Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC
BackgroundVenture capital (VC) is the process of investing private equity in companies, typically in early stages of development, that are believed to offer significant potential to grow substantially and reward investors accordingly. The objective of VC is to generate high rates of return over long periods of time. VC offers institutional investors and high-net-worth individuals high returns (historically better than stocks) and strong diversification benefits from very low correlations with other asset classes. The major negatives of investing in VC are long time frames, lack of liquidity, and high management fees.
VC firms typically manage multiple funds formed over intervals of several years. Funds are illiquid but as companies in the portfolio go public or are sold, the investors realize their returns. Funds typically consist of limited partnerships invested in a number of companies. A general rule for the breakdown of returns among VC company investments is 40% will be complete losses, 30% will be "living dead," with the remaining 30% generating substantial returns on the original investment. The big winners yield 10 or more times the original investment.
It's been a rough few years for the industry and according to Venture-Capital Firms Caught in a Shakeout (3/9/10) from WSJ, last year, 125 venture funds in the U.S. collected $13.6 billion, down from 203 funds that raised $28.7 billion in 2008 and down from 217 funds that raised $40.8 billion in 2007, per VentureSource. VC companies generated $17.1 billion in IPOs and mergers and acquisitions in 2009, down 34% from $26.1 billion produced in 2008, according to VentureSource. Draper Fisher Jurvetson, Battery Ventures and Opus Capital have all offered lower fees to investors in recent months as they have pursued new funds. Venture capital liquidity (4/6/10) from Pensions and Investments shows the dramatic drop off in VC M&A exits and IPOs. See also Venture capital fundraising hits 17-year low in U.S. from P&I. See also Start-Ups Begin to Find Buyers After Drought (5/12/10) from WSJ.
According to this data from NVCA, Venture Capital Deals peaked in 2007 with over 4000 deals for over $30 Billion, dropping to under 2800 and $18 Billion in 2009. According to Venture Capital Performance Q3 2009 (using Cambridge Associates U.S. Venture Capital Index® - 1,287 venture funds formed from 1981 through 2009 with a value of approximately $93.8 billion.), VC returns were weak for the year ending 9/20/9, but very strong relative to US stocks for longer periods.
Steven N. Kaplan and Josh Lerner argue in their preliminary paper It Ain't Broke: The Past, Present and Future of Venture Capital that based on their data, returns for VC funds in the last few years are likely to be strong. The paper summarizes the industry and recent results and includes some interesting facts and graphics. For instance, roughly 600,000 new businesses (that employ others) are started each year in the U.S., yet roughly 1,000 businesses receive their first VC funding each year, which implies only 1/6th of 1% of new businesses get VC funding. However, Since 1999, over 60% of IPOs have been VC backed.
According to Venture Economics, the average annual return on VC funds was 48%, 40%, and 36% for 1995, 1996 and 1997 respectively. Many VC firms reported very strong returns over certain periods and the internet has produced scores of success stories that have yielded remarkable short term returns for VC firms. For instance, Yahoo! which went public within a year of its initial VC financing.
The feature article of the June 1996 issue of Institutional Investor focused on John Doerr of Kleiner Perkins Caufield & Byers. Although the firm almost failed with its first fund, it went on to become a premier early-stage investing firm. The firm is known for having financed Netscape, Compaq, Intuit, Lotus, Sun Microsystems, Amazon.com, and others. Kleiner reportedly "racked up average annualized returns of more than 30% since its founding in 1972, putting it in the top 1 percent of all venture firms." Some other interesting statistics included in the article:
- The industry as a whole has averaged 13.1 percent annual returns over the prior two decades, according to research and consulting firm Venture Economics.
- According to a recent Federal Reserve Board Study, private equity such as VC has been the fastest growing market for corporate finance during the past 15 years.
NEA, another well known VC firm, was featured in an article titled "Paradigm Surfing" in Forbes (11/4/96). The firm's funds had returned 24% to investors since 1978 versus VC average of 14% according to Venture Economics Information Services, and 16% on the S&P 500. Also included in the article was a caption titled "Coattails" which documents the recent performance of IPO's backed by VC firms versus those not backed by VC firms. Warburg Pincus and Venture Economics have created an index of venture backed IPO stocks that according to back testing, has outperformed over the past 3, 5 and 10 years (Source: Pensions & Investments 12/19/96). However, 1996 was not a good year for venture backed IPOs. According to Venture One, the average return for venture backed IPOs in 1996 was 13% versus returns for most indexes of over 20%.
Draper Fisher Jurvetson is another Venture Capital firm that had a hot streak. The firm funded Four11, which was sold to Yahoo in October for $92 million, and Hotmail which was acquired by Microsoft (the price was rumored to be over $300 million).
Before 1946, individuals and families dominated the VC markets. VC became a defined industry in the 1950's, primarily financed by wealthy individuals or syndicates. American Research and Development was founded in the early 50's and was considered the grandfather of modern venture firms. The firm's $25,000 investment in Digital Equipment multiplied into a stake in excess of $100 million. Insurance companies and foreign investors were major players in VC in the 60s and 70s, followed by corporate pension funds beginning in the 70s, and public pension funds in the 80s. The majority of money going into venture capital funds now comes from institutional investors.
"In an efficient market place, trying to exceed the average is often a losing strategy; it is often better to buy an index fund. In contrast, private investment offers an opportunity for exceptional returns because it is an inefficient marketplace in which the outstanding are able to excel."
"This business must be learned from the bottom up. Anyone who has not lost a company and not fired friends is not a venture capitalist."
Stanley Pratt, "Current Opportunities and Future Prospects-Part1," Investing in Venture Capital, The Institute of Chartered Financial Analysts, 1989.
"Venture capital investments are like inefficiently priced stocks, with two differences. First because there are no short-selling mechanisms, a venture capitalist, like a commodity investor, faces potential overpricing. Second, unlike stocks, which represent existing assets, an early-stage venture capital project may be an idea."
James H. Scott, Jr., "Managing Asset Classes," Financial Analysts Journal, January-February 1994.
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