Why venture capital still matters

The real value of venture capital investing

One of the consequences of the current financial crisis is how it has become fashionable to bash the not-so-well understood private equity asset class --- both its buyout and venture capital segments.

While these two different segments are arguably very different from one another, it’s become quite convenient to lump them as “cousins” and ridicule them as a single underperforming and dysfunctional family. 

There’s no doubt of course that the buyout segment is experiencing its fair share of challenges – both from a deal origination and portfolio maintenance perspective.  After all, it’s practically impossible to originate any new corporate buyouts these days without the aid of the aggressive “covenant lite” leverage lines the PE guys have been so accustomed to.  And on the portfolio maintenance side of things, it’ become very challenging to even meet interest expense since cash flows have materially dropped.  In fact, there’s quite a bit of doubt that a good chunk of the equity that these PE firms injected into these buyouts are still worth anything given their out of whack leverage ratios brought about by the dramatic decline in cash flows.  The secondary debt markets have already adjusted for this reality.

On the other hand, Venture Capital remains different and resilient in spite of the media beating it has taken as a result of the much well publicized lack of IPO market (ergo lack of exits or investment realizations).  That’s a different story altogether, but for the purposes of this post let me merely focus on why I believe venture capital still matters. 

First of all, venture capital doesn’t rely on leverage to originate deals which means that in spite of the credit crunch VC funds are still capable of deploying capital to deserving young companies.  Of course whether or not VCs have the will or courage to do so is a different matter.  Secondly, venture capital investments typically take anywhere from 3 to 7 years to gestate so the current state of the financial markets, while it surely causes sweaty palms, shouldn’t matter that much in the whole scheme of things as far as building sustainable businesses.  That’s not to say of course that VC-backed companies are immune to the day-to-day economic viruses, not at all.  All I’m saying is that if your mandate is to help build significant companies for the long term, your decisions shouldn’t be solely based on short-term headlines.  Entrepreneurs should still pursue their vision (or tweak it as needed), stay true to their core values and should keep their focus on the ultimate prize --- building a company that can stand the test of time.

On the risk of “romanticizing” venture capital, let me go out on the limb and proclaim that venture capital has a certain intrinsic social utility to it that adds quite a bit of value to society’s main economic engine – small business and capital formation.  I suspect that a good chunk of VC professionals toil away in this industry because of these underlying principles: 

One: Venture Capital is a true catalyst for innovation because the precious capital is directly infused into the deserving companies themselves unlike other investment funds who merely buy and sell marketable securities in the secondary markets.  It’s difficult to imagine that any of these young yet innovative companies will get any funding without dedicated pools of venture capital.  Unfortunately, start-up companies always get penalized from society’s inherent “pawn shop mentality” so it would be practically impossible for them to get any funding unless it’s a pool of capital dedicated to this cause.  Rest assured the next big idea will be venture financed!

Two: Venture Capital improves our society’s standards of living.  Not only do VC-backed companies employ over 11 million Americans and account for over 18% of US GDP, Venture Capital also supports companies that enhance people’s everyday lives.  Imagine a world without Federal Express, Amgen, Intel, Medtronics, Apple, Google, Home Depot, Amazon, Genentech, Cisco, Salesforce.com, eBay, etc. – I can go on and on but I’m sure you get the drift.  Imagine the quality of the components of the Nasdaq 100 without the participation of venture backed companies.  Venture Capital is the fuel that empowers and drives innovative entrepreneurs to create products and services that improve our daily lives!

Three: Venture Capital has historically produced superior returns than any other legitimate asset class.  According to the recent survey of Thompson Reuters, venture capital continues to exceed Nasdaq and S&P returns across all time horizons, notwithstanding the closed IPO window and the so-called “fair value accounting” standards that often times artificially depresses portfolio values.  I’m not going to complain about “fair value accounting” standards but I do would like to say that while I’m sure fair value accounting has genuine motives, I can’t quite comprehend its relevancy to an asset class that’s inherently long-term in its orientations.  Because venture capital is a long haul sport, the context of its performance should be judged accordingly which means often times “common sense” would be a better gauge than “fair value accounting” when it comes to determining a long term asset’s intrinsic value. 

Thomson Reuters' US Private Equity Performance Index (PEPI)

Investment Horizon Performance through 9/30/2008

                    Fund Type                                          1 Yr             3 Yr             5 Yr             10 Yr            20 Yr

                    Early/Seed VC                                      0.2               3.8               5.1               37.2              21.6

                    Balanced VC                                        -6.4              7.4               11.5             14.9              14.7

                    Later Stage VC                                     8.6              12.0             10.5             8.9                14.7

                    All Venture                                           -1.6              6.6                8.6              17.3              17.1

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                    NASDAQ                                              -21.4            -1.1              3.1               2.1                8.7

                    S&P 500                                               -22.0            -1.7              3.2               1.4                7.5

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                    All Venture (through 6/30/2008)           5.3              8.5               8.8               16.5              16.9

                    All Venture (through 9/30/2007)          26.6             11.0             6.8               17.8              16.4

Source: Thomson Reuters/National Venture Capital Association

My point simply is this: while I understand how venture capital can be an easy target to ridicule these days because of its illiquid nature, perceived risks, long gestation periods, perceived anemic performance vis-à-vis other asset classes, outsized compensation packages for its managers, etc., I believe this cynicism completely misses the point. 

Venture capital remains one of the true asset classes out there that adds real value to the long term sustainability of our society.  Sure venture capital is probably riskier than buying your average liquid marketable securities in the open market but I fail to comprehend how the world can become a better place if all you have is a bunch of market speculators and arm-chair traders buying bits and pieces of paper all in the name of liquidity. 

So yes, boys and girls, Venture Capital still matters!
(Image source: hedgeco.net)