not in the US.

  9. One possibility is that the "winner" firms limit the amount of capital they are willing to accept; they know that there is a limited number of good projects, and that if they get too big they won't be able to keep returns high

    there is more to VC than just putting money in. VC firms negotiate with and get access to management, get people on boards, have industry contacts to help build business/revenue, and have ideas how to buy/merge/consolidate the sector. SOme VC managers have extensive experience negotiating contracts and so on.

    So, some of the VC excess returns may in fact represent work product and contributions as super-business managers.

  10. "By that time, you and I will probably be retired or dead. "

    Probably dead, since it's hard to retire having lost all of one's money :0

  11. Anonymous4:17 PM

    Your post does not examine why this is the case. Marginal pension funds, endowments and family offices invest in this VC asset class even though they know it is a terrible investment since they can't get in the top 1-5% of VC funds where most all the retruns can be fund (see the data from Cambridge- the company not the city) Why? The answer must be that it is the only way you can promise your investors the 8% returns they desire even though it is not possible. If the marginal asset manager who can't get in the top 1-5% of VC funds tells the truth about the asset class, they need to lower assumptions about returns and they get fired. As Grantham just wrote:

    "... The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially..."

  12. It's just what one would expect with government policies increasingly favoring capital over labor. Every pro-business, pro-investment country winds up with too much money to invest and too little income growth, so returns on investment eventually shrink to zero. It seems amazingly obvious, at least to me.

    BTW, My TypePad login is Kaleberg. I'm not trying to post anonymously.

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  14. "Together, these two facts suggest that there are a few really skilled VCs out there who invest successfully year after year, and a large number of truly abysmal VC firms that drag the total return way down."

    The name brand VCs get offered the best opportunities. No-name VCs have to select from whatever the branded VCs reject.

  15. The confusion is that the Internet companies were in many ways "end of cycle" technology. The last mile of bringing computer data search, chat, bulletin boards, formerly only available to the masses.

    So there wasn't really a lot of innovation, just marketization.

  16. I wonder how the same chart would look for angel investing. My suspicion is that either Angels have done even worse since they do deals that VCs won't, or perhaps they've exceeded the performance of VCs as they haven't been under pressure to deploy huge amounts of capital. Any guesses?

  17. Anonymous7:28 PM

    This is one of your more embarrassing posts.

    You don't get paid for taking risk. You get paid for taking risk you can't hedge against.

  18. "Eyes bug out"

    Things are actually *worse* for VC than they would appear.

    If you look at Panel B on Page 32 of the Kaplan paper you will see that the universes from which the VC returns are calculated are tiny (a few dozen VCs at most for each of Bergiss, Prequin, etc.) relative to the *hundreds* of VC firms that existed circa 2000 (I want to say the National Venture Capital Association topped out at something like 850 firms back in the day...).

    Since how a VC firm ends up in a Bergiss, Prequin, etc. survey is something of a mystery (although adverse selection is a strong liklihood - ie, I make my return data available because I *have* strong return data...) I would suggest that the return results are heavily skewed upwards.

    The 750 *crappiest* VC firms from the Bubble never made it into Burgiss, Prequin, etc. because:

    1) You don't share your returns data if it is shitty, and
    2) You don't pay to be included in Burgiss, Prequin, etc. if #1 applies (it is strongly suspected that Burgiss, Prequin, etc. are really *marketing* tools for the strongest VCs rather than fully objective buyside analytical tools).

    But, that aside, a very useful post.

    Now, start crucifying those dead-and-corrupt-at-the-switch public pension funds that pour taxpayer-guaranteed funds into this howling pack of scrofulous dogs.

    1. This is a very good point!

  19. Endrit5:09 AM

    Isn't this what basic micro-economics and general equilibrium should predict though?

    If you are an investor that is willing to invest some personal funds would you put it in a VC fund or in the stock market if the VCs outperform the market by 4 times? The answer is easy, you would always invest in VCs.

    However, overtime enough funds would be invested in VCs so that the marginal return equalizes in both markets in order to have equilibrium. The fact that returns are similar in both types of financial markets seems to suggest that there has been an optimal allocation of resources, not an underperformance of VCs or slowdown in technology like you and Tyler Cowen suggest.

    If I am wrong on this, would you please explain why.

    1. I think the real point is that the VC investment is genuinely more risky, therefore you would expect that the average return would have to be higher, or else no one would bother with it. Roughly speaking, you'd expect that equilibrium would be where risk times return is equal for all investments. But this makes that "rational investor" assumption...

    2. Anonymous5:07 AM

      Ok, but how should this "risk premium" reflect itself?

      One way it would is through a higher average profit. But how high should this be? Should it necessarily be twice as much as regular investments?

      Second, riskier investments could mean higher variance of returns with more severe losses and more impressive profits but with the average being more or less equal.

      Again looking at the graphs I see a flight of capital towards the newer opportunities until some equilibrium was reached.

  20. Anonymous9:23 AM

    A question that occurs to me is what's left of the viable projects available to independent VC firms after they have been picked over by the VC arms of the Intels, Cisco's, etc. of the world.

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