The Kauffman Foundation in a recently published report said that public stock markets have outperformed the average venture capital fund over the last decade. Kauffman is a twenty-year old endowment that as of the end of February 2012 has $1.83 billion in assets under management, and has $249 million of that committed to or invested in VC or growth equity funds. In a study of their own portfolio they have found that only twenty of 100 venture funds “beat a public-market equivalent by more than 3 percent annually”.
Its new 52-page report on VC funds is written by Diane Mulcahy, Bill Weeks, and Harold S. Bradley, respectively the private equity director, quantitative director, and chief investment officer of the foundation. They argue that investors have become enmeshed in a mythology implicit in many a VC manager’s pitch, the mythology of J-curves.
The PME Metric
The authors contend that the small cap Russell 2000 works as a “public market equivalent” for the measurement of VC fund performance because it reflects price volatility and the high sensitivity of small companies to economic cycles, something that cannot be said of the S&P 500 or other large cap indexes.
The ability of VC funds to deliver a bonus above PME has declined over time, as illustrated by the following color-coded graph:
On this graph, a fund that returns five percent excess returns is listed as 1.5 PME, 2.5 percent excess returns as 1.25 PME and so forth. Many of the funds, as you can see, have no excess returns, a PME of 1.0 or less.
Further, the rare VE fund that may be found in the right-hand side, the high-performance side, of that graph is colored blue, which means it has been in existence since before 1995. The purple portions of certain of the bars represent funds that began investing since 2006. These are all to be found in the bars that represent funds that have a PME of 1.5 or less, and chiefly to be found at 1.25 or below.
The title of the report is “We Have Met the Enemy … and He Is Us.” This is of course an allusion to the classic comic strip Pogo, by Walt Kelly, which ran in newspapers in the U.S. from 1948 to 1975. It is employed here to express the view of the authors of this study that it is not the VC model that is broken, but the LP investment model. There are too many LPs investing “too much capital in underperforming VC funds and on misaligned terms,” – this has allowed for the deteriorating performance of the latter.
J Curve Mythology
Part of the reason the LP model is malfunctioning is that too many managers working within it believe the mythology of the J curve. They believe a pitch that says: You have to be willing to accept negative results early in the life of this investment, until the VC gurus can start weeding out the early lemons, so the curve will turn around in the latter years. The authors found a theoretical illustration of such a pitch on the CalPERS website, and included it here.
But that figure, as the Kauffman authors write, “does not appear to be based on actual … data.” Neither does the J curve pitch in general.
Their analysis of their own record of investments in VC indicates that an N curve is more typical. Returns, measured either net or gross internal rate of return IRR, peak at about sixteen months into the existence of a VC fund. That peak is followed by a steady decline, and then a low plateau after roughly two years have passed.
If a fund does generate negative returns early on, the Kauffman data indicates “the odds are no better than random that the fund will remain negative or reverse that trend and generate a positive IRR from year five onward.”
Kauffman will continue to invest in VC Funds. But its plan as an endowment is to employ a more focused approach to this market than it has hitherto. “We anticipate having a long-term portfolio of only five to ten VC partnerships,” in each of which it will seem “a transparent and accountable partnership relationship with our funds, on terms than make economic and fiduciary sense.”