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Tuesday, June 24, 2008

More info on VC funds - and it gets worse...

I have shared my own observations of the VC investment world and the Angel investment world in previous posts on this blog, leading to the Entrepreneur Commons project.
And I have now also found (thanks to my Melcion partners) a very interesting study that shows that in addition to not being a good answer for entrepreneurs, VC investment is also not a good solution for investors (the Limited Partners - LPs - in VC funds). A must-read for anybody interested in VC investment:

The Performance of Private Equity Funds, by Ludovic Phalippou and Oliver Gottschalg - April 2007.

The first striking information from this study of 1328 VCs worldwide is on the returns that can be expected from VC investment:
  • S&P500 +3% before fees
  • S&P500 -3% after the management fees (typically 1% or 2% plus carried interest)
So investors investing in VC funds will make less than market, their investment underperforming the market by 3% on average.

But it gests worse:
The original assumption in the study is that performance of VC funds is related to Size of the fund, Experience of the management team and Past Performance. However a closer study shows that when past performance is included in the equation all the other characteristics lose their significance: Past Performance appears to be the unique explanatory variable for fund performance.
More specifically, it seems that the fund performance after the first 3 to 4 years is the main indicator of the performance that can be expected from this fund at maturity (typically 9 years). Not experience, and not size. If you compare recently raised funds to what more mature funds were doing at the similar early stage, then the conclusion of the study is that new funds have similar expected performance as the mature funds in the study. Again, there is no concept of size and/or experience being a parameter.

What it means is that it does not matter whether the management team has experience from a previous fund, the only parameter that prevails is what they do in the first 3 to 4 years of a given fund, which will be the real indicator of what can be expected in the end.
So while the concept of track record is comforting psychologically, the science does not sustain the idea that it will make a difference.
In the end Limited Partners are playing the lottery when they invest in a new fund, whether it is with a newly formed team or an experienced team.

In summary:
  • Each new fund is a new fund, with only what will happen in the first few years to determine what kind of results can be expected
  • And in the end what can be expected is less than market by 3% on average
One question remains: why are LPs paying all these fees (the 6% that take their average returns from SP500+3% down to SP500-3%)?
If this is to play the lottery and get a chance to finance the next Google, be my guest. But if this is to finance innovation, maybe there are other options.

If anything, this is one more justification for trying other cheaper ways of financing entrepreneurs: back to the Entrepreneur Commons, it seems that while it originally came out of issues identified with Angel Investment as a way for Angel Investors to try something that may give them a better return on their investment, it is also a good answer for Limited Partners currently investing in VC funds, who could be also interested in the potential of better return on their investment while still staying involved in the financing of innovation.

If you are a LP, I would love to talk to you...

1 comment:

Anonymous said...

if I may add, Marc, this survey is, to my humble opinion, giving a good understanding of the behavior of some VC investors themselves: like lab rats suffering from numerous random electrical shocks, they try to explain their good results by a bully behavior rather than to accept the randomness aspect of it.