Public investors just got a taste of what venture capitalists know from experience.
Venture capitalists sell the sizzle of investing in the next Google or Facebook. But a devastating report by the Ewing Marion Kauffman Foundation shows the reality is most investors would do far better by investing in a plain-vanilla stock index. The report is all the more damning because Kauffman based it the actual returns it has earned on its own investments.
The Kauffman Foundation studies entrepreneurship with the proceeds of a $1.8 billion endowment established by Kansas City pharmaceuticals magnate Ewing Kauffman. The foundation examined its own track record investing in more than 100 venture capital funds since 1985 and was shocked to discover the total return through 2009 — when it began selling funds at a loss to get out of the sector — trailed the Russell 2500 small-cap stock index.
“This was a surprising and unexpected conclusion.” the foundation said, especially since Kauffman’s returns ranked it in the top quartile of institutional VC investors.
Blame high fees, a skewed compensation model and inattentive trustees for the problem, Kauffman says. Venture capitalists may say they’re all about financing innovation, but nearly all of them follow the standard format of charging a management fee of 2% of assets plus 20% of any profits. That gives managers an incentive to build bigger funds, Kauffman says, even though industry research shows that funds over $500 million tend to have dismal results.
At Kauffman, not one fund with more than $500 million in assets has returned more than double its investment after fees. At 7 percent interest, money doubles every 10 years, about the expected lifetime of most VC funds.
Advisors sell VC funds based on their supposed “J-Curve” performance, where heavy early losses turn into huge gains. But Kauffman found that is a myth. Most of its funds peaked within three years, then declined steadily from there. The early peak provides a high internal rate of return that VC managers can use to sell follow-on funds, but Kauffman found that the actual internal rate of return– which reflects the timing of cash investments and distributions — was disappointingly low. Only 16 of 94 funds provided a return of 5% a year above small-cap stocks, and most of those were funds started before 1995.
Kauffman blames investors for allowing VC funds to get away with this. (Hence the title of the report: “We Have Met The Enemy And He Is Us.”) Fearful of being cut out of the next hot fund, investors fail to ask for the information they’d demand from any public company: Who owns the fund, how much the owners have invested in it, and how they are paid.
Venture capitalists wouldn’t put money in the next social-networking games company without knowing this (we hope). Why don’t investors require the same essential information?
The full report is available at http://www.kauffman.org/uploadedFiles/vc-enemy-is-us-report.pdf
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout the southeast including Charlotte, Raleigh/Durham, Greensboro, Wilmington, Washington D.C. and South Florida with a team of more than 30 professionals serving more than 100 companies throughout the region.