Investors wonder if venture capital is worth the wait

Venture capital isn't dead, but it is riddled with ailments.

Returns are lousy. Fundraising is down. And exits — both initial public offerings and mergers and acquisitions — are down from 2011, even with 2012's monster Facebook IPO.

This has some pension fund investors wondering whether the asset class is worth its extended period of illiquidity when funds are performing so poorly.

“Corporate pension funds that invest in private equity in a systematic manner maintain allocations to venture capital, but the reality is a lot of them are rethinking” their dedicated venture capital allocation, said Sanjay R. Mansukhani, senior manager and research consultant in the New York office of consulting firm Towers Watson & Co.

The $248.1 billion California Public Employees' Retirement System is in the process of reducing venture capital to 1% of its private equity portfolio over the next five to 10 years, down from the current 7%, said CIO Joseph Dear at a CalPERS forum in December.

“Venture's very, very tough. It may be one of the most difficult fields in which to deploy capital and to achieve success” due to disappointing returns over the past 10 years and the few top-performing firms not accepting public plans as limited partners, Mr. Dear said, according to a forum transcript.

From a risk-return view, venture capital has a number of challenges, said Mr. Mansukhani, who works mainly with corporate pension funds. It is less liquid than other alternatives. And investors lucky enough to invest with the tiny club of high-performing fund managers have to remain with them even through mediocre funds to have a chance at the firm's next fund.

Returns have not been pretty. Venture capital earned a meager 0.6% for the second quarter of 2012 and 6% for the year ended June 30.

That's down from 7% for the year-earlier quarter and 26.3% for the year ended June 30, 2011, according to the most recent data from the National Venture Capital Association's performance benchmark, which is the Cambridge Associates LLC U.S. Venture Capital index.

Returns for the typical private equity hold period of 10 years, while up from the year ended March 31 and the second quarter of 2011, were a slim 5.3%.

“The fundamentals of venture capital continue to be there ... but how can that get translated into investment terms under reasonable assumptions of risk and returns for pension funds that have obligations to meet?” Mr. Mansukhani asked. “Will a return in dollar terms of $3 million or $4 million really move the needle toward the fund's total expected rate of return?”

A lot of money is going to venture capital now, but it's concentrated with fewer firms. Total capital raised increased by 10% to $20.6 billion last year, but the number of funds raised fell by 3% to 182.

Some investors are following the lead of the $1.8 billion Ewing Marion Kauffman Foundation, which in May published a white paper that turned into an investor manifesto, indicting the venture capital industry.

“We have met the enemy ... and he is us,” the paper said. “VC returns haven't significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC,” the paper said.

Executives of the Kansas City, Mo.-based foundation analyzed their portfolio and found only four of 30 venture capital funds with more than $400 million in committed capital produced returns exceeding a small-cap equity index. Of 88 venture capital funds in the sample, 78% “failed to achieve returns sufficient to reward us for patient, expensive, long-term investing,” the paper said.

So the foundation sold some underperforming venture capital fund interests on the secondary market and now is a more selective investor in the asset class, according to the paper.

Sacramento-based CalPERS is slashing its venture capital commitments because of underperformance. The portfolio produced a 1% annualized return for the five years ended June 30.

But not everyone is writing an obituary. “I am not in the camp that thinks venture capital is dead or dying,” said Jessica Reed Saouaf, managing director and co-head of private equity at San Francisco-based consulting firm Hall Capital Partners LLC.

Ms. Reed Saouaf did, however, acknowledge the venture capital industry is facing challenges. “Historically, successful funds have gotten big and there's a mismatch of alignment of incentives with limited partners,” she said.

Venture capital firms with larger funds are able to make money on management fees, she said.

What's more, a small number of marquee firms are now demanding that investors make commitments to all funds the firm offers, instead of picking and choosing, Towers Watson's Mr. Mansukhani said.

And the growing amount of capital controlled by the most desired venture capital firms is pushing up portfolio company valuations and slamming down returns. “Big capital bases also require those firms to write very large checks at the portfolio company level, which has implications as far as pushing up valuations and, in some cases, overcapitalizing companies,” said Ms. Reed Saouaf.

“We're big believers in the small fund, where companies ... are not overcapitalized,” she said.

This means investors also have to think small too, and cannot invest large sums in the asset class. “It's very difficult for large pools of capital to get the right kind of exposure to the asset class,” she said.

Even so, some industry executives say there is still too much capital for too few opportunities.

“From our point of view, despite (fundraising) slowing down, there remains excess capital from prior years relative to the opportunity set,” Mr. Mansukhani said.

So much capital was raised in the past that a sizable overhang of money is aimed at making venture capital investments, he said. At the same time, portfolio companies need less money, he added.

“Advances in the Internet, outsourcing IT needs, etc. have brought the cost of starting enterprises down,” he said. “Relative to declining costs, there is excess capital.”

But Kate Mitchell, managing director at Foster City, Calif.-based venture capital firm Scale Venture Partners, said while the amount of money sloshing around was a problem a few years ago, “the capital has been wrung out of the industry.”

“There are fewer me-too companies being formed. The quality of (portfolio) companies is better and the (venture capital firms') ability to exit is greater,” she said.

Ms. Mitchell acknowledged investors are pruning their roster of venture capital firms, but she sees it as a positive development.

Investors are “narrowing their focus to (firms) that are performing well. You can't buy the index and do well; you have to buy the best decile or, at the minimum, the top quartile. And they are taking the opportunity to do it now.”

Investors are concentrating on firms that performed over time, she said. “It's a very smart approach.”