The Venture Capital Myth

Most people who invest in venture capital funds don’t get rich.

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Many investors believe they are deprived of high returns generated by venture capital funds. They read about the success of Groupon, LinkedIn, Facebook, and others with envy because most individual investors don’t have access to these funds. Historically, the biggest investors in these funds have been university endowments like Harvard, Yale, Princeton, Columbia, and Duke.

No wonder these endowments have achieved outsized returns. It must be their ability to use their massive investing leverage to access these private funds, right? But a recent report authored by representatives of the Ewing Marion Kauffman Foundation, which is responsible for investing its $1.83 billion portfolio, debunks this myth.

The Kauffman Foundation is the largest foundation in the world devoted to entrepreneurship. Its benefactor, Ewing Marion Kauffman, started the pharmaceutical company Marion Laboratories in 1950. He sold it to Merrill Dow in 1989. At that time, it had sales of almost $1 billion and 3,400 employees.

The foundation has a very sophisticated investment committee. Its chief investment officer, Harold Bradley, has an extensive background in the securities industry and is a member of the prestigious CFA Institute’s FAS Board of Regents. He has held appointments from the SEC and his testimony before Congress on securities matters has helped influence industry rule-making.

Unfortunately, Bradley and his colleagues at Kauffman were no match for the slick talkers from venture capital firms who persuaded them to invest in nearly 100 venture capital funds over a twenty-year period. To his great credit, he turned the spotlight on his dismal experience with these funds as co-author of a study of their performance. Every investor should read this report.

The study found that, since 1997, returns in VC funds have returned less cash to investors than has been invested in these funds. Presumably, the Kauffman foundation has access to the very best of these funds. They also have the staff to analyze them. None of this helped. Here’s a summary of the conclusions in the study:

  • Only twenty of the 100 funds in which it invested generated returns that beat the public market equivalent by more than 3 percent annually.
  • The majority of investments underperformed the public markets, net of fees and expenses.
  • Only four of thirty funds with committed capital of more than $400 million delivered returns better than those available from a small cap common stock index.
  • Some 78 percent of the 88 funds in their sample “did not achieve returns sufficient to reward us for patient, expensive, long-term investing.”
  • It’s not all bad news. Someone made a lot of money from these funds. The fund managers charge a whopping 2 percent management fee and a 20 percent profit-sharing fee. Regardless of the fund’s performance, they did just fine. Ironically, they profited handsomely without taking meaningful risk. The study noted that the typical general partner invests only 1 percent of the assets of the VC fund. Investors like Kauffman cough up the other 99 percent.

    Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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