The last year of the 20th century (debatable as that fact may be to some) proved to be the capstone year in the 50-year history of the U.S. venture capital industry as the industry shattered commitment, investment, initial public offering and performance records all in one year. It may seem anticlimactic to talk about the stratospheric returns to the VC industry in 1999 given the extreme public market turmoil in the spring of 2000. However, in many ways the two events are so interconnected that they must be examined in concert.
The venture industry returned a staggering 146% for the year ending December 1999 and has consistently outperformed buyout funds over the last 10 years. Figure 1 highlights the results to the industry for various time periods and fund types. The remarkable story, of course, is the resurgence of early-stage investment. It culminated in nearly a 250% return to investors in 1999, and over the past five years has been in excess of 60% annualized, thus explaining the tremendous infusion of capital into the industry over the last few years. In 1999 alone, the industry invested over $50 billion while raising another $46 billion for investment.
VC and Public Markets Relations Intensify
The U.S. VC industry and the public markets have, as of late, become so inextricably intertwined that it may be virtually impossible to separate the effects of one on the other. The public markets have provided liquidity, valuation information and validated investments.
Of course the “new economy” has been in the forefront of the news for the last five years. The Internet has fundamentally changed much in the world, and the venture capital investors who have created much of the technology impetus for the growth of the Internet have reaped the rewards as the public markets embraced the new companies coming out of the investments.
However, the public markets have proven to be a double-edged sword. As the industry has looked toward the public markets for more and more liquidity, the median age to exit in 1999 approached 3.5 years as compared with 6.5 years in 1993. As a result, the investment, valuation and exit became compressed over a shorter time period, making the industry increasingly sensitive to events in the public markets. Using Venture Economics’ VentureXpert database to calculate the quarter-to-quarter returns to investors in the venture industry, we compared these returns with the quarter-to-quarter returns to Nasdaq, the primary exit market for venture-backed IPOs.
The high degree of correlation between the two series is clearly demonstrated by inspection in Figure 2. The obvious difference is the higher degree of volatility in the public market returns as compared with private market returns. This is most likely an artifact of the valuation techniques used in the private markets. Although venture capital valuations of portfolio companies have been increasing aggressively over the past few years, the lack of true “market prices” dampens down the volatility to venture funds.
The correlation between various sub-sectors of the industry with Nasdaq is highlighted in Figure 3. Not surprisingly, later-stage funds have a higher correlation coefficient with Nasdaq than early-stage funds. It is also not surprising given that later-stage funds are “closer” to exit, they have a theoretical close affinity to public companies.
What does this correlation mean for the industry? Probably the chief result is that the institutional investor can no longer count on venture capital investment to be a truly diversifying vehicle in their asset allocation modeling exercises. The investor cannot invest in the industry as a commodity basket of investable assets like an index, but must be able to select funds that provide the most return for risk and diversification.
’90s Showcase Public Market Impact
The industry has accelerated its investment over the last few years, and while the short-term performance is spectacular, it is largely driven by unrealized portfolio valuations rather than realized returns. Figure 4 examines cumulative cashflow for funds formed since 1990. While the Venture Economics Performance Database has cashflows for funds formed since 1969, the decade of the 1990s is most illustrative as to the impact that the public market has had. It is evident from Figure 5 that funds formed since 1990 have yet to break even on their investment as the rate of investment has outpaced the rate of distributions back to investors. As a result, funds formed since 1990 are in a net negative cashflow position, which has only recently begun to be reversed as distributions from IPOs and other exits in 1999 increased dramatically. However, most dramatic is the geometric increase in the net asset values of funds as the valuations of companies in general partner portfolios increased in response to the extreme valuation increases to companies in the public markets.
It is this increase in net asset value that contributes to the extremely high returns over the last couple of years but, in particular the unprecedented short-term returns for 1999 found in Figure 1. And that is what makes the performance in venture capital funds extremely sensitive to swings in the public markets.
Figure 5 provides total returns for funds formed since 1990 separated into realized and unrealized performance, calculated by cumulative distribution to cumulative paid-in capital as realized performance and net asset value to paid-in capital as unrealized performance. It is easy to demonstrate that while total returns to investment have been about 2.7 times invested capital, distributions still have paid back all capital with only about 80 percent of invested capital being returned (distribution to paid-in capital). The rest of the return is based on unrealized value in portfolios.
What does the future hold?
While these results are only as current as year-end 1999, the turmoil in the public markets since mid-March should indicate that short-term performance should decrease when the 2000 first quarter results are released in early July. However, the real effect of the public markets on short-term performance probably will not be seen until the second quarter of 2000 as much of market downturn has occurred since the end of the first quarter this year.
Why does short-term performance matter? As the industry has accelerated its investment cycle and the time to exit has decreased so dramatically, the fact that portfolio valuations have increased so dramatically in the short run is indication that the industry itself is becoming more and more influenced by short-term factors.
What does the future hold? If the venture capital market continues to be influenced in the short run by public market performance, one only has to watch what happens to the technology-weighted public markets such as Nasdaq to see the short-term performance effects on the private venture capital market.
Figure 1: Net Returns to Investor
FUND TYPE 1YR 3YR 5YR 10YR 20YR
Early/Seed Venture 247.9% 75.6% 63.2% 31.5% 22.7%
Balanced/Diversified Ventu 122.0% 46.8% 39.8% 21.9% 16.9%
Later Stage Venture 70.2% 33.8% 36.4% 26.5% 18.7%
All Venture Capital 146.2% 53.8% 46.4% 25.2% 18.8%
Buyouts 25.9% 19.0% 18.6% 16.6% 20.0%
Mezzanine 8.0% 8.9% 10.0% 11.0% 11.4%
All Private Equity 61.1% 31.4% 28.5% 20.3% 19.3%
Figure 3: Correlation of Performance of
Venture Partnership with NASDAQ
Fund Type w/NASDAQ
Later Stage 80.9%
All Venture 70.3%
Methodology Returns are calculated net to investors after fees and carried interest. Investment horizon results are calculated as point-to-point IRRs using the beginning net asset value as a beginning cashflow and the net asset value at December 31, 1999, as the terminal cashflow and using those values plus any cashflows in the interim to calculate IRRs for the investment horizon in question. All performance calculations were derived using the performance database on Venture Economics VentureXpert online database.