What’s wrong with Venture Capital ? Maybe Limited Partners.

Broken Venture CapitalThe first numbers of 2012 just got released, and Venture Capital, after a great year 2012, is being pulled back on Earth, with investments down 22% from Q4 2011. That’s not good news for entrepreneurs seeking capital, but we can hope the General Partner will raise their investments for the next quarters of 2012. The only positive news are for companies that are at seed and early stage levels, as VCs are more and more prone to invest in them. They represent about 1 investment out of 5 this year, the highest rate observed in years.

The dark side of Venture Capital

On the dark side of the VC topic, the last report of the Kaufman foundation on the “Limited Partners – General Partners*” model has been dropped like a bomb on the VC and entrepreneurship communities. The report alleges that the VC model is completely broken, as most of VC funds are unable to deliver sub-par return on the Limited Partners initial investments. And the foundation, in a very counter-intuitive approach, puts the blame on the Limited Partners themselves, because they are unable to allocate their money into performing funds, have a poor follow-up system to track the performance of their investments, and have interests that are misaligned with those of the VCs themselves ! It’s the first time that the LPs are pointed so openly as the dysfunctional part of the venture capital system.

Until now, VCs had been the one that took the blame, sometimes accused of trying to rip the most money off of some companies instead of actually taking decisions that would foster their long term growth (did I just say Groupon ?). This has been debated a lot, and no data came to support fully one assumption or another.

Whereas in that case the kaufman foundation can rely on fist-handed data: its own results as an LP investor in VC funds ($250M in 20 years). And the result are pretty shocking :

  • almost 80% of the funds failed to deliver returns that beat a public market by more than 3 percent annually
  • 62 % failed to deliver return that exceed public markets, after fees and carry were paid
  • almost 25% of the allocated funds still haven’t been returned to the LPs after more than 10 years, some after 15 years
  • only 4 of 30 funds with more than $400M under management provided returns above public market, challenging the power if big funds

These are some of the remarkable conclusions of the report, and they expose the VC system under a completely new spotlight. It especially higlights the poor management of LPs when it comes to allocating asset to Venture Capital funds, thus harming the potential return on investment they can expect.

Limited Partners must change their assumptions about VC firms

So what could be done to change this system ? The Kaufman foundation came up whith clever ideas, some of them having already been proposed by influent members of the VC community. It  urges the LPs to change their approach to Venture Capital, by :

  • being more picky when it comes to choosing funds they want to invest in, making the performance of the fund as the primary objective
  • reduce their investment in Venture Capital to a limited number of funds, and allocate less money to each of them
  • invest themselves directly in a small protfolio of new companies, to avoid the pain of high fees and carry payments
  • move some of the money they invest in VC firms to public market, as most of VC funds fail to provide better return than public stock, even with a significantly higher risk

Of course, these measures are targeted only at Limited Partners, and only to improve their return on investment. On the other side, if this is really what must happen for the VC industry to start to be really profitable, these assumptions could be bad news both for the entrepreneurs and the VC firm…

A negative impact on VC firms and entrepreneurs ?

All of this is not really good news for the VC firms, who are already having trouble raising money (only $18B in 2012, the worse number since the 2008 crisis). Even if that would go against their financial interest, a raising number of VCs are advocating for a more concentrated industry, with less cash available but allocated more wisely. Without speculating on a “bubble-or-not-bubble” situation, there is little doubt about the fact that some industries receive a lot of VC money to the detriment of other. This is especially true for web and mobile, cherished by investors for the huge ROI they can provide, but way more fragile as the sustainable value these service offer is hardly measurable and gives way to a lot of speculation. Groupon is a great exemple of this situation, as the company saw its valuation skyrocket very fast, until investors realized thet its business model was deeply flawed.

If LPs start shifting some of their investment to other kind of asset such as public market, hence narrowing down the amount of money available for VC funs, this would have a huge impact on the companies looking for money, that would have to face a much fiercer competition in order to raise funds. On the good side it would eliminate pretty quickly the companies that bring no clear value to the market and would decrease speculative behavior such as the ones we observe in “bubble times”.

But that could also be a catastrophy in some areas that could clearly be seen as under-allocated, like the biotech and clean-tech industries, that are very capital intensive and require long term support to be successful. A shrink of capital would be a very hard it for them.

Will the LPs become aware of the situation and change their behaviour ? It is likely, even though it may not be immediate. When that time comes, entrepreneurs better be ready ofr battle, because they will be the ones to feel the heat ! until then, if you have great companies ideas, run to VC while you can !

 * Limited Partners allocate funds to Venture Capital companies, which is represented by the General Partners, who then allocate and manage the funds. Limited Partners are mostly pension funds or endowments.

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