From the June 2012 issue of Investment Advisor • Subscribe!

May 22, 2012

Learning the Hard Way

The Kaufman Foundation admitted its performance in allocating assets to 100 VC funds over the past 20 years has been 'subpar.' The Kaufman Foundation admitted its performance in allocating assets to 100 VC funds over the past 20 years has been 'subpar.'

The venture capital fund industry is reeling from a report issued by the Kauffman Foundation last month. The tediously titled “We Have Met The Enemy … And He Is Us: Lessons From 20 Years of the Kauffman Foundation’s Investments in Venture Capital Funds and the Triumph of Hope Over Experience” is a blistering, self-effacing critique of the Foundation’s own subpar performance in allocating assets to 100 VC funds over 20 years.

The Kauffman Foundation was created to encourage entrepreneurship. Of its $1.8 billion endowment, approximately $250 million is invested in venture capital and growth equity funds. As the 52-page report reveals, the Foundation has little to show in the way of returns for its support of entrepreneurship.

Kauffman’s return in venture capital over the past 20 years was, on average, 1.3 times the amount that it invested in any given fund—well short of the benchmark two-times committed capital venture rate of return. Moreover the expected liquidity of venture committed capital fell short, as 23 of the 100 VC funds continued to retain capital beyond the anticipated 10-year mark, including one fund in its 19th year still retaining more than 20% of the capital that Kauffman committed back in 1992.

There were some notable winners in the allocation data set. Approximately 15 of the 100 funds exceeded the two-times return multiple. But, the high returns came predominantly from funds raised prior to 1995. As in fine wines, getting the vintage year right is critical.

Not surprisingly, the Twitter-trained money media had difficulty absorbing, let alone interpreting, the implications of the Kauffman study. (Perhaps because the title of the study exceeded 140 characters.) The same standard of parochial punditry responsible for the recent page-one USA Today story headline “Invest in Stocks? Forget About It” was in play as drive-by journalists and addled allocators declared venture capital dead only a matter of days before Facebook’s pending IPO date.

Kauffman accepts much of the blame for poor returns. Kauffman chastised itself and institutional venture investors in general for failing to focus on mundane issues such as fees, asset allocation models, liquidity and timing considerations.

In spite of my apparent affinity for the asymmetric return outcome available to venture investors, I have never been a fan of venture capital fund structures. The fee structures of VC funds create irreconcilable conflicts between the VC and their investors. Of course, carried interests ranging from 20% (to, in some cases, as high as 50%) of profits provide VC fund managers with ample incentive to produce returns. Yet, asset-based fees of 2% to 3% similarly incent managers to raise large funds, particularly against the backdrop of a 10-year lockup.

I’ve always given faith to the simple rule that the frequency of bad investment decisions is directly correlated to the number of decisions that an investor makes. Large VC funds are forced to make many decisions as they invest their large sums of capital in order to secure those 10 years of asset-based fees. Inevitably, that forces many bad decisions. The Kauffman study bears this out, citing that the best returns came exclusively from funds with less than $500 million—a practical reality among so-called “top tier” VC funds these days.

Kauffman also criticized rigid model portfolio schemes and their allocators by labeling them “bucket fillers,” as their aspiring modern portfolio models have a “VC bucket,” and their job is to fill it, regardless of timing and type. “[VC funds] we interviewed are very aware of ‘bucket filling’ behavior and said institutional investors with VC mandates act like the money is ‘burning a hole in their pockets.’ They just need to spend it,” the study cites.

That observation resonates with me. Institutional investor bucket-fillers remind me of the Brinson fan base (no less passionate than Justin’s “Beliebers”) that still rise to their morning mantra that 97% of returns are determined by asset allocation.

Considering that 2012 is on pace to be a record-breaking year for initial public offerings, with more than 60 IPOs priced as of May 1, declaring venture to be dead seems hardly prescient.

The most prudent approach to the enviable upside afforded to successful venture investors is identifying compelling “one-off” opportunities through rigorous due diligence. Institutional investors need look no further than the expanding band of zealot angel investors that eschew the high fees, poor liquidity, fiduciary conflicts and forced decision mandates inherent in VC fund structures.

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