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Venture Capital Returns Challenged by Recent Evaluations

September 22, 2016
By: Jason Rittenberg

A spate of recent news challenges many common perceptions of venture capital. Academic researchers have identified critical shortcomings with widely used industry data. Major investors have revealed smaller than anticipated returns. An analysis of thousands of investments indicates fund success requires superstar deals of well more than 10x. These articles should drive new evaluations of public policy and programs to support early stage capital.

A NBER working paper authored by Steven Kaplan and Josh Lerner recently described the dearth of credible data and analysis of VC fund investments and VC performance. Kaplan and Lerner argue that available VC data is incomplete and biased and raise concerns with a reliance on the release of proprietary data from self-selected funds. Their arguments raise questions as to whether investors are giving enough thought before investing billions of dollars into VC funds.

In addition to Kaplan and Lerner’s arguments, a number of developments over the last several months may question public wisdom around VC. CalPERS, the nation's largest pension investor, announced that VC performs worse than any other asset class in its portfolio, and it will eventually pare back its investments to just one percentage of its holdings. A Wall Street Journal analysis of Andreessen Horowitz indicates that the celebrated firm may not actually experience returns near the same level of other popular funds. There has also been a deluge of articles and analysis about fewer IPOs and overvalued unicorns (see here, here and here).

While Kaplan and Lerner are concerned that data on VC performance is selective, it should be noted that selective data does not always paint a rosy picture for VC. The general rule of thumb for fund performance is that out of 10 investments, one needs to have a significant return; put another way, the fund needs a single investment that returns at least 10x. An analysis by Benedict Evans of 7,000 investments suggests funds that achieved the desired return of 3x to 5x to investors actually have at least one success of nearly 27x (for funds with smaller returns, major deals average 16x to19x while funds with larger returns have a 64x investment, on average).

Ultimately, Evans’ findings indicate that a dependence on massive wins -- not just home runs but grand slams, to continue the common baseball metaphor -- implies that investors must identify those startups that can not just grow rapidly, but can disrupt or create industries (and survive the tumult). This has been known to be the hope of investors, but perhaps not understood as a necessary condition for the kind of returns that investors hope for when they invest in VC funds. Indeed, Evans’ analysis shows that the size of the strongest investment’s return, and not the number of successful investments, is the better indicator of fund success.

Because startups with such potential are exceptionally rare, this reliance on star performers could raise questions about whether individuals are wise to make VC investments and if public funds should be investing or enticing the investments of others. Before leaping to conclusions, Kaplan and Lerner's point about proprietary and limited data cuts both ways -- caution should be taken when evaluating the VC industry for both good and bad.

In short, this research indicates more information is required for individual and public investors to have a solid understanding of what VC funds truly require to achieve financial and business creation outcomes. Investors in bond and stock markets can avail themselves of financial reports and a wider array of relatively complete datasets; these sources of information are no guarantee of safe investments but do enable potential investors to have a comparatively thorough concept of fund/asset performance. Because true parallels do not exist for VC, investors would do well to proceed cautiously before investing their funds, track their own investments thoroughly and appreciate the ancillary benefits from VC -- particularly the opportunity to support the creation of new businesses and technologies.


SSTI's 2016 Annual Conference

The importance of measurement to the innovation community and a variety of early stage capital fund concerns (university-driven | crowdfunding | rural access | program management) will be discussed by expert speakers and engaged participants throughout the conference. Join these conversations by registering at ssticonference.org.

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