"I think 'back to the future' is the answer to most of the VC asset class problems," blogged Union Square Ventures co-founder Fred Wilson earlier this spring. "Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals and smaller exits."
The Venture Capital Math Problem post sparked hundreds of comments from entrepreneurs and other venture capitalists as well as follow-up posts from Wilson. Since he published the post back in April, many people have echoed his thoughts, most recently Paul Kedrosky in a report titled Right-Sizing the U.S. Venture Capital Industry that came out Wednesday.
When Wilson's post came out, I was gathering material for a trend piece about the current state of the VC industry, which we published in this week's issue of The Deal magazine. (See Honey, I shrunk the VCs.)
For the story, I interviewed Wilson on the phone twice. Although I quote him there, I suspect Dealscape readers will enjoy being a virtual fly on the wall so I've included more of our conversations below.
The Deal: What is the venture capital math problem?
Fred Wilson: The venture capital math problem is part of a fundamental question about venture capital: What is a reasonable rate of return that one should expect for a broad-based portfolio fund? What is a reasonable return, given the amount of volatility in manager selection and illiquidity in the market?
We have 30 years of return data in the venture capital asset class. I think what we see is that the asset class was pretty stable from the late '70s to the early to mid-'90s in terms of what the mean or the median return ought to be. And then there's a huge goose in returns in the late '90s with the Internet bubble, the telecom bubble and the IPO bubble. And there's a corresponding plunge in returns in the aftermath.
From 2003-2004 until today, there's a new normal. And I think people are looking at it and saying, "Is this a place I want to be?"
What people are finding out is that the average venture portfolio is delivering sub-10% rates of return. That's for all the funds, including the top quartile. Not every investor in VC is heavily weighted into the top quartile.
If you have a portfolio fund where manager selection hasn't necessarily been as good as others, then the return rate is lower.
The Deal: Does an LP know which VC firms are in the top quartile?
Wilson: They change. The firms that were in the top quartile in the '80s weren't the same ones in the '90s; the ones in the top quartile in the '90s aren't the same in this decade. In any period of time, such as the early wave of biotech or the PC or enterprise software or communications equipment, there are 15 to 20 firms that nail that wave. But everybody else is going to be left with the crumbs, and the crumbs don't generate the returns.
The Deal: What is an appropriate return rate for venture capital?
Wilson: Venture capital as an asset class has outperformed the S&P, which is down for the last 10 years. So if you're up 6% or 8% in venture capital and the public markets are down, well, then you've been in a much better place.
But venture capital is different from being in public stocks. With public stocks, you can take your money out whenever you want. You can't do that with venture capital. Your money is locked up for 10 years -- or more.
Private equity has the same issues. The very best funds are hard to get into. There are access problems. So let's say an LP says to itself, "I wanna be in Sequoia." Well, guess what? Get in line.
The problem with the venture asset class is two-fold: the illiquidity issue and the access issue. There's a significant amount of risk that you will end up in a broad-based portfolio if you don't have sufficient access to whatever the firms are at that moment in time that are outperforming the rest.
You need to have a higher rate of return in the venture business than in public securities or stocks or bonds. It's some number of percentage points -- five or 10, I don't know -- but it's not sufficient to say it's the same.
Note: After our first conversation, Wilson wrote a post on The IIiquidity Premium. Using data from Thomson VentureXpert, he calculated that 10-year returns for VC firms as a class are between 5% and 10%, compared with the S&P, which is -5% for the same period. "Is a 10% excess return enough to incent a rational investor to part with their money for an extended period of time?" Wilson asked in the post. "Maybe. It really depends on who the investor is. But it certainly is not a slam dunk in my mind."
The Deal: What should an LP look for in a VC firm to increase the chances of its being one of the top-performing 15 to 20 firms?
Wilson: You need to have a very experienced group of GPs. And when I say experienced, I mean in the venture business. They've been through multiple cycles and understand what it takes to be a strong, capable VC. They should have domain expertise so they can recognize what is a really good opportunity and what is not. Those are the first two requirements. The third is operating in a firm that is relatively small and nimble and doesn't have a lot of bureaucracy, with a relatively modest fund size, focused on a specific domain.
The Deal: Will you name some firms, besides Union Square Ventures, that fit the criteria?
Wilson: No. If I name some, I'll inevitably leave others out.
A lot of LPs know which VCs to invest in. Anyone who's been an LP for a long time and has studied the asset class knows how to do this and knows what to do. If they were the only investors that GPs could raise money from, you'd see returns of the business be much higher. Only the most capable venture funds would get funded.
The Deal: How does what's going on in the VC community affect entrepreneurs?
Wilson: The dynamic has changed for entrepreneurs. As you've written about a lot, it takes less money to start an Internet company today so an entrepreneur can go a lot further without having to tap into the VC market and can end up owning a lot more of the company.
There's a lot of capital out there for entrepreneurs -- $100 billion to $150 billion. Even if VC firms raise only $10 billion to $15 billion this year, you're still talking about lots of money.
The Deal: What about the lack of exits?
Wilson: I think we are in the middle of and will continue to see a pronounced drop in M&A activity. A lot of the big companies are licking their own wounds right now, and we're in a period of time right now when there aren't a lot of liquidity options for companies.
The IPO market will come back later this year, by next year definitely. I also think we're seeing a lot more founder liquidity for the companies that actually build interesting businesses by virtue of late-stage VCs buying from founder equity at pretty attractive valuations. Secondary purchase activity is getting more institutionalized through SecondMarket and others, and there's more transparency and liquidity around that.
The Deal: What do you think about the National Venture Capital Association's plan for stimulating exits?
Wilson: From what I can tell, the NVCA is a lobby group that, for the past 20 years, has largely focused on reducing the amount of taxes that VCs and entrepreneurs have to pay. We can argue about whether that's good or bad. But that's not a big deal in the grand scheme of things.
There are other, more important issues facing our industry -- immigration reform, open spectrum issues and patent reform -- that are either getting in the way of innovation or
would unleash a wave of innovation if we made changes there.
There are some problems we can't fix. I don't think we can fix SarbOx, but it's become the devil we know. It's well understood.
But there are some problems we can fix.
There's a distrust between public markets and VCs. The public doesn't think VCs are in it for the long haul. We could fix that as an industry if we made a commitment to the public markets to say that we would hold onto the stocks for an extended period of time.
- Mary Kathleen Flynn
