Is venture capital model broken? Never believe the hype

Most venture capital funds peddle narrative fallacies such as vintage year and quartile performance, which rely heavily on internal rate of returns (IRR), measures that are often misleading. FILE PHOTO | COURTESY

I stumbled upon a rare and honest self-reflective report about the Venture Capital (VC) industry.

Although penned in 2012, the report by the Kauffman Foundation, a renowned VC limited partner (LP) with more than Sh300 billion in assets under management, still rings true today.

The LP analysed its 20-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership brands. Its conclusion: the VC model is broken.

I’ll highlight five key issues raised. One, most VC funds peddle narrative fallacies such as vintage year and quartile performance, which rely heavily on internal rate of returns (IRR), measures that are often misleading.

Two: a majority of VC funds — sixty out of 100 — failed to exceed returns available from the public markets, after fees and carry were paid.

The Foundation admits getting back only 1.31 times net of fees on average what was invested, which is far below the standard “venture rate of return” of twice committed capital.

Three, the most significant misalignment occurs when LPs don’t pay VCs to do what they say they will, that is generate returns that exceed the public market.

Instead, VCs typically are paid a two percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”).

Four, many VC funds last longer than 10 years — up to 15 years or more. Lastly, LPs are afraid to contest GP terms for fear of “rocking the boat” with VC managers using scarcity and limited access as marketing strategies.

All this revelation was and is still golden. I mean where do you go to find all-round VC metrics like this? Finding detailed information, especially about fund performance is nearly impossible to obtain given the confidentiality terms in partner agreements.

What we only get are press releases on successful fundraisers. But when did fundraisers become indicators of legitimacy? When did fund sizes become a signal to great talent?

It really does not make sense to create narratives that make you appear great to the outside world and not want to show it.

How about we start seeing real performance numbers and not PR smokescreens? These are relevant questions to Africa as similar observations can be made here.

It’s key to note that VC investments in Africa attracted Sh910 billion last year spread over 853 deals according to the African Private Equity and Venture Capital Association.

On the other hand, I want to believe the industry cannot be all bad. I do believe there are good actors who want to do better.

In fact, LPs should find ways to elevate these good ones and shift the industry towards more action and less perception.

But overall, Kauffam’s report raises some key concerns. I support one of its recommendations: VCs should be judged against returns from listed small capitalisation stocks and not the oft-exaggerated “self-reported” returns.

Equally, LPs need to engage “real” talent and not succumb to the razzmatazz of VC campaigns.

On this point, they can take Public Enemy’s advice: don’t believe the hype.

The writer is the Managing Director of Canaan Capital.