A new report out today from the Ewing Marion Kauffman Foundation describes how most institutional investors, including larger state pension funds, endowments and foundations, may be shortchanged by their investments in venture capital funds.
Over the past decade, public stock markets have outperformed the average venture capital fund and for 15 years, VC funds have failed to return to investors the significant amounts of cash invested, despite high-profile successes, including Google, Groupon and LinkedIn.
The report, "We Have Met the Enemy … And He is Us," is based on a comprehensive analysis of the Kauffman Foundation’s more than 20 years of experience investing in nearly 100 VC funds. It illustrates a persistent pattern of inflated early returns in funds that may be used to raise subsequent funds and shows the poor historical performance of funds with more than USD500 million in committed capital.
Interviews with fund managers and limited partners also suggest that many institutional investors commonly maintain inadequate fiduciary oversight and are anchored to narrative fallacies about the benefits of venture capital as an investment class.
The authors call upon institutional investment committees to require deeper due diligence of VC investments and more rigorous data analysis of VC portfolio performance relative to the public markets. The authors also urge limited partner investors to charge more for providing capital to risk assets by insisting on preferred investment returns before sharing profits with general partners – as is often the practice with buyout and growth investment firms.
"Investments in venture capital funds should be measured against the naive alternative investment – publicly traded small company stocks," says Diane Mulcahy (pictured), director of private equity at the Kauffman Foundation and the paper’s lead author.
The authors also recommend that foundations, endowments and corporate and state pension funds negotiate investment terms that better align their interests as limited partners with those of the general partners in which they invest. The report suggests potentially troubling asymmetries between the information required by venture capital funds from portfolio companies and the information they are required to provide to limited partners of the funds.
"At a time when many general partners cannot raise follow-on funds from limited partners, we think that an understanding of how partners share income and budget for expenses is vital both to LPs and to GPs who must co-invest with dependable partners," says Harold Bradley, Kauffman’s chief investment officer and report co-author. "The alternative is a nightmare of recurring arguments over clawbacks, extensions of fund life, and ultimately stock certificates on the wall when a failing general partner walks away from struggling companies."
The Foundation found that the most significant excess returns earned from venture capital occurred in funds raised prior to 1996, and those funds averaged $96 million in committed capital. Many of those successful funds led managers to raise successively larger funds, which significantly eroded returns and maximised general partner profits through fee-based income at the expense of limited partner success.
"The result is that institutional investors end up paying general partners – who typically commit only 1 per cent of partner dollars to a new fund while LPs commit the remaining 99 per cent – quite handsomely to build funds, not build companies," says Mulcahy.
"We believe LPs have a responsibility to fix what’s broken in the investment model, and that starts with better information and budget approval rights," says Bradley. "Some insiders cry that not enough venture money is being steered to early-stage companies – but with six times the capital invested every year this decade than was invested in the entire decade of the 1980s, too much capital is the problem and LPs are not charging enough for that capital."
The report goes on to outline a series of steps the Kauffman Foundation itself will take to correct its approach to venture capital investing. Mulcahy, who manages the Foundation’s VC portfolio, said: "We are changing our investment behaviour based on this data; going forward, we expect to be much more selective and disciplined investors in only a handful of VC funds."