Three Reasons For Weak Venture Capital Returns, 2000 to 2009

Compared to the late 1990s, venture capital fund returns weakened dramatically from 2000 to 2009.  From 1995 to 1999, VC's five year returns were close to 35%.  By the third quarter of 2009, VC's ten year returns were closer to 10%.  What explains this dramatic drop in returns?  Three factors explain this change in fortunes for the VC industry: (1) Weak IPO market, (2) Venture capitalists are making fewer early stage investments, and (3) Fewer venture capitalists have operational experience.

Weak IPO Market

A strong IPO market is critical to venture capital success.  IPOs are the surest way for VCs to realize huge returns on investment.

During the late 1990s, VCs gave their limited partners returns in excess of 35% every year.  The reason?  A large number of IPOs.  Here are the number of VC-backed IPOs since 1995:

• 1995:   205
• 1996:   272
• 1997:   138
• 1998:   68
• 1999:   250
• 2000:   202
• 2001:   22
• 2002:   20
• 2003:   23
• 2004:   67
• 2005:   43
• 2006:   56
• 2007:   76
• 2008:   7
• 2009:   8

As of the end of March 2010, there had been eight VC-backed IPOs. So there are signs that the IPO market is picking up.  However, this slight uptick in VC-backed IPOs does not necessarily mean a return to the heydays of the late 1990s.  The 1990s were most likely an anomaly.

On average, exit by mergers and acquisitions provides lower returns than an IPO liquidity event.  Thus, the increase in M&A exits will result in lower VC returns compared to IPO exits.

Venture capital cannot survive without high return liquidity returns. The lower the returns VC provide, the less incentive limited partners have to give VCs their money.  Subtract out the abnormally robust IPO market of the first half of 1999, and you can see why ten year VC returns have shifted dramatically downward.

Venture Capitalists Are Making Fewer Early Stage Investments

The weak exit market means that VCs will view early stage startups as riskier investments.  That is exactly what is happening.  VCs are putting less money into early stage startups, investing in fewer startups, and giving more company to later stage companies with track record.  From 2002 to 2009, VCs invested most of their money into follow-on and later stage deals. That is what the data shows, whether by dollar amount or number of deals.

As a result of more money going to later stage deals, VCs will give their limited partners lower returns. More VCs, like NEA Associates, are doing private equity type deals.  Private equity deals tend to involve larger capital commitments, with shorter time horizons and lower returns than early stage investments.  The upside is that private equity are closer to exit.  The downside is that private equity deals are less likely to promote the innovation and entrepreneurial creativity that VCs have traditionally backed.

Fewer Venture Capitalists Have Operational Experience

The third factor that is hurting VC returns is fewer VCs have operational experience to help their portfolio companies execute their strategy.  The flip side of that is more VCs are acting like investment bankers, or have finance backgrounds.

Consider these comments from entrepreneurs responding to the 2009 "A Seat at the Table" survey on venture capital, conducted by Dow Jones VentureSource and the National Venture Capital Association.

“I’ve been an entrepreneur as well as a VC. The biggest travesty that VC firms can visit on a portfolio company is putting an inexperienced representative onto its board. Too many VCs have no real operating experience (sorry, having been a I-banker or recruiter does not count as experience).”

“This study is timely because I see a lot of dysfunctional stuff foisted on CEO’s by vc’s who have had no operational experience and who have no idea what it is to run a smaller company.”

“Venture capitalists with previous CEO experience are a vastly different breed than financially trained VCs.  The former tend to be less volatile when critical situations in startups arise and offer more value add to the enterprise.”

While most of the survey's respondents were happy with their investors, the most common complaint was VCs who lacked operational experience.  The reasoning is simple: Startups have to be able to implement.  By itself, financial experience does not contribute to implementation.

Conclusion

Venture capitalists enjoyed unprecedented success during the late 1990s.  Those days may never return as the number of VC-backed IPOs settles to a lower number and the nature of VC investments changes.  These changes raise an important question: How will changes in the VC industry affect innovation and technology entrepreneurs?

Douglas Y. Park

Twitter: @DougYPark

If you enjoyed this post, please subscribe to the blog by RSS feed or email.  You can find the subscription option on the sidebar to the immediate right.  Also, click the Facebook Like button below and Like the DYP Advisors Facebook page.