The Capitol

Why VC can’t fix itself

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I spent some time with Congress and The Senate on The Hill (in Washington, DC) last December discussing the deplorable performance of venture capital (VC), as detailed in my blogs, the preeminent video on The State of Venture Capital and in my new Infographic on The State of Venture Capital.

 

One arrow in my quiver

The start of more fruitful discussions that provides much-needed contrast to a plethora of self-preservation messages venture capitalists (individually and through their lobbying organization, the NVCA) have and will be sending to mask their waning yet largely unpunished merit in the arbitrage of innovation.

I will not detail the play-by-play of all the discussions I have with government on either side of the political aisle. Not merely for the reason they asked me, but also because Renewable Economics™ (the real topic of discussion) do not attach any precedent to political affiliation, and my disclosure should not be used to achieve a partizan advantage. Economics ought to be non-partizan.

On top of that, the overwhelming complexity of the internal workings of our political system requires a lot of education and gestation before significant progress can be made and reported. Forget not that for 200 years we have deployed Neanderthal economics, well impregnated into politics, that now by virtue of my analysis needs to be overturned by upstream economic innovation.

No small feat, considering American politics consists of a large labyrinth of moving parts, with most of us having no interest in delving deep. Neither did I, until I discovered an alarming pattern that affects and erodes all of our financial systems (not just venture capital), and alas our capacity to produce.

The winds of change are in my sails, and my resulting positivity is attached to the regressive nature of old-fashioned economics that proves itself wrong at every turn.

 

Why bother?

One question about venture capital that keeps on coming back and I have answered in different ways to a variety of constituents for a while now is:

Markets will correct themselves so why do we not just leave Venture Capital alone? Why bother?

Let me answer the last part first and add more substance to that question, and then follow-up with answering the first question, and then add and answer a rebuttal that often naturally follows. I am truly playing devil’s advocate here.

 

Question:
Why bother with venture capital? Especially since the capital allocation to venture capital is such a minute part of total exposure, and most limited partners (as the investor in VC) can afford to lose a single digit percentage of total-assets-under-management if things go wrong again.

Answer:
The problem with venture capital is not so much the absolute sums of moneys lost by institutional investors, but the diminished output that performance yields in contribution to GDP.

In initial fighting-form venture capital was responsible for some 20% of GDP as a result of $1B companies it spawned (according to the NVCA). Now, with the improper deployment of risk (subprime risk) by venture capital, and as a result of Neanderthal economics in violation of free-market principles, is responsible for the erosion (of twice the speed) of that 20% of GDP.  And a clear reason why everyone who cares about the success and prosperity of the United States should care about the yield, authenticity and renewable capacity of venture capital.

 

Question:
Markets will correct themselves so why do we not just leave venture capital alone?

Answer:
No marketplace in violation of free-market principles auto-corrects, yet instead becomes regressive. Due to multilevel oligarchic pileups that increasingly fragment the deployment of risk and money, they instead turn guaranteed subprime. Hence venture capital as the arbitrage of innovation, in blatant violation of free-market principles, is non-renewable, and thus merely a self-fulfilling prophecy.

 

Rebuttal:
Ok, but isn’t venture capital contracting (at the moment) proof that the market is working?

Rebut answer:
Not quite, a marketplace that contracts simply means it contracts. In this case because some limited partners, have given up hope and significantly reduce their exposure to venture capital, with the largest pension fund in the country; CalPERS leading the public charge in the assessment of venture capital as “the most disappointing asset class over the past 10 years as far as returns”,

But that reduction (we estimate venture capital’s effective size now to be as small as 40 years ago) does not mean that the firms that remain suddenly understand why venture capital has failed to grow up to an adolescent financial system clearly incapable of feeding the 80% greenfield of technology innovation that awaits. Nor will new venture firms that enter the fray after. And thus the inability for venture capital to grow up economically, is an artificial shoke-chain to the entrepreneurial capacity it can discover. The five or so monolithic venture firms that produce returns (today), cannot be expected to serve the greater opportunity.

To put it differently: you don’t cure the economic equivalent of cancer in venture capital with a simple observation that the patient’s fever has gone down.

 

Economics baby

The economics we deploy in venture capital are fundamentally incompatible with finding the outliers of innovation. Of which the primary symptom is that the decline in performance of venture capital is opposite (by any measure) to the massive new opportunity that awaits. Their performance is so bad, that even corporate innovation-arbitrage is putting venture capital to shame (during the same period).

We need to fix the Neanderthal economics of venture capital that refuses entrepreneurs their constitutional right to free-market access, if we want to stop venture capital from giving groundbreaking entrepreneurs and innovation in this country a really bad rep, and stop the flawed guidance venture capitalists deploy in what it means to build innovation with renewable socioeconomic value.

 

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About Georges van Hoegaerden

Georges is a serial entrepreneur, venture catalyst, 4x CEO, board director turned innovation economist (by fate). His ideas have raised $14M in venture capital and produced over $100M in returns. More.

  • Steve

    Georges – you’re too politically correct in this missive. S.

    • http://venturecompany.com/ Georges van Hoegaerden

      Just another arrow in my quiver.

  • http://www.Aarzoo.Com/ Vinod Sujan

    Georges – Superb assessment. My two cents after spending equal time in India and USA on Deal Flow…The support for culture of innovation in US seems intact while in India does not exist at all…and as long as the culture of innovation is respected and rewarded here in the US, hope will stay alive that Venture Capital through continued investment in innovation will bring US back to its glory :-)
    My respects and regards to you for sharng a brilliant assessment, as expected of you.

    • http://venturecompany.com/ Georges van Hoegaerden

      Vinod,

      Thanks. Well, as VC has turned predominantly subprime so has the innovation intake. Hence subprime VC is now intertwined in a dance with subprime innovation that nobody wants to watch (i.e. lack of IPOs, lack of socioeconomic value, -30% 2-year post IPO value).

      So, the faith and culture of innovation has already been eroded severely over the last 20 years. But our capacity to innovate will rebound quickly, once we turn VC prime again.

      Great entrepreneurs will survive because they can reinvent themselves. I am not so confident many VC can do the same.

  • Marc Kneepkens

    Maybe crowdfunding will make up for it. There is always a return to balance, at some level.

    • http://venturecompany.com/ Georges van Hoegaerden

      No Marc. Crowdfunding is merely a new distribution of even more fragmented deployment of subprime risk. Hence, the returns of crowd-funding will be even more abysmal than they have been.

      Crowdfunding does not solve venture capital’s perennial problem, except perhaps that crowd-funding’s impending failure will make for another juicy index against which venture capital’s returns look like the one-eyed king in the land of the blind.

      On your comment of balance:
      The reason why we aim to build more modern and dynamic economic systems is that we want that return to balance to happen before we lose our leadership position. We should not wait until death is the ultimate arbiter of that equilibrium. (see my blog on the evolution of innovation)

      Not in the least because during venture capital’s demise we throw a lot of entrepreneurial capacity (false negatives), that of groundbreaking entrepreneurs who have other options than to chase subprime money, away with the bath water.

      So, doing nothing is not an option for a nation with ambitions.

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