Venture Investing To Be Cut in Half?

Are relatively low returns and a dearth of exit options indicators the venture capital industry should shrink itself by half? Yes, according to Paul Kedrosky, well-known investor and author of the widely cited Infectious Greed blog.

In a study released this week by the Ewing Marion Kauffman Foundation, where he is a senior fellow, Kedrosky cites stagnating and declining returns coupled with rapid expansion in assets under management as evidence that the VC sector must shrink to remain viable.

"Professionals in the venture industry have gotten comfortable with the way their industry is set up in terms of size, structure and compensation," Kedrosky says. "It has been a profitable business for many. However, our study indicates venture participants now need to overcome their resistance to change, so they can most effectively fund entrepreneurs and offer investors competitive returns."

Working against the diminution of the market is the fact that VC players are paid based on the volume of assets under management, so it's not in their fiscal interest to shrink the market.

VC Investment Performance

Venture capital will continue to be crucial to some forms of high-growth companies, especially those in the IT, clean energy and biotech industries. Still, Robert E. Litan, vice president of research and policy at the Kauffman Foundation, says the venture industry needs to shrink its way to becoming an economic force once again. "To provide competitive returns, we expect venture investing will be cut in half in coming years," Litan says. "At the same time, lowering valuations and improving overall exit multiples should help resuscitate the industry."

Litan argues that VC returns will turn negative at the end of this year when the dot.com bubble venture exits of 1999 wrap up. Relative returns are mixed, with VC returns lagging the small-cap Russell 2000 Index by 10 percent on a 10-year timeframe, although leading the Russell 200 on a five-year timeframe.

While the economy clearly impacts industry results, the study cited other performance factors that predate the current downturn. The industry itself might be structurally flawed: The core markets that made it successful - information technology and telecommunications - are now mature and less capital-intensive.

In addition, exit markets are unwilling to take on young and unprofitable companies. Given that, the study says, the real question for venture is one of capital and size. As opportunities shrink, the venture business should shrink too, possibly by as much as 50 percent.

"It's inevitable," said Kedrosky. "Whether it realizes it or not, whether it wants to or not, the venture industry has to change."