Monday, April 30, 2007

VC Returns through 12/31/06

Today, the NVCA released venture capital returns performance data through year-end 2006.

The data suggest an early, if not yet sustained, recovery in venture performance.

While Keynes famously said, "In the long run, we are all dead;" retrospectively the long-term investment returns are excellent.

The key question is whether the current structural reality - i.e. # of funds, amount of committed capital - of the venture industry will support like returns over the next 10-20 years.

Returns are driven by two key components, systematic returns and idiosyncratic returns (see CAPM model). Systematic returns are market returns. Idiosyncratic returns, however, are where professional investors earn their stripes - they are returns in excess of the market.

To be a decent investor, one must at least deliver systematic returns. To be a great investor, one must deliver idiosyncratic returns. In the bubble, random investments looked genius. The systematic returns (returns for the asset category at large) were simply amazing, thereby creating great wealth and perhaps reputations for genius that were more due to circumstance and timing than investing prowess.

The questions for us to ponder is what will be the future systemic returns to the venture capital asset class, and has the inflow of money and people into the venture capital industry made it impossible to generate idiosyncratic returns. Are funds' returns systematic (an index of the market) or extraordinary? Will there be a Vanguard-like vc fund that is a low-fee provider of index funds for the private markets!? What is the basis for extraordinary performance over the market index? Is the success of vc investors and funds due to serendipity or to process?

These are key questions for investors (both general and limited partners). Can one deliver quality returns in an industry full of capital and people chasing "good" ideas?

One key difference between the public equity markets and the venture capital markets is the degree to which information is transparent. The public markets are by regulation open and transparent with data available to all.

The private markets are marked by imperfect information, proprietary insights, and information asymmetries. Certain private investors simply enjoy access to information, ideas, and talent that are not generally available to others. For example, certain leading firms leverage the footprint of their portfolio (talent, ideas, reach) to drive insights that lead to investments that others are not in a position to make. An obvious example, is Sequoia Capital's investment in Yahoo! and Google. With a BOD seat at YHOO, Mike Moritz enjoyed access to information relative to GOOG's search technology simply not available to others weighing the decision to invest in GOOG, presuming they even had the chance.

The question for venture capitalists may be as simple as, "what do I know that others don't?" With the corollary, yet vital question begging, "will I be smart enough and sufficiently certain of myself to act on such information?" For as Keynes famously once said, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

If one knows nothing proprietary, has no unique relationships, access to ideas, and information, then life may be very challenging.

1 comment:

  1. Will,

    Interesting post. Few VCs I've met tend to think in public market risk/reward terms, but alpha is ultimately what we are all after.

    A few thoughts:
    1. As you point out, the lack of transparency in the VC market makes constructing a reasonable benchmark even more difficult. VC returns are generally thought to be highly correlated with the performance of the Nasdaq, and the level of risk (in beta terms) is very difficult to quantify. As a result, the real yardstick should be a risk-adjusted benchmark, akin to levering up the S&P500 to achieve a similar beta. As David Swensen of Yale pointed out (Pioneering Portfolio Management), a risk-adjusted S&P 500 benchmark has wildly outperformed most private equity portfolios.
    2. Worse still, there is a tremendous survivorship bias in private equity data, making true asset-class risk and return difficult to estimate over long periods.
    3. Institutionalized venture capital portfolios have really only existed in size during a period of general market expansion (the bull market and general multiple expansion since 1982). As a result, we really don't know how this asset class will perform in severely troubled periods.
    4. Research has also indicated that VC/PE returns are highly skewed (75% of all VC funds are average or below, so only 25% or so are really outperforming, with the top 1% outperforming massively) and generally serially correlated--past performance does indicate future results. This is obviously a strong argument for investing in/working at top funds with a proven track record.
    5. Too much money can destroy even the best results--not because it clouds the judgment or impairs the deal flow of top VCs, but because it reduces returns to all involved as prices are bid up. As Buffett has said, even in buying a great company, a bad price can make for a bad investment.

    Enjoying your blog, and definitely looking forward to reading other interesting posts in the future.