Profs say nothing to fix with venture capital model

U.S. institutional investors are shunning venture capital at exactly the wrong time, two private equity professors say in a yet-to-be published paper.

Venture capital funds raised in 2009 and 2010 are likely to be strong performers, according to the paper by Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance, The University of Chicago Booth School of Business, and Josh Lerner, Jacob H. Schiff Professor of Investment Banking, Harvard Business School Arthur Rock Center for Entrepreneurship, Boston.

“There's too little going into venture capital,” Mr. Kaplan said in an interview. That sets up the probability that values of deals will rise, boosting returns.

The two professors set out to see whether the venture capital model is indeed broken, as many observers have contended.

Their research analyzes venture capital commitments and investments as a percentage of the total stock market. It shows that, in the long term, the amount of capital committed to venture capital funds as a fraction of the total stock market has been fairly consistent. Over the 30 years ended Dec. 31, 2008, venture capital commitments have been an average of 0.13% of the total stock market. In 2009, that percentage dropped to 0.1%.

The analysis reveals that U.S. venture capital commitments have never gone below 0.05% of the total stock market; and with the exception of the three dot-com boom years of 1999 through 2001, commitments have not gone above 0.23%. Since 2002, commitments have run 0.146%, just slightly above the historical average of 0.139%, states the paper, “It Ain't Broke: The Past, Present and Future of Venture Capital.”

VC investments stable too

Investment by venture capital firms has also remained relatively stable, Messrs. Kaplan and Lerner conclude. On average, U.S. venture capital firms have invested 0.164% of the value of the stock market each year in portfolio companies over the past 30 years. Again, with the exception of the three dot-com boom years, investment has not exceeded 0.203% of the stock market, the paper states. Venture capital investment between 2002 and 2009 has run 0.155%, a bit below the historical average of 0.164%, they found.

These comparatively low levels of commitments and investment could lead to higher venture capital returns, they say.

In an earlier study, by Mr. Lerner and Paul A. Gompers, the Eugene Holman Professor of Business Administration at Harvard Business School, found that when commitments to venture capital funds are low, valuations of venture capital deals rise. In a prior research paper, Mr. Kaplan showed that greater amounts of capital lowers returns.

“We see little that makes us believe that the VC model has changed or is broken,” Messrs. Kaplan and Lerner wrote in their new study. “As far as we can tell, we are leaving a period with slightly above-average capital and slightly below-average returns for a period of well-below-average capital. We would not be surprised to see this followed, perhaps quickly, by a period of above-average returns.”