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Is Venture Capital Investing An Overhyped Money Pit?

Whether it’s Facebook, Instagram, or Groupon (Nasdaq: GRPN) (well, the pre-IPO Groupon, anyway), watching the hot investment stories today suggests that the only people making money are those who get in early.

And if you want to beat the crowd, there are only two ways to go: Start your own company or invest in one through venture capital funds.

However, for most investors, venture capital funds are off limits due to high minimum investments and other legal requirements.

Don’t fret it, though, because it turns out that you should actually be thankful you can’t put money into VC funds. At least not if you don’t like throwing your money away.

It’s no accident that you don’t often hear comprehensive performance figures for venture capital firms, as these firms go a long way to their keep performance numbers secret. This includes requiring investors to sign confidentiality agreements that prevent them from publicizing results.

And the secrecy’s far reaching. When certain public institutions like the University of California released investment returns due to a court order for transparency, several venture capital firms refused to allow them to invest in order to keep return figures under lock and key.

But now the secret is out. And quite frankly, it’s looking dirty…

Venture Capital’s Dirty Secret

An extraordinary new report published by the Kauffman Foundation reveals data that’s never been available to the public.

What it shows is that the reality of venture capital investing doesn’t match the hype.

The foundation was created to foster entrepreneurship and education, and of its $183 billion endowment, it invested roughly 5% into venture capital. By “anonymizing” the returns – this means we can’t tell which funds returned which performance – the Kauffman Foundation was able to release its detailed study of the 100 funds it’s invested in.

The foundation’s investments spanned two decades and what the data reveals is financially damning: Venture capital investments lag the market.

According to the authors, the results “show chronically disappointing returns over most of the 20 years studied, no matter which way we slice the performance data.”

The average venture capital fund didn’t even break even, and most (62 out of 100) failed to return amounts higher than the public markets (as measured by the Russell 2000).

The last point is particularly alarming, as investing in venture capital is risky and illiquid, so investors expect a higher return than the market.

Despite such expectations, only 20 of the 100 funds beat the public stock market by more than 3% per year. (And 10 of those funds started investing before 1995, meaning they got a big performance boost from the dot-com bubble.)

All told, venture capital funds lag lots of other investment options that have less risk and better liquidity.

Don’t think that the Kauffman Foundation is just bad at picking venture capital funds, either. Kauffman is a heavy hitter, meaning it gets access to the best venture capital funds available. A 2009 report by Cambridge Associates analyzed multiple investors and ranked Kauffman in the top quartile of venture capital investors.

Of course, investing in early-stage companies is difficult, which accounts for some of the poor performance. But there may be more to it than that.

In theory, the purpose of a venture capital investment is to take positions in very young companies that take a long time to pay off, so venture capital funds are designed to run for 10 years at a time to prevent a focus on short-term returns.

Given that scenario, the returns of a venture capital fund should have a “J-shape,” like the green line shown in the chart below. The early years show a negative return while the young companies lose money. Then, adding up over time, the returns slowly turn positive.

You can see that the returns Kauffman experienced were something extremely different. The funds reported high early returns that degraded over time.

Here’s what’s happening: Venture capital funds start at a specific time, but they allow new money to be invested for a period after that. The median fund allowed new investors for 25 months, represented in the graph by the purple line.

In those 25 months, the venture capital funds invested in illiquid, early-stage, private companies. When the funds report early returns to investors, they can list these investments at essentially whatever value they’d like.

In other words, the Kauffman data suggests that venture capital funds overstate their own performance during the time they’re wooing new investors to raise more money.

It makes sense from the venture capital fund’s end. Most of a fund’s own profits come from the 2% fee it collects on the total funds raised. In fact, the Kauffman Foundation alleges that “venture capitals have moved from professional risk-taking and investing to professional fundraising.”

The report goes on to ascribe blame largely to the investors in venture capital funds and suggests ways to fix the system.

But the lesson for most investors is that they haven’t missed out on anything but the disappointment of poor returns.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk