Buyout vs. Venture returns

There are some rules in life that one can never ignore: what goes around comes around; there’s no cure for a hangover; take your vitamin “C”. In the institutional fund industry, the current thematic is “Venture returns are poor; Buyout is the place to be”.

But is that really so?

I’ve got the U.S. data in hand from Thomson Financial, and the Buyout returns are not what I expected. Certainly not given the universal mood of the pension fund and institutional investor crowd. They are continuing to plow their funds headlong into the buyout world, despite the chilling backdrop of a credit crunch and a looming economic contraction.

Here’s the snapshot.

Buyout 3 yr. avg. performance: 14.9%
Venture 3 yr. avg. performance: 10.4%

Buyout 5 yr. performance: 14.3%
Venture 5 yr. performance: 6.7%

Buyout 10 yr. performance: 8.3%
Venture 10 yr. performance: 17.9%

Buyout 20 yr. performance: 12.8%
Venture 20 yr. performance: 16.4%

Over the long term, the average Venture fund outperformed the average Buyout fund. In the 3 year category, the results aren’t very compelling, either. The return in the “small buyout” category (up to US$250MM fund size) was just 8.4%, and the large buyout (funds between US$500MM – US$1) returns were 9.4%. These results were below the “balanced VC” and “later stage VC” figures of 14.4% and 10.5% respectively.

Where do the limited partners get the idea that the only place to be is Buyout? Over the long term, VC results have exceeded the Buyout averages. In the short term, mid and later stage VC results exceed most Buyout funds of US$1 billion and smaller — the vast majority of the Canadian Buyout market.

The more troubling news is that the 10 and 20 year returns for the Mega Buyout category are more than 500 basis points below the same time horizon for Venture Capital. Why, pray tell, is Canada’s own pension plan, the CPPIB, almost exclusively active in the Mega Buyout space?

The last direct investment the CPPIB made in the Canadian venture space was a $50MM comitment to Celtic House Fund III in 2005, but their subsequent buyout commitments now include Birch Hill ($85MM in 2005), Clairvest ($40MM in 2006), Edgestone Equity III ($100MM in 2006) and Tricap II ($300MM in 2006). Word is, CPPIB will never again invest directly in Canadian Venture. The firms are just “too small” and the commitment opportunities “don’t move the needle”.

In the U.S. category, CPPIB has no direct commitments to such top U.S.-based VC funds as Battery, Benchmark, General Atlantic, Kleiner Perkins, Sequoia, etc. But they’ve gorged themselves (and all of us) on Apollo (US$400MM in 2005 and US$600MM in 2007), Blackstone (US$406.7MM in 2005), Goldman Sachs ($200MM in 2006), JP Morgan (US$317.4MM in 2006), KKR (US$475MM in 2006), Providence (US$400MM in 2006), Thomas H. Lee (US$250MM in 2006), TPG (US$500MM in 2006), Welsh Carson (US$200MM in 2005). And this list isn’t exhaustive – it’s just US$4 billion of the U.S.-based highlights.

The only recognizable fund with any tech link was Silver Lake Partners, which received a US$500MM commitment in 2006. With more than eight times the money being committed to Buyout versus Venture, we beneficiaries of the CPP had better hope and pray that the 3, 10 and 20 year returns of Mega Buyout vs. Venture Capital are not indicative of the returns to come in the future.

Naturally, none of the CPPIB staff making these commitments will still be working there 20 years from now to account for the outcomes of their decisions. And few, if any, of the current senior partners at these U.S.-based Mega Buyout funds will be actively involved in CPPIB’s massive commitments, either. And speaking of old saws. We’ll be left to hope that the historical data isn’t reflective of future performance.

In the meantime, the absence of direct VC commitments is in stark contrast to what pension funds such as CDP or CalPERS are doing. CalPers’ tech comitments include Flagship, Francisco Partners, Garage, Information Technology Ventures, Insight, Lighthouse, Oak Hill, Silver Lake, Technology Partners, Vantagepoint, etc., etc.

Let’s not forget that 3COM, Apple, Cisco, Electronic Arts, Flextronics, Google, Hyperion, Network Appliance, NVIDIA, Oracle, PayPal, PMC-Sierra, RSA, Symantec, Yahoo and YouTube were all once venture-backed companies.

There’s little doubt that if you were going to put money into U.S. buyout, you’d likely choose many of the funds that CPPIB has picked. But the question must be asked: where’s the venture allocation?

If historical financial returns aren’t what are driving asset allocations at CPPIB, I’m at a loss to know what model supersedes prior success as a sound predictor of future opportunity. Perhaps they have a crystal ball. How else can they ignore the results? Venture returns trump Buyout.

MRM