Where are the realizations?
Perry C. Douglas
June 15, 2024
More and more venture capital is being structured into managed products/managed funds and funds-of-funds for early-stage financing of companies. Creating another industry for professionals to earn fees.
The Canadian government, for example, is even pushing its recalibrated federal program that provides $1 for every $3 raised by “fund-of-funds.” The federal government presses pension funds to invest more at home, but this only leads to an exclusionary institutional and professional investing class. Where entrepreneurs and ordinary investors don’t actually benefit from venture capital investing but are sold those promises.
The news about the federal program on its face looks to be good news for Canadian technology and startups in general. However, putting venture capital funds overlay and in the hands of analysts turned fund managers, has not worked out in the past.
What we are created is just another mutual fund type industry sales industry, disguised as real venture capital and startup investing.
The VC fund management business has been one of poor returns, often returning less cash to investors than their capital put in.
In a Harvard Business Review article by Diane Mulcahy, titled Six Myths About Venture Capitalists; based on her comprehensive analysis of the more than 20 years of experience investing in nearly 100 VC funds. Her research advises aspiring entrepreneurs against falling victim to common myths about venture capitalist and their ‘funds’.
She warns that VCs are not the primary source of start-up funding; “Actually, angel investors fund 16 times as many companies than VCs,” she says. And it’s also a myth “that VCs take big risks with start-ups. (Often they’re insulated against risk by hefty annual fee streams.)” “Most VCs offer great advice and mentoring,” is also not the case. It is also a big myth that “VC generates spectacular returns. (Since 1997 less cash has been returned to VC investors than they have invested.)” Her research also shows that “Bigger is better. (Research shows that fund performance declines as fund size increases above $250 million.)” And finally, the myth that “VCs are innovators. (Apparently not. The innovation is not coming from them [whatsoever but from other places.]”
Further, one of the main problems with VC fund investing is that they sell it as “diversified” investing to ‘manage risk’. In other words, VC funds are run like public markets mutual funds. And we know 95% of fund managers don’t ever be the averages, i.e., the S&P index, but unit holders continue to pay high fees. This is precisely why we are seeing the rise of do-it-yourself investment companies like Wealth Simple, succeed.
VC Adventure published an analysis highlighting data from Correlation Ventures showing just how skewed venture returns are, specifically that 65% of investment rounds fail to return 1x capital and only 4% return greater than 10x capital.
The chart below highlights how that translates to returns in venture capital as an asset class. The difference between the best-performing and average-performing firms is incredibly wide. Venture is a make-hits business, so if you think about a typical venture fund of almost any size, having somewhere between 25–40 investments, the chances of any one of them being a true outlier and returning a strong multiple of the fund, is slim.
Fund managers offer no amazing money-making skills, they just hope for an outlier return for at least one of their investments. So why would you pay a fee for ‘management,’ when you can achieve the same shitty-odds yourself?
A $100M fund with 30 investments, that’s a little over $3M per investment — this is a mutual fund folks, not venture capital investing.
The best-performing mutual funds have multiple companies performing but the median funds do not. So too, the average venture fund doesn’t have multiple companies performing which makes it a poor investment, particularly when it sells investors on venture-like returns. This is why so many venture funds fail to even return capital.
Venture funds and mutual funds face the same fundamental problem: no one can actually pick the winners and that’s why the vast majority are perennial losers. So the key to being a successful venture capitalist, according to David Cohen, is: “Luck”.
Therefore, venture funds are just another industry sales pitch of deception, and managers are the typical MBA types with no experience in entrepreneurship or running real businesses. Just what they read in their textbooks.
VC funds develop biases based on their past experiences and environment. VCs often rely heavily on patterns and trends in the macro environment and fail to understand the dynamics of the founder and business. Instead, industry group thinking leads the way, and everything these days is about generative AI, not the actual unique companies. Just say “GenAI,” and anyone with a pulse and an MBA can get VC money.
But it begs the question: if every fund manager is doing the same thing, how can these funds find the big winners? They don’t…but give the impression that they do by slapping many startups on their sites.
This herd mentality continues to generate cycles of bias and leads to poor decision-making over time, says Aki Kakko, Founder of Alphanome.AI — Finance AI Research Lab.
In the AI domain, for example, facial recognition trained mostly on white male faces has difficulty performing on people of colour. So analysts are trained the same way and many who have been previously successful in making investment predictions about dot-com companies, for example, have migrated their disciplines over to VC. Applying similar investment methodologies to VC/startup investing. Even though the characteristics and dynamics of each sector are vastly different.
These divergences and biases are just some of the many reasons why VC funds continue to deliver such lacklustre returns.
The most common feedback venture capital general partners are receiving these days while fundraising is “Where are the realizations? I need to see that before I commit to the next fund,” says Northleaf Capital Partners, managing director Ian Carew.
However, according to recent data, very few Canadian venture capital funds and funds-of-funds have any returned any meaningful cash distributions to investors. This has been a widespread complaint particularly since the tech downturn began in 2021, according to a recent Globe and Mail article titled Wealthy Canadians Investing More In Government-backed Venture Capital Funds.
Another issue with VCs is the uniformity and modelling problem – fake narratives: Accelerators and incubators, VC funds usually have a selective “application” for the entry, which means they are looking for a specific set of characteristics, which inherently breeds uniformity and mediocrity. Always missing the outliers that go on to become the businesses that end up changing the world.
According to Airbnb founder, Brian Chesky, “…if you have a really good idea you’ll almost certainly be dismissed by the ‘professional’ investors.”
In addition, the VC capital acts as a conformer to the ideas of the more powerful partners or key decision-makers in the organization’s management ecosystem. They almost always think that they know better and smarter than the founder with a good idea. What they are consciously doing, however, which is destructive, is setting up the startup for a short-term valuation bump with the hope of unloading it to another VC or selling it to another company, being taken over by a big tech company. VCs serve the needs of big tech mostly.
It should be clear by now that there is absolutely no link between acceptance into an accelerator, direct VC funding, or through a fund, that there is any positive correlation between VC-related investing and the future success of the businesses.
According to iterate.ai, only 1.5% of startups that go through accelerator programs or VCs ever reach unicorn status. And the number is practically the same for those that go without VC.
Here are some facts
In 2022, over half a trillion venture capital dollars were invested in companies around the globe. And yet, despite all that cash flowing into VC-backed companies, twenty-five to thirty percent of them will fail. And one in five fail by the end of their first year; only thirty percent will survive more than ten years.
In the end, VC funds are not geared toward building great sustainable businesses, it’s more of an industry-like mutual fund play to collect high fees and return very little to investors. There is no magic formula to making real money, you have to be willing to do your homework and invest in real businesses, in the right sectors at the right time. Those with identified authentic market fits and technology to get them there.
Times and technology might have changed but intelligent investing fundamentals have not.
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