Venture capital is sucking (your money)

Many of America's tech startups are funded by venture capital. But why on earth would any venture capitalist invest in a risky, unproven new company with a risky, unproven new technology? Answer: High risk goes hand in hand with high returns. Most of the new companies will fail, but the ones who succeed will be huge, more than making up for all the failures. 

Well, that's the theory anyway. If venture capital is taking all that risk and not making stellar returns, then something is severely broken.  

Friday's finance seminar here at UMich was by Steven Kaplan of the University of Chicago's Booth Business School, who presented a paper he's writing with Robert Harris and Tim Jenkinson entitled "Private Equity: What Do We Know?". In this context, the term "private equity" refers both to buyout firms (i.e. what we normally call "private equity") and venture capital firms. The paper is all about measuring the returns that these industries have earned in recent decades.

Most of the talk focused on the buyout industry; only in the last few minutes did Kaplan actually get to talk about VC. But when he did, what I saw made my eyes bug out! Here is the key picture from the paper:

The different lines represent not different VC firms, but different data sources - each line is the average across all VC firms studied. On the x-axis we have "vintage" year, which is the year a firm started investing. On the y-axis we have the Private Market Equivalent ratio, which is a measure of how well funds did relative to the S&P 500 (a PME of greater than 1 means that a fund beat the S&P). Thus, if a line is at PME=2.5 at 1995, it means that, on average, VC firms that started investing in 1995 made 2.5 times the return of U.S. public stocks in general.

So what happened was that before the dot-com bubble burst in 2000, VCs did amazingly well. In the decade since, they've done slightly worse than the S&P 500 - in other words, they've done so poorly that you'd have been  better off buying Ye Olde Vanguard 500. And when you factor in risk, the comparison isn't even close; venture capital has a beta of well over 1, meaning that VCs are exposed to more aggregate risk than an index fund.

In other words, since the end of the dot-com bubble, venture capital has proven to be a sucker's bet. 

Now, you can respond by saying "OK, sure, but that's only one decade. What we really care about are longer-term returns." And maybe that's right. Maybe VC returns will eventually bounce back, justifying this long fallow period. BUT, whether poor VC performance in the 2000s was structural or random is something we won't be able to know for a long long time - not until we've gathered a statistically large sample of VC performance. By that time, you and I will probably be retired or dead. 

In the meantime, all we can do is guess. And dang it, but that graph sure looks like a structural break to me.  Something looks like it broke the VC business model after the dot-com crash. Maybe the new tech bubble (Facebook, etc.) will pump those returns back up, but there have been some big IPOs and some big acquisitions in Tech Bubble 2.0, and VC returns haven't really bounced back yet, so I'd be cautious. What's more, I'm starting to read about a slump in venture funding...

Could this be the (temporary) end of the VC industry? If so, is it a harbinger of technological stagnation, or simply the passing of a financial fad?

(Oh, one more thing. Kaplan et al. find that buyout firms, in contrast to VCs, have consistently beat the market over the last three decades or so. Maybe that has something to do with that enormous tax break they get for buying up firms, loading the firms up with debt, and then paying themselves a dividend while leaving the firm to die...)

Update: An anonymous commenter suggests that a few VC firms manage to consistently beat the market. It turns out she's right (at least as of 2005). This paper, also by Steve Kaplan, shows that VC firm performance is persistent; those firms that make good returns in one period are likely to make good returns in the next period. VC firm performance also appears to be highly skewed - a few firms are making most of the money. Together, these two facts suggest that there are a few really skilled VCs out there who invest successfully year after year, and a large number of truly abysmal VC firms that drag the total return way down. This begs the question of who is throwing money at all these awful VC firms when there are proven winners out there! One possibility is that the "winner" firms limit the amount of capital they are willing to accept; they know that there is a limited number of good projects, and that if they get too big they won't be able to keep returns high. This means that if an investor wants to invest in VC, she may simply not be able to give her money to one of the "winner" firms. This explanation would be bad news for proponents of market efficiency, but would be consistent with the picture of overall stagnation in the VC-funded part of the tech industry, since the driver of low returns would still be the limited number of good new tech ventures.

Update 2: Peter Thiel explains some reasons why a lot of VC funds fail.

Update 3: More reasons the VC model is broken.

Update 4: Here's a Felix Salmon blog post saying essentially the same thing as this post, except with many more charts, graphs, and explanations.