VC overcrowding means AUM must fall for returns to recover: Expert

By: Konstantin Danilov, Editorial Board.

VC Traffic JamIn his recently released paper, Paul Kedrosky of the Kauffman Foundation discusses current state of the U.S. venture capital industry and ponders whether its burgeoning size is limiting investors’ returns from the asset class. LPs have continued to allocate increasing amounts of capital to VC funds, despite the precipitous decline in performance over the past five years: the 10 year returns for the industry, as calculated for the author, are barely ahead of the Russell 2000 Index, and will turn negative in 2010 as dotcom bubble returns are excluded. The lackluster performance is a fairly recent phenomenon – the string of low to negative returns began in 2004 – which Kedrosky attributes to three potential causes.

Maturing Sectors

First, the “bread and butter” sectors for VC, IT and Telecom, have vastly matured over the past two decades. While open source technology and vastly lower networking costs have decreased the barriers to entry for IT startups, venture investments in the sector have yet to show a commensurate decline. In 2008, tech-related investing still accounted for more than half of VC investment on a dollar amount basis.

No Cash-Flows, No Thanks

Some point to the decline in IPOs in a post-Sarbanes-Oxley world as the main culprit behind the recent performance woes. While, in the past five years the annual number of VC-backed IPOs has declined to almost half of the late 90s average, it is still in line with pre-dot-com levels. Kedrosky argues that, relative to the late 90s, the market has become less willing to stake early-stage companies with negative cash-flows – a phenomenon which should not be expected to reverse. The problem, it seems, lies not with the exit market itself, but with VCs ability to bring attractive offerings to the market.

Too Much Capital, Not Enough Venture

Despite the structural and exit market issues and the corresponding decrease in the opportunity set for VCs, capital has continued to flow into funds at an increased rate. The relationship between commitments and returns is glaringly negative, as is to be expected with any asset class facing an influx of capital after a period of strong performance.


To keep up with the elevated levels of capital flows, VCs have continued to invest at a pace similar to that in 98-99; at $30 billion a year, the rate is more than three times the pre-bubble levels. Turning away capital by closing funds earlier would mean higher returns for LPs but lower management fees and less compensation for partners.


The LP Solution

Given the limited investment opportunity set and poor performance of VC funds, Kedrosky says LPs should allocate less to the asset class going forward. Less capital should lead to lower valuations and better overall exit multiples. Kedrosky envisions that the pace of investing and overall AUM need to fall by half to $12 billion per year, and $100 billion respectively – these are the levels at which the sector was last able to generate competitive returns.

Will LPs be able to accurately adjust their allocations? The long duration and overall illiquidity of VC funds make it difficult to reallocate away from the asset class quickly. Other examples do not inspire confidence in the average LP: buyout funds have provided uncompetitive returns relative to public markets for years (see this AAA article), yet continue to draw investor capital year after year.

Data from the first half of 2009 shows promising results: year-to-date fund raising figures are less than a quarter of the total for 2008, and capital disbursements into companies by VCs have also dropped significantly. Valuations during venture financing rounds have also fallen by a significant amount, especially in later rounds. Whether or not this correction is a meaningful and lasting change or merely a brief response to the financial crisis will determine the future of the VC industry.

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