Venture capital is the gatekeeper of innovation. And with poor performance to boot, the false negatives it produces are at least twice the size of their failure.
The debate is heating up about the impending regulations from the government applied to Private Equity (PE) and its sub-class Venture Capital (VC), fought by the National Venture Capital Association (NVCA) and reluctantly supported by the Private Equity Council (PEC). The latter is stating that private equity does not represent systemic risk. Perhaps not, if the council excludes VC from its membership, but VC as Private Equity poses a systemic risk as to the gatekeeper to innovation.
Why the government is forced to step in
The government has decided to step in and we, as participants in the ecosystem, should present our government with the facts (good and bad) so it can make informed decisions going forward. If we give the government self-serving information, rather than the circumstances, we will get punished by regulations that miss their intended target. So, now is the time to separate greed from honesty and shape the rules that will be bestowed upon us.
The most rational explanation as to why the government is tightening our private equity belts came from Bob Grady, Managing Partner at The Carlyle Group (who worked for the government for a while) at the recent IBF conference. He suspects that the government wants to reduce the size of the financial services industry as a percentage of GDP (Gross Domestic Product).
Not unreasonable, considering the collapse of our financial system and the discovery of an endless supply of imploding derivatives (and vice-versa). Simply put, the equilibrium between people who create products, and those that capitalize on them is out of whack. We need more innovation, with fewer derivatives attached to them.
VC is a systemic risk
The creation and growth of the Internet (and all the components around it) could not have existed without the faith and dollars from Limited Partners (LP), deploying their assets through VC firms. Kudos to people like IBF lifetime award winner Bill Draper who started Venture Capital by literally knocking on the door of a new company, buying his first shares for $20,000. But the last nine years have been dismal for VC performance, almost 900 U.S. VCs producing less than 10% IRR, tarnishing the technology ecosystem and prompting LPs to look around to reallocate money to a different asset class.
Why VC needs to work
While venture-backed companies represent around 0.02% of GDP before exit, post-exit they represent about 18% of GDP (according to the NVCA) and 9% of jobs in America. So, the decision-making process by a VC of what company to invest in is vital to building a healthy economic conversion rate. And I predict information technology will claim a more significant stake of GDP as it continues to mature from its infancy. So while VC is a small percentage of the total Private Equity pie invested, it has proven its ability to produce a strong stimulus to the economy.
What has changed
We can look at the statistics from the NVCA and debunk those statistics with reality, but common sense tells us that most of us would be hard-pressed to name ten ground-breaking technology innovations in the last ten years. So, if 900 VCs produce this few real innovations, the billowing smoke is sufficient indication of a fire. On top of that, companies like Apple show us how to invest in categories (like music) VCs had unsuccessfully invested in for the last ten years, challenging VC fundamentals to its core.
Proper assessment of investment risk
The problem with VC is that it is inherently risky (more than other forms of Private Equity) and with the wrong people running VC firms, the asset – risk – that produces excellent returns is being sucked out of the investment equation.
Smaller funds, feverish syndication, easy exits are all instruments that create more rather than fewer derivatives to the creation of disruptive value. VCs now sell to LPs a similarly destructive pattern of risk as sub-prime lenders sold to their investors. Hence our frequent use of the sub-prime VC classification throughout this blog.
As a result of a lack of meaningful segmentation and guard rails by many me-too VC funds, LPs have invested deep rather than wide in information technology (as the included chart points out). For the last nine years that has created a massive number of false positives and false negatives and a continued downward spiral that attracts only entrepreneurs that comply with this risk-deflated investment mold, rather than attract entrepreneurs with genuinely disruptive ideas (that hold their value in any economy). So, for the last nine years, LPs have invested deep in a risk-averse technology sector while they expected their 10-15% venture share of total allocations to be applied to the inverse.
Many LPs are ready to cut all but their top-quartile VC funds from their portfolio by flushing them through (i.e., letting them run their course without re-upping new commitments). That means over the next five years we are going to see many VC firms disappear, some replaced with new VC firms with more relevant entrepreneurial pedigree and investment models that are as unique as the strategies of the entrepreneurs.
New regulations by the government and stricter practices by LPs will make our industry more transparent and aim to create a platform in which the old aristocratic VC model will be replaced by a model that supports a meritocracy at every level of the investment pyramid. That is a fantastic development for entrepreneurs and VCs who are attracted by – and deserve – the merit.
Big stakes, significant returns, fewer players, better innovation
LPs expect more significant gains (before more substantial commitments) from their allocation in venture and the only way to get it is to deploy risk. VC is designed to be the intermediary between the LP and the entrepreneur to mitigate that risk for LPs. Because of the commoditization of VC investment strategies, the VC model has failed to produce.
With LPs retrenching (to perhaps another asset class), the VC firm that wants to survive better articulate a differentiated investment strategy with new GPs that can recognize and attract more disruptive (and sustainable) innovation, knows how to commit and helps make its portfolio companies work.
A new day
To create better returns for LPs, VCs need to rethink how to pick better companies with more disruptive (and sustainable) innovation and invest in upside rather than the downside. The smart entrepreneurs are out there (we talk to them), waiting patiently for the right investment climate to light up their flame. Remember, great innovation can afford to be patient.
Venture Capital as the derivative in the investment pyramid between the assets of the LPs (money) and the assets of the entrepreneur (innovation) needs to provide a better service to both parties (or else it will be tossed out as a “dating service”).
Until we fix VC, will it remain a systemic risk to our asset class, economy, and frankly our reputation as the most innovative country in the world?