ANALYSIS

Few stars in the bleak venture capital universe

For venture capital investors, the days of receiving 100-plus per cent internal rates of returns (IRRs) from a broad sweep of managers are gone. But this doesn’t mean investors should give up searching for the few remaining outperformers.

During the dotcom fervour of the late 1990s, the boundary marking top-quartile IRRs soared beyond 70 per cent in 1997, and then fell sharply to about 6 per cent in 1999. Since then, returns from managers across the industry “have struggled to recover”, writes research house Preqin in its special report, The Venture Capital Industry.

According to Preqin, which tracks the performance of 70 per cent of venture capital funds, 52 per cent of managers posted IRRs of 20 per cent or more in 1997, the industry’s golden year. Since then, less than 5 per cent of 1999 and 2000 vintage funds have returned 20 per cent or more, and the median manager has been in the red.

But a small segment of managers have been able to generated IRRs of 20 per cent or more, Preqin finds.

This proportion of outperformers fluctuates. In 2000, 3.9 per cent of venture managers achieved 20 per cent-plus IRRs; in 2005, the number was 19.6 per cent; and in 2007, it was 8.7 per cent.

“Overall industry performance may be disappointing, but there are also many success stories, growth areas and an elite group of firms,” the researcher states.

These top managers have achieved solid returns since the dotcom heyday. According to Preqin, 70 per cent of firms posting top-quartile returns go on to outperform the median manager in subsequent funds. And investors and consultants know who they are: these managers have “raised new vehicles in relatively quick time, even in the current financial climate”.

For investors, a truism in the alternatives space – that manager selection is critical – certainly applies. In 1998, when the median manager posted a 12.6 per cent IRR, the standard deviation among IRRs was 74.7 per cent. And even though IRRs have dropped since then, the gulf between median and top-quartile performance has persisted: in 2007, when the median manager’s return was zero, the standard deviation among IRRs was 25.2 per cent.

Amid this variance in returns, some managers have shut shop. The venture universe expanded rapidly from 1996, when it was populated by fewer than 400 managers, to number 1790 in 2009. But since 2000, a number of firms have failed to raise a fund and are now considered inactive, eventually resulting in a drop-off in the number of managers in Preqin’s database, which now numbers about1700.

Venture capital has been backed by some big pension funds, primarily in the US, UK and Europe. The $205 billion CalPERS allocates 16 per cent of its $30 billion private equity portfolio to the sector, and the $13 billion Alaska Retirement Management Board puts 27 per cent of its $1 billion private equity holdings in venture. Among the 2,100 venture investors tracked by Preqin, pension and fund-of-funds investors are the biggest supporters of the sector, each accounting for 12 per cent of funds committed globally.

In recent years, investors’ attitudes to the industry have been mixed: “Some claim that the venture capital model is broken, while others believe that an evolution is required if the industry is to improve upon the overall performance experienced in the past 10 years,” Preqin writes.

Some investors think that lower start-up costs for businesses, enabled by technology, are at odds with the investment model pursued by larger funds, which are hunting for bigger minimum investments. And as firms compete for these deals, they risk bidding up deal prices and undermining future returns.

This has spurred on smaller funds, which are supplied with more private capital than institutional commitments, to exploit this mismatch and snap up smaller deals.

In the past five years, investors have continued to favour IT deals, a tradition stemming from the industry’s long association with technology-based industries – “due to their innovative nature and the potential rates of return from disruptive technology”. Health care companies have also gained attention, with 35 per cent of venture funds aiming to include health care in their portfolios.

Interestingly, venture funds in Asia are sourcing much of their capital domestically. In China, the US$900 million Suzhou Ventures Group, a fund-of-funds focused soley on domestic venture managers pursuing opportunities in the start-up and early-stage growth phases, is fundraising for its next vehicle, which will concentrate on the IT, bio-medicine, energy and environmental protection industries.