Institutional Investors Loved Venture Capital to Death
The "Venture Capital is broken" meme isn't new. It was recently re-ignited by a refreshingly honest report from the Kauffman Foundation that laid bare the endowment's not-too-impressive history investing in the asset class.
What's new is that limited partners (the institutional investors, universities and endowments, and high net worth individuals that back in VC funds) are finally getting their shit together. They don't really have much of a choice -- returns from venture capital are generally lousy, and LPs are being held increasingly accountable for their investment decisions.
LPs I've talked to at the Dow Jones LP Summit in New York this week echoed the concerns of the Kauffman report: Funds are too big, management fees are bloated, returns on anything below the difficult-to-access top-four or -five funds are lackluster. They said most LPs feel similarly, but only Kauffman Foundation was bold enough to say so. CalPERS, for example, buries its venture returns within its $49 billion alternatives portfolio.
The biggest problem, they say, is that venture is waiting for superman. "There was only one Internet," several quipped. The early days of the Internet made everyone rich. VCs have promised investors that many things would be The Next Internet since then. Nanotech was meant to drive venture returns, cleantech was meant to drive venture returns.
Social media is the currently new venture superman. Except, as of this month, it kinda isn't. Facebook, the rising tide meant to lift all social media ships, is by all counts a dud. Its share price is now $10 below its IPO price -- the $100 billion company now has a market cap of $60 billion. Now solid companies are reconsidering their IPOs, and other social media stocks like Zynga are trading down.
LPs want to invest in venture capital. If the Kauffman report is correct that rising fund sizes have killed performance, then LPs have been willing accomplices to VCs' failures. They have poured so much money into the venture capital that they literally loved it to death, one LP joked. (Insert Tommy Boy reference.)
Each one I talked to kicked off comments on pulling away from the asset class with "I love venture capital, I really do. But I just can't keep losing money." Wimpy LPs, once scared to stand up to GPs for fear of not being let into a hot fund, are finally starting to put their foot down, it seems.
There are firms returning money. The top five, ten, or even 15 firms produce returns that beat public stock indices. But it's not easy for everyone to get into those funds, and some cap investment sizes, preventing large institutions from coming on board. (A $49 billion alternative asset program can't really write checks smaller than $50 million, which is the reason CalPERS gave for cutting its VC exposure from 7 percent to 1 percent.)
The sense I got was that LPs are under more pressure than ever before to consolidate relationships and stop backing underperforming managers. It's starting to show in the form of dismal VC fundraising numbers (buoyed last quarter by a few large raises) and a steady proliferation of walking dead VC firms (i.e., functioning firms that are managing out old funds but aren't able to raise a new one). Now the problem is, if there is less capital to go around for startups, who will pick up the slack?
It's a particularly poignant question for Kauffman Foundation, which has a stated mission of promoting entrepreneurship. When the foundation pulls commitments to venture funds and advocates to others to do the same, less entrepreneurs get funded.
Diane Mulcahy, the author of the study and Director of Private Equity at the Kauffman Foundation, put it to me like this:
The percentage of companies that get venture capital financing is teeny-tiny. That's not to say venture capital isn't important, but there are lots of ways to support entrepreneurs that don't involve venture capital. It will mean less capital to support high growth companies, but less venture capital doesn't mean less startup capital.So who will pick up the slack then? The answer, apparently, lies in angel investors and crowdfunding. Thats what Mulcahy said, and that's what many of the LPs I talked to at the Dow Jones LP Summit said. Kauffman Foundation is a direct investor in Angel List and the Angel Capital Association, for example. "Venture capital is one way to promote entrepreneurship, and it's not even a very good way. If there's a misallocation of capital with too many people investing too much money in an underperforming asset class, it's not good for anybody," Mulcahy said.
With the growth of angel investing and, soon enough, crowdfunding, startup capital is evolving beyond venture capital. Facebook may have killed the IPO pipeline and venture capitalists' social media dream, but at least it's produced a fresh crop of angel investors.
Of course, there are problems with the angel investor solution -- angels don't provide the guidance young companies need, they don't want to take board seats, they don't have enough skin in the game to help entrepreneurs succeed. And crowdfunding carries its own set of Madoff-y risks that has everyone freaking the hell out.
VCs and LPs know venture capital needs to evolve. As VC shakes out, the proposed solutions may have some warts, but right now it's the next best thing.