Few stars in the very bleak venture capital universe

For venture capital investors, the days of receiving 100-plus per cent internal rates of returns (IRRs) from a broad sweep of managers are gone. But this doesn’t mean investors should give up searching for the few remaining outperformers. During the dotcom fervour of the late 1990s, the boundary marking top-quartile IRRs soared beyond 70 per cent in 1997, and then fell sharply to about 6 per cent in 1999. Since then, returns from managers across the industry “have struggled to recover”, wrote research house Preqin in its special report, The Venture Capital Industry. According to Preqin, which tracks the performance of 70 per cent of venture capital funds, 52 per cent of managers posted IRRs of 20 per cent or more in 1997, the industry’s golden year.

Since then, less than 5 per cent of 1999 and 2000 vintage funds have returned 20 per cent or more, and the median manager has been in the red. But a small segment of managers has been able to generated IRRs of 20 per cent or more, Preqin finds. This proportion of outperformers fluctuates. In 2000, 3.9 per cent of venture managers achieved 20 per cent-plus IRRs; in 2005, the number was 19.6 per cent; and in 2007, it was 8.7 per cent. “Overall industry performance may be disappointing, but there are also many success stories, growth areas and an elite group of firms,” the researcher stated. According to Mark Carnegie, a co-founder of Carnegie Wylie and one of Australia’s prominent private equity investors: “Venture capital is not a good asset class – it’s a spectacular asset class once every 20 years”, since it generated returns at opportune points in industry cycles, he told the SuperRatings 2010 Day of Confrontation last month.

“Ten-year returns are so appalling is because (of ) all of these mis-marketed dotcom funds that people got into. That was a bubble. That wasn’t venture.” But Preqin reported that top managers had achieved solid returns since the dotcom heyday: 70 per cent of firms posting top-quartile returns went on to outperform the median manager in subsequent funds. And investors and consultants know who they are: these managers have “raised new vehicles in relatively quick time, even in the current financial climate,” the researcher stated. For investors, a truism in the alternatives space – that manager selection is critical – certainly applied. In 1998, when the median manager posted a 12.6 per cent IRR, the standard deviation among IRRs was 74.7 per cent.