The 2000s, once over, were described by Time magazine as “the decade from hell” – a 10-year span during which nothing seemed to move in the right direction.
And while “hell” might be too strong a descriptor for the venture capital industry during the 2000s, it is fair to say that an investment strategy that was so celebrated coming out of the 1990s is now having its right to exist questioned within certain institutional portfolios.
A recently released draft of an important study on private equity performance confirms what most people already strongly suspected: venture capital, on the whole, underperformed the stock market during the 2000s, which was a pretty dismal decade during which to underperform the stock market.
The paper, “Private Equity Performance: What Do We Know?”, is from esteemed academics Robert Harris, Tim Jenkinson and Steven Kaplan of the University of Virginia Darden School, Oxford University’s Said Business School and University of Chicago Booth School, respectively. The study’s main headline is a pleasing one for most participants in the private equity asset class: even median buyout funds have outperformed the public markets over most periods of time.
The news isn’t as good for venture capital funds, however: the study found that “average venture capital fund returns in the US outperformed public equities in the 1990s, but have underperformed public equities in the 2000s.” Facebook and Groupon notwithstanding, there simply weren’t enough VC success stories to lift average performance to an attractive level during the 2000s.
Judging by these data, one major problem may be that there are just too many funds – and that many of them are too large.
In the buyout market, size of fund does not appear to be much of a predictor of performance. Although the buyout funds studied by Harris and team seem to have performed better at the small-to-mid range, it wasn’t by much. The findings are different within venture capital, and with an odd twist. VC funds in the 2nd and 3rd quartile size range significantly outperformed the largest VC funds. The mean IRR of a 3rd quartile-sized VC fund is 13.4 percent, while that of a top-quartile sized fund is 8.7 percent. Interestingly, the worst performing kind of VC fund, on average, are the ones in the smallest quartile, with a mean IRR of 5.4 percent.
What does this mean? Possibly that there is a “sweet-spot” for venture performance that exists somewhere above the scant resources afforded by a tiny fund, but somewhere below the “let’s put billions to work” level of funds that have ballooned in size.
The growth of the VC asset class, both with regard to number of managers and size of funds, was a natural response to the wild successes of the 1990s – investors piled into VC in a big way. The study shows that while average buyout fund size increased 3.6 times between the 1980s and the 2000s, average VC fund size increased 4.6 times over the same period. One could argue that the phenomenon of bigger buyout funds is less of a problem – after all, mature, functioning companies come in a variety of sizes throughout the world. But early stage companies don’t show such a diversity of size or capital need. As such, maybe it’s the case that if you unleash a big population of larger funds on the start-up world, you get a downtick in average performance.
Of course, few investors in the VC asset class experience a true “mean” performance; instead they experience the performance of the handful of managers to which they are actually allocated. Those connected to the small group of top VCs aren’t likely complaining about the 2000s. But for the best managers, space continues to be limited – which is leading many to question whether there is actually enough natural room in all of venture capital to effectively accommodate the institutional dollars allocated to it.
It could be that venture capital doesn’t scale, and that those outside its super-connected inner circle should simply tip their hats toward Silicon Valley but spend most of their time investing in the mature economy – including backing the few winners to graduate from the VC scene into the profit-positive world prowled by buyout firms.