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Kauffman Foundation report calls for ‘right-sizing’ of ailing venture industry

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If the venture capital industry wants to return to the days of profitable exits and produce positive returns for investors, it must downsize in several ways, according to a new study from the Kauffman Foundation.

“By half” in terms of annual investments and the size of funds, says Paul Kedrosky, a senior fellow at the internationally recognized foundation for entrepreneurship. Kedrosky, a frequent analyst on CNBC, also writes the Infectious Greed blog and a venture capitalist.

In the report, titled “Right-Sizing the U.S. Venture Capital Industry,” Kedrosky also wrote that venture capital is not as essential for high-tech and life science growth as is widely believed. Over the decade from 1997 to 2007, only 16 percent of the Inc. 500 list had received venture backing, he noted.

Pointing to declining returns and valuations of portfolio companies, Kedrosky warned that the venture industry faces more grim news in the near future. Once 10-year returns of companies that “exited” before the dot com bust in 2000 and 2001 are removed from reports, returns on investments will worsen, he said. Plus, the maturation of the information technology industry means investors are going to look for other types of companies such as clean tech.

Kedrosky also stressed that the VC downturn predated the current economic crisis. Plus, he downplayed the impact of Sarbanes-Oxley regulatory legislation in the wake of the “dot com” crash that drove up costs and challenges for companies to go public and remain publicly traded

Recent reports from the National Venture Capital Association and Dow Jones VentureOne have recently documented a decline in the number of VCs and VC firms. NVCA President Mark Heesen predicted Tuesday that the industry would contract but also said he expected VC firms to invest at similar levels this year as in 2008.

'Alarmist,' One Critic Says of Report

However, Kedrosky’s report didn’t receive universal endorsement from some VC industry members.

One, speaking on background called the report “alarmist” and “a little melodramatic.”

“People in the industry have been saying much of this for years,” the member of a southeast firm said. “There are some firms who have not actively invested for the last eight or nine years and they will disappear” as 10-year agreements with investors expire. As for rates of return, the person added, the VC industry still ranks very favorably with other markets.

Bill Warner, a veteran angel investor and a frequent contributor as a columnist to Local Tech Wire, agreed with Kedrosky on some points, but not all.

“It is true that venture capital performance has been poor since 2004,” Warner said. “He has added a valid point of view that the amount of capital in play is much higher than the market can support. I don’t agree that the pace is unreasonable given that what I see in new opportunities.

“I think he is wrong in not attributing equally the impact of Sarbanes Oxley, decline of IPO’s and the downturn of the public markets.”

Industry at ‘Inflection point’

“The U.S. venture capital industry is at an inflection point,” Kedrosky wrote. “It has had many successes over the past three decades, and is prominent worldwide for its role in financially catalyzing notable, high growth companies.

“Most recently, however, venture capital returns have stagnated and declined, with the industry having seen little recovery since its go-go days of the late 1990s,” he added.

Kedrosky also said that declining returns and lack of exits, such as initial public offerings, predate the current economic crisis. Venture return data dropped starting in 2004 as the fallout of the dot com collapse began being felt on five-year data and has remained “slightly on either side of the zero line ever since,” he wrote.

What went wrong?

“There are at least three possible reasons, all interrelated,” Kedrosky said. “There could be too much capital allocated to venture, the effect being higher valuations and lower exit multiples. The second explanation might be shrinking exit markets, with, for example, the decline in IPOs preventing venture investors from earning the same returns as they have historically. Finally, it is possible that the venture business itself might be structurally flawed, with the core markets that made it successful—information technology and telecommunications—now mature and delivering sub-standard returns, while new venture-ready markets have not emerged.”

In the report’s conclusion, Kedrosky stressed that “venture capital returns have deteriorated immensely, predating the current economic downturn and traceable to the rapid expansion in venture capital assets under management in the United States in the late 1990s, a figure that has fallen less speedily than one would expect, in part because of the long duration of funds and the general illiquidity of venture capital investments.”

According to Kedrosky, a drop of some 50 percent in investment capital to some $12 billion annually, smaller funds for VCs to manage, lower valuations of portfolio companies would lead to IPOs at “lower multiples” of investment return and thus boost the venture industry.

Industry Fallout - or Not?

What happens if changes aren’t made?

Kedrosky warns that investors such as the “asset class” and limited partners such as retirement funds will seek better havens for their dollars if changes don’t occur.

“While there is no question that venture capital can facilitate some forms of high-growth entrepreneurial firms, its poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this underperforming asset,” he wrote.

“While any estimate is subject to much uncertainty, it seems reasonable—based on returns, GDP, and exits—to expect the pace of investing to shrink by half in the coming years. We should also expect a continuing sharp decline in the amount of money invested in information technology, a maturing sector with declining capital requirements in its remaining innovative segments. Capital will continue to grow in other areas, including clean technology, but the sector must shrink its way back to health if venture capital is to provide competitive returns and secure its own future as a credible asset class and economic force.”

The VC representative who talked with LTW strongly disagreed.

“Everything we have heard is that the limited partners are not getting out of venture capital,” the executive said. “They think 2010 is going to be an amazing, vintage year because everyone knows great companies are built in downturns.”

Kedrosky realized that his conclusions wouldn’t be accepted universally.

“This change will not come easily,” he said. “Many venture industry participants are comfortable with their industry’s size, structure, and compensation model, which is tied to assets under management and can be highly remunerative. At the same time, the industry has become conflated with entrepreneurship in the popular imagination as well as in policy circles, with the result being a widespread and incorrect belief that venture capital is a necessary and sufficient condition in driving growth entrepreneurship. The result is strong resistance to change, as well as much support for the venture industry in its current form.”

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