“We have met the enemy…and he is us.” So begins the 51-page report from the Kauffman Foundation, a $2 billion non-profit with a vision to foster “a society of economically independent individuals who are engaged citizens, contributing to the improvement of their communities.” Towards this end, the grants it distributes are focused on the advancement of entrepreneurship and the improvement of education. With a $5,000 investment in 1950, the eponymous founder started a pharmaceutical company (Marion Laboratories) in his basement that grew into a substantial business with annual revenues of $930 million. In 1989, Marion Laboratories merged with Merrell Dow Pharmaceuticals, leaving Mr. Kauffman with a huge windfall. Given the roots and mission of the foundation, it is easy to understand why it would have a significant part of its portfolio in venture capital funds. Unfortunately, the investments have not performed as expected, and the report delves deeply into understanding the reasons behind “the triumph of hope over experience.”
Investors in venture capital funds are deemed to be limited partners (LPs), while it is the general partners (GPs) who decide which start-up companies will be funded and when the investments in the start-ups will be liquidated. It is not uncommon for the LPs to supply 99% of the fund’s capital while the GPs supply a paltry 1% while collecting a 2% annual management fee plus a 20% share of profits realized. This compensation structure creates a perverse incentive for the general partners to grow the funds as large as possible and to run the funds with a large amount of turnover. Neither of these activities is in the best interest of the limited partners. Unfortunately, the data presented by the Kauffman Foundation is limited to their own experience because “detailed information about VC fund performance and structures is nearly impossible to obtain given the confidentiality terms in the typical limited partner agreement.”1 The authors note with some irony how the managers of the start-up companies are required to make extremely detailed salary and expense disclosures if they wish to obtain funding while the general partners of VC funds operate in a shroud of secrecy with respect to their limited partners.
To determine whether a VC fund provided a successful investment experience, the authors compared the return received to what would have been obtained from a comparable investment in the public equity markets (specifically, the Russell 2000 Index of small cap stocks). Based on their own research and discussions with other institutional investors, the authors assume that a reasonable expected return for a VC investment is 3 to 5% above the return provided by the public equity markets. The underlying intuition behind this assumption is the high cost of capital attributed to start-up companies due to their high risk of complete failure. Unfortunately, only 20% of Kauffman’s VC fund investments provided this level of return. The majority of funds (62%) failed to exceed the return of the Russell 2000 on an absolute (non-risk-adjusted) basis. Not surprisingly, the authors found that larger funds (those in excess of $400 million) were more likely to underperform. These results are not surprising given that the average VC fund fails to return investor capital after fees.
Declaring the LP model “broken”, the authors make several recommendations:
- Abolish the idea that any institution is required to have a mandated percentage of its portfolio in venture capital funds. This would give LPs a much stronger negotiating position. It also would address the problem of too much capital chasing too few great ideas for new companies.
- Eliminate the secrecy that VC funds insist upon. As the authors astutely observe, “Institutional investors aren’t paid for taking on the additional risk of investing in VC firms with black box economics.” Furthermore, GPs should put up at least 5% of the fund’s capital.
- Replace the commonly used 2% management fee plus 20% profit-sharing with a compensation structure that “pays fees based on a firm budget, and shares profits only after investors receive their capital back plus a preferred return.”
- Measure VC performance relative to widely followed stock market indexes such as the Russell 2000 with an adjustment for the additional risk of venture capital.
While the administrators of the Kauffman Foundation have resolved to radically change both the degree and the manner in which they invest in VC funds, they see little reason to be optimistic about the asset class in general. One of the underlying issues repeatedly mentioned is that it is a business built on longstanding relationships among fund administrators, investment consultants, and GPs of VC funds.
In publishing this honest self-appraisal, the Kauffman Foundation has performed a tremendous service for other institutional investors. Let’s hope they take notice.
1 Diane Mulcahy, Bill Weeks, Harold S. Bradley, “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, Ewing Marion Kauffman Foundation, May 2012, pg. 2.