By Georges van Hoegaerden

I saw an article a few days ago from an enthusiastic young General Partner (GP) declaring that "Venture is Back" and it reminded me how frighteningly naive some people in the venture business are.

A naiveté that gives entrepreneurs (and Limited Partners) false hope. And we do not need more false promises in the venture business.

Believe me, I want nothing more than to leave this horrible decennium of venture behind and start a new one afresh, but I cannot get excited about the mere sound of a spinning engine that gets the car rocking back and forth. Frankly, the car is still stuck in the sand with spring breakers drinking the kool-aid and cheering it on.

Spinning the wrong wheels

I too see the statistics on the venture pace going up and down and depending on whose reporting of an in-transparent venture business you believe, you can pick your pill of the day.

But how fast Venture Capitalists spin their wheels is irrelevant to the performance of the venture business. And even how many deals are done and how many exits are produced is irrelevant. Short of any transparency in the venture business those metrics are poor derivatives to report on its ups and downs.

What matters is fund returns

But what really matters to Limited Partners is how much money goes into the VC fund and how much comes out at vintage (after the 7-10 year life-cycle of the fund). Only a fund return that outscores any other asset class a Limited Partner (LP) invests in, can count on receiving continued commitments that add to the growth of the venture sector. And the venture sector is far from growing.

Why venture remains broken

There are much more fundamental reasons as to why in the years between 9/11 and the economic crisis of 2009 venture funds have not shown dramatically better performance while the wind was blowing in the sails of VC who had their LP commitments lined up (see how we counter the hope-and-pray philosophy).

Here is my top 3:

- Flawed deployment of risk

The majority of VCs today rely solely on what I call "technology grazing" as the method to extract greater business value. While that not only reduces potential upside it also deploys a flawed risk profile to the creation of early stage companies.

Venture Capital has died and resurfaced as micro-PE (Private Equity) that deploys an inappropriate risk model to innovations that are supposed to set the world on fire. To the many VC funds larger than $100M, chasing companies that have access to less than $1B in monolithic revenue opportunity and less than a $300M exit opportunity is simply a waste of time.

But the GPs have done so in droves anyway, because God forbid if they would have to give money back to LPs unable to find truly disruptive innovation and forego some of their management fees.

- Too many cooks who can't cook

The vast majority of VCs in the venture business today have never themselves crossed the chasm that would allow them to find the outliers and arbitrate innovation accurately. While GPs in Private Equity may get away with rudimentary skills to accelerate growth, the venture sector relies on specialist GP skills to turn early ideas into highly relevant innovations.

And even then, outliers are usually detected by outliers themselves, not by people who merely followed an educational trajectory cum laude. From a dissection of their bios on their websites you will find the evidence that most General Partners have no merit in judging how and when an early stage company should make the transition from an early adopter to a mass market and with what kind of an investment.

Experienced entrepreneurs are like discerning food lovers, they have a choice and stay away from bad restaurants.

- Endless diversification without accountability

Excessive multi-level diversification does not work and leads to more fog than clarity of purpose. Everyone and everything becomes a derivative, with no line-of-sight to accountability.

First the LPs diversify their risk by deploying a mere 10-15% to alternative assets (which includes venture, relying on other assets to produce the majority of LP returns), then they diversify to commitments in a multitude of venture firms, who then diversify into multiple funds, that then diversify to multiple GPs, who then diversify in multiple startups, who then diversify investments in multiple rounds, and then syndicate with multiple VC peers.

Hence my reference to a venture soup. And the asset holders, LPs and entrepreneurs are not liking the way it tastes.

The real fix

The underperformance in venture is similar to the car driving in the sand with the wrong tires and without locking differentials. The size of the engine (VC fund) does not matter, nor does it matter how fast you sped away on other roads. Only the way you apply the power to the current surface does. And so what matters is to what risk the moneys of a VC fund are applied.

So, unless the VC funds are setup and mandated to chase different risk, I do not expect to see any positive sustainable change in venture performance.

Yes, macro-economic confidence will increase investment pace and even improve the pace of mergers and acquisitions, but as long as we keep filling the pipe with sub-prime investments, we will not see more than sub-prime returns. We simply keep producing insufficient innovative disruption to significantly outpace other prime LP asset classes.

Over the next couple of months our government should instill free-market principles to the financial industry that through transparency can expose the real merit of investors in the venture business. But before that each individual LP can make immediate changes to their VC commitments now, to stave off the lingering curse of subprime VC.

The good news is that the future of the venture business is solely in the hands of the LPs, who by virtue of more discretionary VC selection are able to enthuse the outliers of innovation who, because they have more options, are currently patiently lying in wait.

Tags: Limited Partners, VC, Transparency, Disruption, Assets, Diversification

By Georges van Hoegaerden

I covered the systemic risk of Venture Capital (VC) many times (see in my previous article "Less is more") and emphasized how the passion to create disruptive innovation is the driving force of our great nation, an asset the rest of the world looks up to and I aim to protect with everything I have.

I came to this country some 15 years ago to pursue my entrepreneurial endeavors and despite my successes have seen the effects of a debilitating venture business restrict the dreams and bright future of others.

Even some of my entrepreneurial work could have yielded better financial returns, were it not for the subprime nature of some VCs (and their entourage) of whom, in an in-transparent business (read "How to fix VC once and for all"), it is often impossible to establish their real merit (and character) ahead of time.

The Venture Dilemma

Limited Partners (Pension funds, Endowments, Family trusts etc.) who supply their money to VC in capital-calls are faced with the harsh reality that venture (the venture capital sector) has produced less than 10% IRR for the last ten years and are now asked again to buy into the rhetoric from General Partners (GPs) at the VC firm that none of this was their fault, and renew 10-year multimillion and sometimes billion dollar commitments. The question for the Limited Partner (LP) arises; should I stay or should I go?

Many Prime VC Firms have Turned Subprime Too

Top quartile performance (a meaningless definition in its own right) by one VC fund is unlikely to rescue the plethora of under-performers nor yield much higher than 10% IRR in total LP sector returns. And even the performance of classic top-tier VC funds leaves a lot to be desired.

Mayfield Fund appears to have no regret admitting “classic bubble” mistakes and “bringing in big company management”, non-market risk mistakes that do not belong to a seasoned investor. Sequoia Capital issued a dramatic cutback message at first dawn of the economic crisis to its portfolio companies, in essence communicating that their companies are not disruptive enough to withstand economic aberrations. From public reporting by a public pension fund, Draper Fischer Jurvetson does not appear to be knocking it out of the ball-park either. Rumor has it that another top-tier firm, Benchmark Capital is the only firm in Silicon Valley to produce more than a 1x return on all of its funds. This is totally unacceptable performance and behavior of venture firms we collectively tend to think of as top quartile. Are they?

Many of the top-tier funds that flourished in strong winds and made even turkeys fly, have diluted their teams with general partners who simply lack the relevant operational experience (read "Why VCs really need relevant operating experience, now") needed to prevent them too from sliding into the overwhelmingly subprime venture ecosystem.

The Threat to Innovation

Clearly LPs have alternative options of deploying money into other asset classes (liquid or illiquid) and not buying into the feeble VC (and their lobbying organization) arguments will by default yield to a significant reduction of funding for innovation if not cause the industry to spiral further down to inappropriately applied risk and deal commoditization (we refer to as subprime VC).

At least ten years of subprime VC continues to attract subprime entrepreneurs which in turn creates more subprime performance and turns venture capital into micro private equity (PE). The erosion of the venture sector is well on its way and LP assets meant to be deployed to high-risk/high-yield innovation have instead slid down to high-risk/low-yield scale. LPs who meant to invest in venture, have instead invested in micro-PE.

Technology is Not the Risk

Fragmentation and further diversification at the VC level is not the answer to an ailing venture business. While it is exciting for the unknowing entrepreneur to see new angels attempt to fulfill the role VCs are not; such as Jason Calacanis, Adeo Ressi from The Funded, and other new angel groups, the early stage technology trials (as I prefer to call them) continue to deploy the wrong risk and continue to pull the venture business further into the swamp of subprime innovation. As I described before (also read my reference to Vinod Khosla's model of investing), technology development is not the investment risk of the venture business.

Smart LPs Look for a New Breed of GPs

Those LPs who do not want to flee the venture sector and realize that technology still has a bright future ahead better not make the same mistakes twice. The dating service of innovation (VC) may not be working correctly, but the real asset holders in the marketplace of innovation (see my article on the innovation marketplace) are eager and aplenty to monetize a new world of change.

New VC fund requirements need to be established to reintroduce risk-taking Venture Capital to the technology sector which subsequently attracts entrepreneurs that have the capacity and drive to change the world.

LPs need to:

• Establish new GP qualification criteria. Money without merit is not likely to yield outlier results.
• Re-evaluate Private Placement Memorandums to focus on market risk rather than technology risk
• Drive defragmentation and accountability of the investment thesis
• Implement merit based GP remuneration, including downside

Financial marketplace imperfections aside, the miserable performance of the venture sector has nothing to do with the economy and has everything to do with the risk we as early stage investors deploy to attract truly groundbraking innovation.

I have been called taking cheap shots at VC when they are down - by one VC titan I reached out to. But for some reason I do not feel bad demanding excellence from people driving their Maseratis and Porsches from the mostly public money that feeds them. It is not personal, but we owe it to our economy to return merit-to-money.

Limited Partners are in full control of their own destiny in venture, by virtue of how they commit. And now is the time to commit to venture with more discretion and expertise and hit the VC reset button.

Tags: Limited Partners, VC, Assets, Transparency, Subprime, Marketplace, Meritocracy