Venture Is No Longer The Best Performing Asset Class

Is the little “fun fact” that occurred at the beginning of this year which Dick Kramlich, General Partner and co-founder at New Enterprise Associates inconspicuously threw into his acceptance speech of the special achievement award from IBF’s Venture Capital Investment Conference last week.

I told you so…

 

VC governance is broken

That is a serious message which refutes all the relativity theories from Venture Capitalists (VCs) and highlights how broken Venture as a financial instrument is. Especially because entrepreneurial activity, according to the Kauffman Foundation, is now higher than in any of the last 14 years, and VC funds have been fully loaded with commitments from supportive LPs over the previous ten years. Short term, even NASDAQ performance beats 2009 performance in Venture.

What it means is that in the marketplace of innovation in which supply and demand are performing well, the governor of innovation (the VC) failed to make financial sense, and its arbitration fails to produce merit.

The Limited Partners (LPs) who unchanged keep pumping money in a decaying financial instrument genuinely deserve to be called Idiot LPs. But we do not want LPs to flee as technology venture remains a highly rewarding investment sector for LPs, just not with the current market model and the present financial derivative. Just because governance is broken does not mean the marketplace is.

 

Checks and balances

According to the panels at the event, the contraction of VCs has started, and venture firms are down some 33% with practitioners down 30-50%. Funding rates are currently at about 900 companies per year, leaving about 3,000 companies with previous investments without extended funding runways. The risk profiles tumble further down the subprime slope with early rounds fetching about $1.5M and $70-90M exits on average. Heavy reliance on syndication is the model going forward, and VCs are hoarding liquidity.

Even though net returns for investors (LPs) are missing, some panel members predict (or wish) no fundamental change will occur. Many LPs unjustifiably appear afraid that if they turn the screws on VC too much, those VC will not let them participate in their next fund. With a new market model, we are more than happy to find them a more competent replacement for each. Many LPs stay away from VC, 2x returns on $20M investments is not a great way to deploy Venture risk for many. No v-shape recovery in venture fundraising is expected anytime soon.

 

A better understanding of underlying assets

Many LPs appear more open to a “forensic analysis” of the Venture ecosystem (get it here), to better understand the asset class and be able to “touch” the companies to which assets are being deployed. Transparency issues are being discussed. Early-stage investing requires a different thesis, and LPs are (eagerly) looking for them, with placement agencies sending many VC firms back to the drawing boards. Venture overhang is getting smaller, turnover in LPs is increasing. Empirical evidence of a recent $3B VC fund distributing only $100M back to the LPs makes the IRR’s (Internal Rate of Return) calculations quickly lose their value in determining the health of the LP commitments. A stronger emphasis on money-in versus money-out is what now drives LP agendas moving forward.

 

Making sense

My observation from discussions with pension funds, private equity firms, and treasuries is that many Limited Partners are confused. On the one hand, they want to get out because of disappointing returns, and on the other hand, they do not want to miss out on the massive opportunity in Venture they know still lies ahead.

A conversation with an LP at the event brought home what that confusion looks like (forgive the brevity on either side, we both sat through the last panel session of a packed two-day event – me lingering for a cocktail appointment with another LP).

…before the panel session…
LP: What do you do, Georges?
Georges: I am a Venture Economist.
LP: Huh, what is that?
Georges: I help LPs make sense out of their venture strategies.
LP: We should talk.

…after the panel session…
LP (before we can leave the room): So tell me.
Georges: Venture cannot and will not perform using the current model.
LP: Well I know Venture is broken
Georges: Yes, but it is important to know the difference between cancer and a fever.
LP: Fair enough, but I don’t have a problem.
Georges: Really? So, why are we talking?
LP: Uh, I think it is broken too. But my returns were okay.
Georges: Really? You deployed Venture risk, and you’ve gotten micro-Private Equity returns, why is that okay?
LP: Uh (blushing); you are right.

 

Finance is easy

It amazes me how common sense has prevented to enter the minds of LPs who (in some cases) continue to be swayed by convoluted fairytale stories of a better future. A solution to the Venture malaise needs to include not just a market-model that deploys Venture risk more appropriately, but should also include the canvassing of new general partners with the confidence and capabilities to produce merit in that new system. Both are incorporated in my systemic fix to Venture, a prelude of which (the detection of the disease) can be found in The State of Venture Capital.

Naturally, I will not paraphrase every discussion I have with LPs and continue to treat them as the other asset holder (like entrepreneurs) in the Venture marketplace with the utmost respect. But LPs should not just listen to VC rhetoric and expect them to come up with fundamental improvements (or perhaps required cannibalization) in the Venture business that jeopardizes their cushy, no downside, protectionist stance. For LPs, I am the resource and the voice-of-reason for those who want to challenge “best-practices” of VCs that have not and will continue to fail to produce proper returns.

But, dear LP, if you aim your frustration with Venture at me instead of the VC, I will kick you out of my process for a much better future in Venture. After all, Venture performance is indeed your problem, not mine.

 

Let’s lead the world by example with new rigors of excellence we first and successfully apply to ourselves.

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