Editors' note: This is a guest column. See Ashton Newhall's bio below.
Let's begin with our conclusion: Venture capital is not broken. It is thriving -- albeit in a smaller, more concentrated ecosystem of fund managers who are largely closed off to new investors.
In May, the Ewing Marion Kauffman Foundation - the world's largest foundation devoted to entrepreneurship - published a report entitled We Have Met the Enemy ... and He Is Us. It stated that the Foundation had a less than a positive experience investing in the asset class over the past twenty years. The report's damning review of the asset class caused quite a stir in the venture community by suggesting that investing in venture capital may not be a great idea.
I agree with several points made in the report. But over the past twelve of years of investing in the venture capital asset class, our experience at Greenspring Associates was profoundly different, suggesting that many of the Foundation's damning, broad-brushstroke proclamations were the result of an analysis of their own experiences. In that vacuum, they lead us not toward a more responsible industry, a more robust entrepreneurial ecosystem, or a more innovative economy.
In conducting an exhaustive analysis of the report, our findings are that the Foundation is simply wrong about venture. I take issue primarily with three key points in the report:
- The average VC fund barely manages to return investor capital;
- Big VC funds (over $400M) fail to deliver big returns; and
- Venture capital managers are misleading investors.
There is nothing "average" about top quartile
Although the "average" VC fund may barely manage to return invested capital, the top-quartile fund continues to outperform each of the major U.S. stock indices on both a relative and absolute basis for each of the 25 trailing-year periods. As such, investors seeking to allocate to the venture capital asset class should be allocating to managers able to perform within the top-quartile of their respective vintage year.
And while identifying the firms with consistently top performing funds is no mystery thanks to readily available benchmarks and public pension plans' FOIA disclosures, the true challenge lies in gaining access (and significant allocations) to such managers. The 15-25 managers driving the asset classes' top quartile returns are each heavily oversubscribed and largely inaccessible to new investors. Moreover, recognizing those emerging managers, or up-and-comers which could one day displace an elite manager, is where a focused investor with a specialists' view toward the asset class can help separate the haves from the have nots.
Institutional investors should not seek to fill their venture allocation with whatever is readily available simply to fill a venture "bucket." The Foundation apparently overlooked this point, as greater than 62 percent of its venture portfolio has failed to exceed public market returns. Without a significant allocation in the consistently top-performing 15-25 managers in the industry, an "average" venture capital portfolio will almost always be below average.
Historical top-quartile investment performance is an important due diligence data point. Top-quartile performing managers are statistically more likely to continue to raise top-quartile performing funds. For example, at the time we made our initial investment in each of our underlying managers' fund(s), over 80 percent of these managers' predecessor funds were top-quartile, which remains more than representative of our managers' current performance today.
As $400 million funds go, so goes the industry
The report claims that large funds do not deliver big returns. Perhaps smaller funds are more likely to produce above-market returns, but it is also true that the top firms in the industry comprise a larger percentage of the total dollars raised. New Enterprise Associates, Bessemer, Benchmark, Accel, Redpoint, Kleiner Perkins, Lightspeed, Founders Fund, Greylock, Andreessen Horowitz, Matrix and Battery have each raised nearly $1 billion since 2007, making up over 35 percent of all the dollars raised during the same period. Some have raised much more. Given that each of these firms is currently investing out of a $400 million plus fund size, are all of their investors continuing to allow the triumph of hope over reality? I don't think so.
We have experienced extraordinary events over the past decade, including two wars and globally crippling recessions. These tumultuous events have also challenged the industry. It takes longer, for instance, for larger funds to return capital, so I strongly believe that the final chapters are yet to be written.
It costs less to start an Internet-based business today than it did ten years ago; it takes a significant follow-on capital to build, scale and drive a startup to an IPO or acquisition. If these $400 million plus funds are unable to deliver outsized returns, no one in the industry can.
Leading - not misleading - investors
Venture capital managers are not misleading their investors. Kauffman states that certain fund managers are artificially marking up valuations within their unrealized portfolios simply to gain entry into the "top quartile" of their vintage year, making it easier to raise a successor fund. We analyzed our portfolio of over 3,000 companies and noted that when we have more than one fund manager invested in the same company, 80 percent of these companies are all being carried at the same valuation by such managers. Our data suggests that at least our managers are not artificially marking up assets, or if they were, there may be mass collusion at hand. Highly unlikely.
Several of our managers sit on the same boards and do not want to value a company significantly differently than their peers. This is more a reflection of conservatism rather than their penchant for mass collusion. In fact, many managers are either holding off on raising a subsequent fund until there is additional liquidity in their portfolio, or are spending additional time with prospective investors, illustrating projections and future growth within the relatively young portfolios.
To Kauffman's point, there is a narrow subset of managers that are inflating performance, giving them an edge in marketing a successor fund. However, this is generally within a subset of the "emerging manager" universe of venture capital managers. These managers do not necessarily have the network effect that the 15-25 elite venture capital firms in the industry today share, including:
- A track record of historical outperformance
- A revolving door of repeat entrepreneurs
- Industry thought leaders on their investment team
Additionally, these more established firms have longstanding relationships with existing investors, making it easier to raise subsequent funds. Both qualitatively and quantitatively speaking, our experience suggests that the preponderance of venture capital managers worth investing in are neither artificially nor misleadingly marking up unrealized assets simply to win our capital commitments.
What conclusions should you draw?
The myth that venture capital is broken is patently false. The greatest way to support the innovation economy and entrepreneurship, and to foster job creation in the United States, is by judiciously funding the venture capital ecosystem. Perhaps only the elite, consistently outperforming venture capital funds merit allocations from an investors' portfolio; institutional investors that gain access to these managers and co-invest in their most promising portfolio companies will be rewarded handsomely for their patient investment in the greatest driver of private sector GDP growth in the U.S., as venture capital investments account for just 0.02 percent of GDP but venture backed portfolio company revenue accounts for over 18 percent of GDP.