I tend to be an optimist and have been accused by friends (and others) of being too rosy in my outlook. If that’s true, I suspect it is because of athletics. I have played sports all my life and I’ve found that, in sports, the competition is fierce and if you believe that you can’t win, you will be right. I also think sports have a lot of parallels to business. Both are very competitive and your mindset is critical. As a business lawyer, I have to analyze all of the potential downsides in a transaction, so my optimism is tempered significantly. As a periodic investor in the markets, my optimism is trickier to control.
Being an optimist, I see a bright future for the VC industry, but others disagree. Many of you have now heard about the Kauffman report on the state of the VC industry. The report, available here (Kauffman report), was entitled “WE HAVE MET THE ENEMY… AND HE IS US” Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope Over Experience. It was widely publicized and gave a somewhat dire picture of the VC industry. The Wall Street Journal Venture Dispatch summarized the report as “bashing” the VC industry.
As summarized by the WSJ VC Dispatch, the report found:
[From Kauffman's] portfolio of nearly 100 VC funds, including what it says are some of the most notable and exclusive names (confidentiality agreements barred it from naming them), the foundation found that only 20 of them beat a public-market equivalent by more than 3% annually, and half of those started investing before 1995.
Kauffman also found that smaller funds (under $400M) were much more likely to beat the public markets (quoting again from WSJ):
The report also offers support for the belief that small venture funds are the most successful. Only four of 30 VC funds in the foundation’s portfolio with more than $400 million in committed capital produced returns better than those from a publicly traded small-cap stock index fund… The foundation promises to take its own medicine. It said it will invest in venture funds of less than $400 million whose partners have consistently shown they can outperform public markets and who commit at least 5% of the fund’s capital. It also plans to do more direct investing to avoid paying management fees and sharing profits with VCs. And, it plans to shift money from venture capital to the public markets.
Here is a talking-heads style video that has a good summary of these issues. As you will see, Kauffman isn’t saying that the VC business is dead, but more that the VC industry is challenged and, as a result, fund managers should give them better terms.
Kauffman also found that the J curve effect has not been pronounced since 1997, meaning that VC funds have not actually lost money on average in their first few years. They use this to argue against the usage of deal-by-deal carry and to argue that LPs should have more priority on distributions in order to avoid ‘clawback’ (where the fund managers receive profit distributions early on that were excessive in light of fund’s ultimate return). In my experience, reputable fund managers often manage their fund to avoid clawback notwithstanding the fund’s contractual agreements, but this may be a situation where some bad apples are souring the stew.
Notwithstanding Kauffman’s doom and gloom, I am not the only optimistic person bullish on the industry. Mark Suster recently wrote a great counterpoint to the Kaufman Report: “It’s Morning in VC“. It’s an incredibly detailed and well thought out article that should be a must read for those interested in the future of the VC industry. Spoiler: As the title suggests, Mark views now as the beginning of a great “day” for VC. Mark is one of the best writers in the business and his analysis is compelling. Even his picture (right) paints a gloriously optimistic sunrise.
Being the optimist, I happen to think Mark is more correct than Kauffman on the state of VC over the next few years. I definitely hope so. For what it’s worth, Kauffman continues to invest in the VC industry.