Evaluating the performance of venture capital investments

Business Horizons, Sept-Oct, 1994 by W. Keith Schilit

Unfortunately, there is a lack of data available on the portfolio performance of most venture capital firms. Some will not provide data because their investments are at too early a stage of development to reflect their performance or, simply, have not performed as well as expected. Other venture capital firms will not provide data because, as privately held venture capital firms investing in privately held companies, it is their policy to keep that information confidential.

A related concern. Regardless, an important concern of the industry is that, as portfolio performance industry-wide has declined, and as the number of venture capital funds and the capital being committed to those funds has increased so substantially, there may be a shortage of experienced venture capitalists or greater competition for good deals in which to invest. Unlike years ago, when venture returns were generally higher, the industry has become quite competitive, forcing venture capitalists to be more skillful in managing their portfolios.

Although there have been short-run "booms" in the industry as a whole for example, in 1961, 1967-1969, 1972, 1980, and 1983---in which venture capital funds realized returns of approximately 30 percent or more, the overall annual rates of return over the past 20 years have been less than 20 percent. It is not surprising that these boom periods have coincided with favorable markets for initial public offerings (IPOs) because the new issues market allows for liquidation of (privately held) venture capital investments.

Given that venture capitalists invest in ventures with high risk-return characteristics, the commonly held perception is that their portfolios would perform admirably. However, many of their investments have low or negative returns while few have substantial returns, which thereby reduces the returns of the entire portfolio. Research suggests that over the long term, 10 to 20 percent of the investments in a typical venture capital firm's portfolio are complete losses (compare these low failure rates to the 70 percent or 80 percent failure rate characteristic of new ventures throughout the population); 10 to 20 percent of the investments have annual rates of return of better than 40 percent; and fewer than 5 percent might be considered "superstars," with annual rates of return greater than 80 percent.

The popular notion (which is consistent with the JEC study cited earlier) is that venture capitalists strive for a 25 to 40 percent return--an increase of at least fivefold and, perhaps, up to 15fold--on their investments. Such returns are certainly possible for any given investment. However, the research cited above suggests that the portfolios as a whole have not experienced such high returns. It is less important to recognize that as venture capital funds have grown in size, and as their portfolios have become larger and more diversified, it becomes more difficult to realize the 30 to 40 percent returns that were prevalent over the late 1970s and the early 1980s.