Behind the VC Music

While in San Francisco last week, I had dinner with a group that included some National Venture Capital Association staffers. As we were saying our goodbyes, I said something like:

“I’ve heard that the vast majority of VC funds have been in the red for nearly a decade. Is it true? If so, can the industry even survive, besides a few successful outliers?”

Stone faces, no responses. In the car-ride back to Redwood City, my boss couldn’t quite decide if he was bemused or horrified. But he was certainly curious to know if it was true.

Which brings us to yesterday, when the NVCA and Thomson Financial released their latest set of VC performance data (dowload: Performance.pdf).

The lead sounded good: “Venture capital performance continued to show positive returns across most investment horizons ending March 31, 2007.” And a corresponding chart puts average five-year returns for all VC at 2.7%, with far stronger performance for one-year (18.1%), three-year (9.6%), 10-year (21%) and 20-year (16.4%). Only the five-year underperformed the Nasdaq or S&P 500, and that can be chalked up to venture getting hit particularly hard by the Internet bubble burst.

Go back now, and see if you can find the operative word in that last paragraph. Find it? That’s right, it’s average – and the averages are being artificially inflated by outstanding performance in the top two deciles. A look at the medians reveal a much sorrier state of affairs.

I went into the Thomson database, with a specific interest in funds raised post-bubble. Most LPs have discounted everything that happened before then anyway, so it seemed appropriate. And, just to be safe, I ran separate data for vintage years beginning in 2001 and 2003.

Through the end of Q1 07, funds raised between 2001 and 2007 have a median IRR of -2.6 percent. Moreover, the supper quartile benchmark was at just 4.1%, which means that the vast majority of VC funds raised since 2001 have underperformed a typical savings account.

The data beginning in vintage year 2003 is even worse (which is probably to be expected with the J-curve). The median for these funds is -5.7%, with the upper quartile benchmark at -0.2 percent. That’s right, more than 75% of VC funds raised since 2003 were underwater through the end of Q3. 

Want  some anecdotal evidence? How many times during the carried interest debate have you heard a VC say: “We haven’t seen carry yet this decade.” In fact, it’s become a perverse rallying cry.

This is simply unsustainable, and the endgame scenarios are troubling. VCs were paying relatively low valuations for companies between 2003 and 2005 (or at least should have been), and the IPO and M&A windows have been steadily improving. If most funds are losing money in that environment, then what happens when some of today’s inflated valuations – particularly in clean-tech and later-stage deals – come home to roost?

My after-dinner questioning of market “survival” after dinner might have been a bit exaggerated but, unless something changes soon, the market could be much smaller in just a few short years. There is a lot of laissez-faire attitude in the LP community, but even the dumbest of dumb money can tell the difference between black and red.