In the Kauffman Foundation's recent report "We Have Met the Enemy...and He is Us," we present the disappointing returns generated from the Foundation's venture capital portfolio. Like many other foundations, endowments and pension funds, Kauffman's investments in venture capital have, for more than a decade, persistently failed to generate the promised "venture rate of return" of at least two times our capital invested, after fees and carry.
Here at the foundation of entrepreneurship, we spend a lot of time thinking about the growth and financing of startup companies, so it made sense for us to rigorously analyze our own portfolio of 100 VC funds that we've invested in over 20 years. What we found is that VCs are good capitalists. They sell what their investors will buy, and they charge what their investors will pay.
The real problem, it turns out, lies with the institutional investors -- the ones doing the buying and the paying -- and their investment committees, who are charged with the fiduciary responsibility to oversee and approve venture capital investments. These committees continue to approve investments of about $20 billion each year in underperforming VC funds. We found at least three persistent myths of venture capital that help explain why.
Myth #1: Investing in Venture Capital Generates High Returns
The story of venture capital investing is a compelling one. Successful venture capital investments and exits in companies like Google, LinkedIn, Zynga and Groupon perpetuate the narrative that VC is a highly lucrative asset class and generates great returns for investors. But the actual performance data tell a very different tale. In the Kauffman Foundation's portfolio, only 20 of our 100 VC funds outperformed the public markets by the 3 percent to 5 percent annually that we expect, to compensate us for the illiquidity and risk of investing in private instead of public equity. Even worse, 62 of our 100 funds failed to even beat the returns available from a small cap public index. Industry-wide figures suggest that our experience is not unusual. The National Venture Capital Association and Cambridge Associates performance data indicate that the venture capital industry has underperformed for more than a decade, based on both internal rate of return and multiple of capital measures.
Myth #2: Investors Pay VCs for Great Investment Performance
The conventional wisdom is that the market standard "2 and 20" compensation model of a 2 percent management fee on committed capital and 20 percent profit sharing pays VCs well for great investment performance. Data from the Foundation's portfolio show that investors, particularly investors in large VC funds, regularly pay VCs high levels of personal compensation through management fee streams, rather than through great investment performance. For example, none of our funds over $500 million in size generated a "venture rate of return." Yet each of those funds generated at minimum of $10 million per year in management fees that compensated VC investors well despite their underperformance.
We also found that investors pay VCs to raise bigger funds more frequently. The 2 percent management fee paid under the 2 and 20 model is based on committed capital, which means bigger funds generate bigger fee streams. Investors also pay VCs to raise funds more frequently. The cumulative impact of a 2 percent management fee across several active funds can generate significant annual fee income independent of investment performance.
Myth #3: Investing in "Brand" VC Firms is the Best Investment Strategy
We talked to many VCs and institutional investors as part of researching our paper and asked for their list of the top five VC firms. Everyone had a different list. We don't know definitively who the top VC firms are because performance data are not generally available and are not consistently reported. In the absence of actual data, "brand" and reputation have become proxies for performance. The narrative around "brand" is that the best entrepreneurs will seek capital from the brand VC firms that will be able to invest in the best companies, and therefore, generate the best returns. It's an interesting, but unproven, hypothesis. The data in the Kauffman Foundation's portfolio tell a different story. We are or have been investors in several "brand" VC firms that have consistently failed to generate venture rates of return, or even returns that beat a low-cost, fully liquid public equity index. The takeaway from our analysis is that institutional investors should pay significantly less attention to "brand," and significantly more attention to actual performance when evaluating VC firms.
It's our conclusion that the best way to avoid investing in the myths of venture capital is to invest in the realities of venture capital performance, and to pay VCs to do what they say they will -- generate great returns in excess of the public markets.