(MoneyWatch) Venture capital! Even the name of this alternative asset class is tantalizing. Investors, both institutional and individual alike, yearn to be "players." They make investments for the same reason they buy Rolex watches and buy oversized Gucci bags with labels proudly displayed. Just as with such "accessories," they want their investments to convey status, wealth, and sophistication. This need or desire to be a member of an exclusive club explains why there's so much investment in venture capital (and hedge funds).
Yet the evidence (as presented in my book "The Only Guide to Alternative Investments You'll Ever Need") demonstrates that investments in private equity and hedge funds have largely represented the triumph of hype and hope over experience. The latest proof comes from a study by the Kauffman Foundation, a major investor in private equity funds. After two decades of experience, its investment team decided to analyze its 20-year history with venture capital investing in nearly 100 funds, including some of the most notable and exclusive firms. The following summarizes its findings:
- Venture capital returns haven't significantly outperformed the public market since the late 1990s, and since 1997 less cash has been returned to investors than has been invested.
- Succumbing time and again to narrative fallacies, foundations, endowments, and state pension funds invested too much capital in underperforming VC funds on frequently misaligned terms.
- The average VC fund fails to return investor capital after fees.
- After fees, the majority of VC funds -- 62 out of 100 -- failed to exceed returns available from the public markets. In other words, investors weren't compensated for taking the incremental risks of illiquidity and lack of diversification.
- Only four of 30 VC funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small-cap common stock index.
- Because of the cumulative effect of fees and carry, 69 of the Kauffman Foundation's funds (78 percent) didn't achieve returns sufficient to reward them for patient, expensive long-term investing.
- Many VC funds last longer than 10 years, and as long as 15 years or more. The foundation had eight VC funds in their portfolio that were more than 15 years old.
The situation is even worse than they found. The reason is that the public stock benchmark they used was too low. The authors suggest using the Russell 2000 Index, a benchmark of more similar small-cap stocks than the often used benchmark of the S&P 500 Index. They suggest this index because of the higher price volatility, higher beta, and higher sensitivity of small companies to economic cycles than have the large capitalization stocks of the S&P 500 Index.
However, the transparency of Russell 2000 Index has created well-known problems with its returns. For the period 1979-2011, the Russell 2000 returned 11.2 percent. Contrast this with the return of the similar small-cap CRSP 6-10 Index, which retuned 12.7 percent. However, even that benchmark is too low. Because of their incremental risks, to justify investment VC should provide incremental returns (perhaps 3 percent) above a small value index. For the same period, the Fama-French Small Value Index returned 14.6 percent. Using that hurdle would have made for an even more compelling case against venture capital.
The authors note:
"The historic narrative of VC investing is a compelling story filled with entrepreneurial heroes, spectacular returns, and life-changing companies. The quest to invest in the next Google guarantees that VC will retain its allure and glamour, even in the face of the disappointing results we've just discussed. Investors are still attracted to the 'lottery ticket' potential VC offers, where one lucky 'hit' investment like Zynga or Facebook can offer the potential to mitigate the damage done to a portfolio after a decade of poor risk-adjusted returns. The data suggest that such 'hits' are unlikely to salvage industry returns."
David Swensen, the noted chief investment officer of the Yale Endowment Fund and author of "Unconventional Success," offered this warning for those considering investing in private equity: "Understanding the difficulty of identifying superior hedge fund, venture capital and leveraged buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating, active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection poses grave risks to portfolio assets."
The authors provided the perfect conclusion. It's from the film "War Games." A supercomputer dubbed "Joshua" states: "A strange game. The only winning move is not to play. How about a nice game of chess?" Investors who, in their search of higher returns are considering venture capital investing, should instead invest in either a small value index fund or a well-structured, passively managed small value mutual fund.
Photo courtesy of Flickr user mrsdkrebs