CVCA audience crib notes

Dateline: Ottawa

Have you ever attended an industry conference and wanted to ask a pithy question, but didn’t for fear of a negative reaction from the panelists or audience regarding your “too true” question/statement? Fear no more. In the interests of arresting any further deterioration of Canada’s start-up and venture capital ecosystem, here are some helpful crib notes on the opening day of the annual Canadian Venture Capital and Private Equity Association conference in Ottawa.

Invariably, one of more panelists will say “the VC model is broken”, or “VC returns have been poor”. These panelists will often be the very limited partners who have suffered from the recent results of Canada’s venture capital industry. In their experience, they could be right. The GP choices they made didn’t generate the returns they’d anticipated; at least not so far. Why risk your career and put more money into an asset class that hasn’t served you well of late?

With that thematic as the backdrop, many LPs have completely shut off their investing spigot, while others are using the lack of LP competition to opportunistically and dramatically change the terms of their VC investing strategies, whether your fund has earned investors a positive return in the past or not. To borrow a cliche, the baby is being thrown out with the bathwater.

This “VC returns suck” concept has become accepted wisdom within the domestic LP community, even if it isn’t supported by the facts. On a relative basis, VC returns exceed almost ever other asset class (see prior post “VC returns trump all” June 2-09) other than, perhaps, Bordeaux wine futures.

Should you have the courage, here are a few points you could make to rebut what has become a staple of any VC confernce over the past four years:

Myth #1: “VC returns are poor”

Fact: As at 12/31/09, the 3, 5, 15 and 20 year returns of the US VC Index exceed the returns of the DJIA, NASDAQ and S&P 500. Only the 10 year DJIA return exceeds the venture return, but the NASDAQ and S&P continue to lag both.

Although these are U.S. figures, several Canadian VC industry funds have earned their investors a positive return in recent years, according to data published by the CPPIB. These names include Celtic House II (2002 vintage), Edgestone Venture Partners I (2000 vintage), Lumira Capital I (2002 vintage), and of course Wellington Financial’s Fund II (2004 vintage) and Fund III (2006 vintage).

Myth #2: “The VC model is broken”

Fact: According to CPP Investment Board CEO David Denison, long term investors need to have a long term horizon, and not get caught up in one, two, or even ten weak return years:

Our five and 10-year results should be viewed in the context of the performance of major global financial markets over the same period. The past 10 years of investing have taken place during the worst calendar decade of performance for equity markets in the nearly 200 years of recorded stock market history,” said Mr. Denison. “If we look back over the span of the last 25 years the CPP Reference Portfolio, which serves as the market-based benchmark for the CPP Fund, substantially outperformed the 4.2 per cent real rate of return on a rolling 10-year basis in all periods except calendar 2008 and 2009. We are confident that with the Fund’s current portfolio composition and reasonable levels of capital market returns, we will be able to generate the returns required to sustain the CPP at its current contribution rate over the longer term.”

What Mr. Denison, the Dean of Canadian Limited Partners, is saying is incredibly relevant to the VC asset class. If the long term investment experience of VC investing has been positive, which it has, one cannot ignore the impact that a 10 year negative NASDAQ return will have on private valuation multiples for Tech, Biotech and Lifescience companies. If the public market returns have been brutal, private company investors can’t perform well, he says. What could be more relevant to the VC industry than this simple explanation, put forward by someone with $24 billion committed to private equity and venture capital sectors?

To reduce VC allocations to zero based upon short term industry results (and not the long term performance of the asset class) is no better than investing new capital based upon short term results; something that is diametrically against the basic investing philosophy of the pension fund world.

To my CVCA colleagues: fell free to use these crib notes over the coming two days. Don’t leave it to others to fix our industry’s false storyline.

If these urban myths aren’t dealt with soon, the entire start-up and VC ecosystem will be lucky to be a shawdow of its former self. LPs have every right to allocate the funds under their stewardship as they see fit. But let’s not let these allocations be determined based upon false assumptions. If Mr. Denison is right about how the CPPIB sees the world, every LP in Canada of any size should have an allocation to venture capital.

MRM