21 Comments

Summary:

Updated: Adeo Ressi, the serial entrepreneur behind the venture-capital rating site TheFunded, has been getting a lot of attention for a presentation he gave at Harvard Business School in which he argued that the VC industry is “broken.” His central point is that there are simply […]

Updated: Adeo Ressi, the serial entrepreneur behind the venture-capital rating site TheFunded, has been getting a lot of attention for a presentation he gave at Harvard Business School in which he argued that the VC industry is “broken.” His central point is that there are simply too many venture capital funds chasing too few opportunities, with unrealistic expectations. The result, as he notes in one eye-grabbing slide, is that VC returns over the past five years have fallen below the total amount of money invested over that same time period.

It’s certainly the kind of slide that makes you sit up and take notice. But is it evidence that the VC game is kaput? Hardly. Instead, it’s reminiscent of Warren Buffett’s quip about how if he had been at Kitty Hawk he would have shot Orville Wright’s plane out of the air, because the airline industry over the last 100 years has been a net destroyer of capital. While that may be true (I haven’t double-checked Buffett’s numbers), that’s not to say investors haven’t been able to make money throughout that troubled history. To quote another great economic mind, John Maynard Keynes, in the long run we are all dead. In the short run, however, some successes are possible.

adeo1Have there been too many funds created, too much money poured into finding the next Facebook, Twitter or YouTube? Undoubtedly. But the VC industry is subject to the same economic forces and laws of supply and demand as any other industry — in other words, if some funds are making money, others will emerge and try to duplicate that success, even if they know the odds are against them. The same dynamic can be seen in plenty of other businesses, including the mining industry: When gold is hot, everyone wants to be (or invest in) a gold miner, even though they all secretly know that too many miners means less gold for everyone.

An industry like that is inevitably going to grow and contract, and now sure feels like a time of contraction. But that doesn’t mean smart VCs can’t prosper by concentrating on what they know, or by staying small enough to get more “home runs,” as angel investor Austin Hill notes in a comment at TechCrunch (disclosure: I know Austin, and consider him a friend). The VC industry isn’t broken any more than any other boom-and-bust industry is broken. It’s likely to go through a restructuring as a result of the current downturn, and some VCs will undoubtedly go out of business, as they should. But there will always be VCs, just as there will always be gold companies — and airlines.

Update from Om: Looks like Darwin is doing his thing. Bloomberg reports that universities and pension fund investors are dumping their stakes in VC funds. “Investors have venture-capital stakes valued at more than $2 billion up for sale, double the $800 million this time last year,” the newswire writes. Everyone including large university endowments are having sleepless nights. 

TheFunded – Canarie

View SlideShare presentation or Upload your own. (tags: lp investing)

Image courtesy of Adeo Ressi via his blog.

  1. I think your post makes good points. I also believe that good VC’s will always be around, however, it is the entrepreneurs that will drive much needed change. The great majority of exits are less than $50M.
    I believe that you will see more rounds include structured insider sales in the future when VC’s want to invest larger Series A and B’s. Its completely silly to think that VC’s interests are aligned with that of founders of companies. I’ve been there first hand and can tell you its bullshit. If VC’s want $500M exits than they should reduce the founders risk by aligning monetary interests.

    Just as no one could have imaged the entire investment banking industry being wiped out in a matter of a few months the VC industry will go through a similar nuclear winter with only a few left standing. Except, this time it will be initiated by their LP’s and driven home by the entrepreneurs.

    Share
  2. I’ve scorched Ressi’s presentation elsewhere (I think it’s insane to complain about poor VC returns, and then suggest the answer is for VCs to be *less* selective), but I do think that the nature of the game has changed a bit, at least in software.

    At this point, the smart play is to invest in going concerns, rather than ideas. The great entrepreneurs will always find a way to get their companies off the ground, VC connections or no. Might as well wait until there’s real traction before jumping in with an investment.

    Share
  3. Great piece, Om!

    RE: Chris
    Isn’t “investing in going concerns rather than ideas” a shift that has already happened? How many VC investments (in web companies, anyway) are made before there’s some kind of proven traction? My sense is not many.

    Share
  4. Er, Matthew rather. Sorry!

    Share
  5. The VC model is broken, but you are right that the VC industry is not, at least not yet. And this is because VC money is “alternative investment”, in other words the crumbs of guys who have a lot more money to deal with.
    That means that until now and as long as everybody was comfortable with who they deal with nobody really cared that the returns were not always as expected. Crumbs are crumbs and if the team that deals with my crumbs can justify results one way or another, I am not going to bother.
    What is happening however (at least this is what I hope), is that suddenly there is noise, and the LPs who have money in these VC funds cannot ignore the issue as much. And then they may have to re-consider this VC model: what is the goal, how does this work? And they may realize that there are better alternatives if you want to finance innovation, or help entrepreneurs. I started Entrepreneur Commons (www.entrepreneurcommons.org) to try to bring an answer to these questions. And if you want to read good science on the issue, I recommend this study by Ludovic Phalippou and Oliver Gottschalg: http://www.soxfirst.com/50226711/private.pdf
    The result, looking at 1328 private equity firms worldwide is:
    S&P500 +3% before fees
    S&P500 -3% after the management fees (typically 1% or 2% plus carried interest)
    So investors investing in VC funds will statistically make less than market, their investment underperforming the market by 3% on average.
    The VC model IS broken, even if nobody paid attention until now and people have kept pouring money into it.
    I am glad to read that some LPs are pulling out, hopefully this money will go next time into the right model…

    Share
  6. Thanks for the comments, everyone — and @Jonathan, thanks for noticing it was me :-)

    Share
  7. [...] Ingram of GigaOm writes.. But is it evidence that the VC game is kaput? Hardly. Instead, it’s reminiscent of Warren [...]

    Share
  8. [...] a few thoughts and anecdotes about a lot of the discussion flying around the web about the VC model being broken. James D. Robinson [...]

    Share
  9. Jonathan,

    Classically, VCs would invest in companies before they launched; you needed millions of dollars to build your product, and then you’d raise more money to market it.

    Today, it’s really a game of “dump and chase” (to borrow a hockey term). Companies launch and get traction before raising money. This is true of several of the investments I’ve been involved with, like PBwiki (first VC investment 18 months after launch) and Ustream (first VC investment 12 months after launch).

    Share
  10. University Endowments and most large institutional investors are mandated by their charters to only have certain percentages of certain types of investments. Therefore, many can only have say 10% of their portfolio in VC. When their other investment categories tanked, many found themselves out of compliance having a larger proportion than allowed in VC. These organization were then required to put the VC assets on the market. (they may also have to back out of their funding commitments to a VC funds, hence the sudden actions by Sequoia and others to instruct their portfolio companies to cut back immediately)

    Therefor the big jump in Endowments putting VC assets on the market reported by Bloomberg and referenced in the article may not be signaling the overall demise of this investment class, as it is just a structural realignment due to larger market aftershocks. It would be more telling to know what the Angels, Hedge Funds and Private Equity types are doing with their VC assets, as they typically do not operate under these constraints.

    Share

Comments have been disabled for this post