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Median is worse than mediocre

Today's VentureBeat had an article pointing out that the uptick in some of the macroeconomic factors won't translate quickly into an uptick in the venture capital economy.  Of course, there are some links between the overall economy and the VC world:

  • Late stage investors are heavily influenced by the public stock markets.  They have to calibrate the higher valuations they pay with the exit timing and ultimate exit valuation that the company will earn.  This applies to companies going public (not any time soon) or companies being acquired.  Public acquirers obviously worry about their own stock price when determining what they can pay for an acquired company.
  • Buyout firms are like late stage investors, but also tend to finance a significant portion of their deals with debt.  Obviously, the debt market is incredibly tight these days.  Not much of this type of deal activity here, although you may see some debt free deals such as small public companies going private to avoid the cost of being public while they regroup.
  • Early stage VCs shouldn't worry about the public market too much.  The deals they do now won't exit for 5-8 years.  Who can predict the exit environment then?  Early stage VCs should worry mostly about uniqueness of the opportunity, target market size, team strength, and capital efficiency.  However, early stage VCs also tend to get skittish during these times.

The most interesting statistic in the VentureBeat article is in the following:

But most venture capitalists will remain under considerable strain. Even when they invested during the last down cycle of 2002 and 2003 — when valuations were lower, letting them get a larger ownership stake in companies they backed — VCs didn’t do well. The median internal rate of return (IRR) for a 2002 vintage VC fund (a fund that began investing in 2002, when the stock market was rock bottom) is -1.2%, according to PE Wire, citing Thomson Reuters data. That means they’ve lost the equivalent of 1.2 percent every year over the past six years, even though VCs have had about that long to grow the companies. With the market turning downward now, it’s unlikely that number will increase significantly, as firms may have a tough time selling companies and locking into profits.

The median IRR for a 2003 vintage VC fund is 0.9 percent.

These performances are worse than many expected. The question is whether VCs will do as poorly with their 2009 funds. Uncertainty about this will only cloud the outlook for startups going forward.

The problem here isn't that a down cycle is the wrong time for an early stage investment.  In fact, I think that it is the best time as many investors are on the sidelines, lowering the competition for the new company.  However, I think that the reason why the median returns for these funds is so low is that there are just too many venture funds with too much money to invest.  By the time you get down to the median fund, you are much closer to the bottom of the barrel than you would like to be.  If the current top quartile of venture funds were all that existed, the category would look pretty strong.  So, that means that VCs will only be able to deliver the returns that their investors expect if the number of funds is cut by 75% and the amount of capital by about 60% (many of the top funds are also larger than the average).

LPs who invest in venture funds have figured this out, but the exodus from venture is slow.  And, there are many more LPs who have been waiting to get into the category who may be propping up funds that should otherwise be going away.  Over time, venture can only be a healty category if it takes a haircut just like the Dow Jones Industrials have.  Unfortunately, I don't see that happening any time soon.

PS - This is one reason why my new fund will be doing something different than traditional venture capital.

Update - Just after publishing this, I found this report from Silicon Valley Bank that includes lots of details on venture fund performance on page 9.  See the table below from the report that shows that even the top quartile VC fund hasn't done extremely well lately.

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