Let's shut the stock market
Truths, Myths and the Roadmap Part One
Coming out of the annual general meeting of the Canadian Venture Capital & Private Equity Association (see prior post “The juices are flowing at annual CVCA conference” May 28-09), one is left with the impression that there is an unhealthy expectation gap in the venture industry. VC funds expect that long term investors understand that it takes time to build a company, and that the lack of public market exits has only extended this window. Pension funds expect the VC industry to produce returns, with no excuses about why that might be problematic at certain historical junctures.
Based upon the conversations at the CVCA meeting, that gap won’t be narrowed.
Pension fund investors understandably expect to be compensated for the risk they take when they invest in any asset class, whether it be private equity, venture capital, debt or public equities. What’s annoying is that it became apparent last week that there might be a double standard being applied to the public vs. private asset classes.
One key theme from institutional investor panels went something like: “the Canadian VC industry has produced weak returns and needs to shrink to between 8 or 10 different funds”. A powerpoint slide during one presentation showed 10 year average returns to be flat. Who wants dead money? Shrinking the industry might make sense, if you thought returns would improve, leaving aside the impact that will have on Canada’s Innovaton Economy.
But what of the public market’s performance during that time horizon? From June 4, 1999 until last Friday, the S&P 500 was down 382.7 points, or 29.4%. The Dow Jones 30 has performed better, but is still down 19.5%. The NASDAQ, which is known to be tech heavy, is down 28%.
Why are pension fund managers not advocating a 50% reduction in their public market weightings and managers? When an equity manager reviews his/her performance, they gets kudos if they lost less money than the market indicies did last year. My favourite line of a recent pitch was “we added 220 basis points of value”, by losing just 22% last year. (Makes you wonder why the stock market isn’t being shut; thus my tongue-in-cheek headline.)
Why, when many in the VC industry have beat the public markets over the past ten years, are allocations being cut to zero on the basis that “returns are poor”? Why does half the industry (half of those still standing, that is) need a lesson in Darwinism?
One hears no calls for a shuttering of the public markets, despite the 10 year losses in that asset class; CPP Investment Board, for example, has 57.4% of our pension capital in public equities. OMERS is sitting at 60.2%. OP Trust’s allocation is at ~45%, having moved 10% into short term money market instruments last year. HOOPP is at 32.9%, while the CDP’s allocation is 22.4%.
Go back 25 or 30 years, and venture has also beat the public markets.
Why the double standard?
MRM
Mark,
You’ve fallen into the trap of focusing on median VC returns, rather than the distribution of returns across the asset class. The reality is that VC returns are highly skewed with 3/4 of VC funds underperforming the S&P on a risk-adjusted bssis over a 20 year period. See: http://bit.ly/Q6rTf.
This is exactly the problem with the VC industry and why it needs to significantly contract and consolidate. The vast majority of funds have not met the minimum threshold returns to justify their very existence. As a result, they are an economic drain on the entire industry (and economy) resulting in excess capacity, overfunding, negative economic value and an overall dampening of median VC returns. These funds not only need to be shuttered, they will be. LPs will no longer support these funds and with greater transparency investors will flock to top-quartile performers. For example, Calpers is “looking to reduce its relationships to only the top quartile VCs and getting out of the mid and bottom tier ones altogether.” (http://bit.ly/EphM5).
However, the real problem with the VC industry, as suggested above, is the LACK of transparency. VCs are rightly uneasy and unwilling to publicly disclose their performance to the industry and to their customers (ie, start-ups). Imagine if a third party such as Deloitte or even the CVCA would audit the performance of VCs, rank them by quartile and publish the results. Within a few months most of the VCs you know would no longer be in operation.
As a founder of a start-up, I have no idea whether Growthworks, JLA, Vengrowth, iNovia, etc outperform equity markets over a 5, 10, 20 year period or their relative ranking and performance against their peer group. As a result, I don’t have sufficient information as a “buyer” to purchase their services. Basically, start-ups are betting blind on their backers. How crazy is that? In the meantime, VC partners continue to draw down their management fees, sit back in comfy leather chairs looking out their floor-to-ceiling windows with a view of the lake.
Let’s face it, the VC industry is increasingly archaic. New seed stage funds, angels and enterpreneurial funds like Y-Combinator, etc. better meet the needs of today’s Web 2.0 companies. My advice to VCs is to start creatively destroying their industry by: getting “naked” and publicly reporting their performance and returns; shuttering underperforming funds; and getting more entrepreneurial both in terms of how they run their business and also by actually recruiting serial, successful enterpreneurs to lead their funds rather than ex-money managers, investment bankers and lawyers that make up most of today’s VC partners.
In a nut shell, the VC industry needs to: Get small, Get trasparent and Get entrepreneurial.
Why bite the hand that fed you before and may feed you again? My observations of asset managers (mutual fund managers, investment counsellors, et al) in the public markets is that they don’t like to move outside the public markets since there are no benchmarks to hide behind. (ie your example of losing 22% vs the market loss of 24.2%).
Mark Z.
Thanks for the thoughtful comment. Getting this discussion going is useful.
But your assumption about the concentration of returns is incorrect. It is true that 3% of funds have commanded returns of 100%, but not all are losers. According to a study presented last Fall at NAVCS by Harvard Professor Josh Lerner, at least 54% of U.S. venture funds had a positive return since their inception (as at 3/08).
MRM
Mark,
I’m not suggesting that three quarters of funds had negative returns. Rather, I’m suggesting or more accurately, the data indicates, that three quarters of VC funds underperformed the S&P over a 20 year period. From an LP’s perspective this is the key indicator not overall returns. This data suggests that on a risk-adjusted basis, 75% of VC funds should not have been funded at all. Rather, this money should have been invested by the LPs in an equity index fund.
The public market bias has always been there, and is pervasive. It looks like in the end the liquidity of major public markets is highly valued, maybe more than returns over any specific period of time, and the market has spoken.
The lack of transparency of venture is part of the problem, but unsolvable valuation issues and survivor bias means transparency only takes you so far. Picking time frames to compare returns, and including (or exlcuding) the bubble years means many conclusions are possible with the same data.
In the end, people just don’t believe venture has delivered on the whole, and data that suggests it has doesn’t square with the instincts.
Better to argue the merits of a venture business model, a correctly sized firm, smaller syndicates, better real governance potential, and highlight as many realistic examples as possible. Perhaps complementing the public markets is an easier task than competing with them for capital.
Mark M,
Definitely in agreement with you. I checked out Mark Z’s informative link, and it actually supports the thesis that VC investments are good on average (mean or median) as he says, but that the distribution of returns is over a greater range.
There’s an implicit assumption in that argument: that any new additions to VC funds or investments will automatically be 3rd or 4th quartile performers. I disagree. While a lot of dumb money flew into VC at the tail end of the Web 1.0 era, that is not generalizable. The new VC I’ve been seeing has been focused and differentiated – Wellington itself, or the BlackBerry Fund, are two local examples.
I could go on about the economies of scope, the positive externalities of more VC such as a critical mass of professionals that acts as an attractor for more talent and capital, but will leave it with my core argument: VC has solid returns, and plan sponsors can earn excess risk-adjusted returns by wisely choosing VC funds in which to invest.
Byron,
You make some very good points. However, the key issue remains that of transparency. Without the data, we are all left to guess which funds are or will be in the top quartile and thus most likely to generate the appropriate risk-adjusted returns.
The wide distribution of VC returns is actually not surprising given the dynamics of the industry. For LPs the key issue is to discern whether, as you suggest, there is (or is likely to be) sufficient turnover in the top quartile. If so, then LPs need to continue to evaluate a wider pool of VC funds for investment. If the turnover is very low among the top quartile, then the LPs’ investment decisions are much clearer. However, as I keep saying, the data to evaluate these issues seems to be sadly lacking in this industry.
Just reading this now.
The real reason why we believe VCs are horrible performers to date is that they have squandered public trust in the 90s, by pushing technologies through the IPO funnel that never had any Social Economic Value to begin with. And then subsequently retrenching in (unjust) fear and turning micro-PE.
And to concur with Byron on more than just lack of transparency I explain in my many blogs why the market-model we deployed in venture by definition can’t work.
And I’ll close with the comparison on public markets. Technology venture should have blown any public market or private market asset class away because of its massive greenfield (5/6 of the world) and because of the steady growth in technology adoption. Venture does not outperform the sector it is riding on.
Comparing a 20 year old technology sector with 100 year old stagnating indices is comparing apples and oranges.
Best,
-Georges