News Column

Decline in Venture Capital Returns Is Manageable

April 18, 2013

John Shinal

Venture Capital

US venture capital funds raised an aggregate $100 billion in 2000 amid an explosion in the number of VC firms, but many veteran VCs predicted that such a rapid expansion would not be good for the industry.

With annual U.S. economic growth averaging roughly 3% during the 50 years after World War II, there could be only so many lucrative investment opportunities -- even in places as entrepreneurial as Silicon Valley.

Too much money chasing too few deals would depress the long-term average returns of VC funds that invest in startups, the thinking went, making venture capital less attractive as an asset class.

This would lead to a shakeout within the VC industry, with only the marquee firms doing well, resulting in fewer sources of funding for entrepreneurs and, ultimately, a blow to U.S. innovation.

Now that full-year industry numbers are in for 2012, though, they show that only the first part of those predictions have proven true.

While the 10-year average rate of return for venture capital funds has begun to lag behind those of the public stock markets, what's been a bummer decade for most VCs hasn't necessarily been bad for entrepreneurs.

Thousands of startup CEOs are still raising money every year, thanks to other funding sources -- including angel investors, corporate VCs and crowdfunding websites.

"Innovation is still happening, but not all of it is being funded by traditional VCs," says Bryan Pearce, director of the venture capital advisory group at Ernst & Young, the accounting and consulting giant.

U.S. venture capital investment fell 15% in 2012 to $29.7 billion, from $35.1 billion a year earlier, according to an Ernst & Young report released last week.

While the amount was higher than in the recession year of 2009, it was lower than the amount invested in each of the three years prior to the U.S. economic downturn.

Uncertainty in U.S. financial markets also cut the number of acquisitions of VC-backed companies by 21% last year, to 433 deals.

That's the second-lowest total in seven years and close to the recession-year nadir of 427 deals in 2009.

That trend is bad news for VCs, because while huge public offerings such as the one from Facebook last year produce the biggest fund returns, most successful exits for VC-backed firms come in the form of acquisitions, not IPOs.

So while the number of VC-backed IPOs ticked up to 50 last year from 46 in 2011, and the amount raised in IPOs surged -- thanks mainly to the Facebook offering -- the decline in acquisition-related exits has helped push down long-term returns for VC funds.

For the 10 years ended last September, the average internal rate of return (or IRR) for U.S. venture capital funds was 6.1% annually, according to Cambridge Associates data.

During the same time, the Nasdaq rose 10.3% annually, and the Dow Jones industrial average returned 8.6% a year.

Given that VCs skim the first 20% of annual venture fund profits off the top, pension and stock fund managers who invest in them -- and who are known in the industry as limited partners -- have begun to wonder what they were paying for.

"Limited partners have looked at the returns and seen they weren't being compensated for the added risk" of investing in VC funds, Pearce says.

The number of VC-backed funding rounds also shrank last year, dropping 4% to 3,363 invested rounds.

At the same, the number of angel investments in the U.S. rose 4% in the first half of 2012, to more than 27,000, according to a report from the Center for Venture Research at the University of New Hampshire.

Other estimates put the number of annual angel investments at between 50,000 and 60,000.

Here's more bad news for VCs: Crowdfunding site Kickstarter alone has raised more than $500 million since its founding, and 26 of the funding deals consummated on the site raised at least $1 million.

If all that weren't enough competition, U.S. corporations are now putting some of the estimated $2 trillion in cash on their balance sheets to work via venture investing.

Whereas most corporate VC investment was once made via acquisitions of VC-backed start-ups, a growing number of U.S. companies are incubating their own investments with home-grown accelerators or investments in early-stage companies, Pearce says.

"Corporate VCs are coming into the game earlier in the startup life cycle," he says.

This is forcing VCs to change how they invest, in an effort to reduce their risk and boost returns.

While the number of VC investments in early-stage (pre-revenue) companies has declined for three straight years, funding rounds of later, revenue-stage companies have risen during the same time, according to the Ernst & Young report.

While a few dozen established, top-tier VC firms still have no trouble raising money, industry trends have the majority of VCs hoping for a big 2013.

Many of the VCs who entered the business a decade ago were former entrepreneurs who made fortunes by selling their own companies or taking them public. Others were mavericks who broke away from more established firms to start their own.

While top-tier firms have little trouble raising new funds, these less-seasoned VCs have the most to lose from the lagging performance of venture capital as an asset class.

"They need some very big exits this year to jump-start the cycle" of fundraising and investment, Pearce says.

John Shinal has covered tech and financial markets for 15 years at Bloomberg Businessweek, San Francisco Chronicle, Dow Jones MarketWatch, Wall Street Journal Digital Network and others.

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Source: Copyright USA TODAY 2013