Back in May this year, the Kauffman Foundation published a very interesting paper titled  “WE HAVE MET THE ENEMY… AND HE IS US” - Lessons from Twenty Years of the Kauffman Foundation’s  Investments in Venture Capital Funds  and The Triumph of Hope over Experience. Coming from Kauffman, this paper should get even more attention as it is based on 20 years of data analysis.

The paper illustrates the many reasons for why the Limited Partners (LP) investment model is broken. VCs only deploy other people’s money (the LPs), who aren’t thinking about negotiating better alignment, transparency, governance, and terms that take into account the skewed distribution of VC fund returns. The guy in the pension fund responsible for VC investments isn’t in a hurry to say that VC investments don’t work….

To demonstrated this, the Kauffman Foundation investment team analyzed the twenty-year history of venture investing experience in nearly 100 VC funds and found some scary findings. Just take a look at this excerpt from the executive summary:

  • Only twenty of 100 venture funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those began investing  prior to 1995.
  •  The majority of funds—sixty-two out of 100—failed to exceed returns  available from the public markets, after fees and carry were paid.
  • There is not consistent evidence of a J-curve in venture investing since 1997; the typical Kauffman Foundation venture fund reported peak internal rates of return (IRRs) and investment multiples early in a fund’s life (while still in the typical sixty-month investment period), followed by serial fundraising in month twenty-seven.
  • Only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index.
  • The average VC fund fails to return investor capital after fees.
    Many VC funds last longer than ten years—up to fifteen years or more. We have
    eight VC funds in our portfolio that are more than fifteen years old.
    Investors are afraid to contest GP terms for fear of “rocking the boat” with
    General Partners who use scarcity and limited access as marketing strategies.
    The typical GP commits only 1 percent of partner dollars to a new fund while LPs
    commit 99 percent. These economics insulate GPs from personal income effects
    of poor fund returns and encourages them to focus on generating short-term,
    high IRRs by “flipping” companies rather than committing to long-term, scale
    growth of a startup.

Rather than rant about the reasons for why the model is broken/not broken, I’ll let you read the paper and decide for yourself. What do you think the VC industry should do to fix the broken LP model?

Read the full report:

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Eze Vidra

Head of Google for Entrepreneurs Europe and Campus London at Google
Eze is the Head of Google for Entrepreneurs Europe and Campus London. In 2005, he started VC Cafe to shine a spotlight on startups and Venture Capital in Israel, and in 2012, Eze founded Techbikers, a non-for-profit that supports education through cycling challenges for techies.
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