Venture Capital is Even More Broken Than We Thought

Fight disinformation: Sign up for the free Mother Jones Daily newsletter and follow the news that matters.

Back during the dotcom boom of the 90s, venture capital funds performed pretty strongly. Since then they’ve pretty much sucked. So what happened? Felix Salmon directs our attention today to a new report from the Kauffman Foundation that addresses this question in considerable detail. The basic answer, I think, comes early on in the report:

Investing in venture capital in the early to mid-1990s generated strong, above-market  returns, and performance by any measure was good. What has happened since?….Longtime venture investor Bill Hambrecht notes that, “When you get an above-average return in any class of assets, money floods in until it drives returns down to a normal, and I think that’s  what  happened.”

Yep. There’s no such thing as an asset class that consistently outperforms the market on a risk-adjusted basis. If it does, money will keep piling in until it doesn’t.

But things are worse than that. According to Kauffman, VC fund returns aren’t just average, they’re lousy. This means that money should be exiting until returns go up. But that’s not happening: “Despite more than a decade of poor returns relative to publicly traded stocks, however, there appears to be only a modest retrenchment…. We wonder: why are [investors] so committed to investing in VC despite its persistent underperformance?” The chart on the right tells the story. Since 2000, the best performing funds have an internal rate of return that’s only barely positive. The worst funds actively lose money. Taken as a whole, the return on all funds is just about zero. Kauffman says that its VC portfolio hasn’t outperformed the Russell 2000 stock index since 1997.

Felix comments further:

If you look at the performance of VC funds during the golden years of 1986-1999, it turns out that once you strip out the top-performing 29 funds, the rest — more than 500 — collectively invested $160 billion, and managed to return $85 billion to investors. If you can’t get into one of the best funds — and everybody knows which funds those are — then there’s really no point investing in venture capital at all. But what happens is that some investment board looks at VC returns inclusive of the best funds’ returns, and then mandates a certain investment in VC which assumes they’ll have some kind of access to those top-tier funds. And that’s an extremely dangerous assumption to make, because most of the time it won’t be true.

After looking at the evidence, Kauffman concludes that most VC funds manage their investments not to produce long-term returns, but to provide high returns after about two years, just in time for them to go out for their next round of capital raising. What’s most interesting, though, is that Kauffman doesn’t really blame VC funds for this state of affairs. They blame institutional investors, who (a) put aside preset amounts for VC investment regardless of the state of the market, (b) don’t pay attention to proper investment metrics, (c) have such high turnover that no one is really much interested in long-term returns in the first place, and (d) agree sheeplike to pay fees to VC funds in a way that practically begs them to game the system.

The full report is here. Felix has much more here if you want an abbreviated version. Bottom line: as with everything else, there’s no magic. Nothing outperforms the market automatically, and Wall Street doesn’t care how it makes its money. Generating returns is fine, but keeping suckers on the hook and extracting rents from them is fine too. Caveat emptor.

AN IMPORTANT UPDATE

We’re falling behind our online fundraising goals and we can’t sustain coming up short on donations month after month. Perhaps you’ve heard? It is impossibly hard in the news business right now, with layoffs intensifying and fancy new startups and funding going kaput.

The crisis facing journalism and democracy isn’t going away anytime soon. And neither is Mother Jones, our readers, or our unique way of doing in-depth reporting that exists to bring about change.

Which is exactly why, despite the challenges we face, we just took a big gulp and joined forces with the Center for Investigative Reporting, a team of ace journalists who create the amazing podcast and public radio show Reveal.

If you can part with even just a few bucks, please help us pick up the pace of donations. We simply can’t afford to keep falling behind on our fundraising targets month after month.

Editor-in-Chief Clara Jeffery said it well to our team recently, and that team 100 percent includes readers like you who make it all possible: “This is a year to prove that we can pull off this merger, grow our audiences and impact, attract more funding and keep growing. More broadly, it’s a year when the very future of both journalism and democracy is on the line. We have to go for every important story, every reader/listener/viewer, and leave it all on the field. I’m very proud of all the hard work that’s gotten us to this moment, and confident that we can meet it.”

Let’s do this. If you can right now, please support Mother Jones and investigative journalism with an urgently needed donation today.

payment methods

AN IMPORTANT UPDATE

We’re falling behind our online fundraising goals and we can’t sustain coming up short on donations month after month. Perhaps you’ve heard? It is impossibly hard in the news business right now, with layoffs intensifying and fancy new startups and funding going kaput.

The crisis facing journalism and democracy isn’t going away anytime soon. And neither is Mother Jones, our readers, or our unique way of doing in-depth reporting that exists to bring about change.

Which is exactly why, despite the challenges we face, we just took a big gulp and joined forces with the Center for Investigative Reporting, a team of ace journalists who create the amazing podcast and public radio show Reveal.

If you can part with even just a few bucks, please help us pick up the pace of donations. We simply can’t afford to keep falling behind on our fundraising targets month after month.

Editor-in-Chief Clara Jeffery said it well to our team recently, and that team 100 percent includes readers like you who make it all possible: “This is a year to prove that we can pull off this merger, grow our audiences and impact, attract more funding and keep growing. More broadly, it’s a year when the very future of both journalism and democracy is on the line. We have to go for every important story, every reader/listener/viewer, and leave it all on the field. I’m very proud of all the hard work that’s gotten us to this moment, and confident that we can meet it.”

Let’s do this. If you can right now, please support Mother Jones and investigative journalism with an urgently needed donation today.

payment methods

We Recommend

Latest

Sign up for our free newsletter

Subscribe to the Mother Jones Daily to have our top stories delivered directly to your inbox.

Get our award-winning magazine

Save big on a full year of investigations, ideas, and insights.

Subscribe

Support our journalism

Help Mother Jones' reporters dig deep with a tax-deductible donation.

Donate