It is tempting to seek to explain the out-performance of U.S. venture funds during the 1990s solely by reference to the amazing market conditions that flourished during the second half of the decade.
At the end of 1990 the Nasdaq index stood at a lowly 374, while by the end of 1999 it had risen to 4069. That is why it is tempting to seek to dismiss such out-performance on the grounds that “a rising tide lifts all ships.” If the equity market that provides your main exit route and your main exit valuation benchmark rises more then tenfold in a decade then, the argument runs, you would have to have been pretty stupid not to score good returns even if only by accident. Kleiner Perkins, for example, was reputed to have earned a transaction IRR in excess of 50,000% on its investment in Amazon.com based on 1999 stock prices, though it is unlikely that this was the real figure achieved in practice.
However, this argument is simplistic and pays little regard (or respect) to the very real skill base that exists among the best U.S. venture capitalists. Yes, by the end of the decade company valuations had risen to ridiculous levels. Yes, this was a genuine bubble and, yes, experienced and skilful venture capitalists who should have known better fell for its siren call in much the same way as others did, but much was achieved that was genuine and cannot be explained by this simplistic analysis.
High quality companies were created that are today acknowledged global leaders, many of which are solid technology businesses, such as Cisco, Sun, Intuit and Lotus, in addition to Internet success stories such as Google, AOL, eBay and Amazon. These are outstanding companies that would have succeeded in any equity market environment because they were based on sound business principles and run by highly talented individuals. Yet the “value-add” that their venture capital backers provided also played an essential role in their success.
While there have been some very honourable exceptions (Accel and Benchmark are two obvious examples), most firms in the Golden Circle have shown little inclination to spread their operations to other parts of the world.”
This value-add was largely absent in Europe during the same period, where most venture capitalists tended to have an investment banking or management consultancy background rather than the hard operating skills gained first hand by entrepreneurs. While there is ongoing debate as to the precise level of European venture returns during the ‘90s, there can be no argument that they were considerably lower than those gained by their American counterparts, and this lack of value-add, such an essential component of the U.S. venture model, undoubtedly played a large part in the lower returns. However, the accompanying table shows that, even so, European venture should not be underestimated. If we look at the performance of the best partnership in each vintage year then we see that certainly from about 1994 onwards there was at least one partnership in Europe each year that one would have been happy to feature even in a U.S. venture fund portfolio.
When comparing U.S. and European venture capital, there are a couple of points that need to be taken into consideration and which I am not sure are properly understood. First, with regard to the huge explosion in venture fund-raising and valuations, it is fair to say that while this happened in Europe to some extent it was not on anything like the same scale as in the United States. Valuations never reached the peaks they had scaled in the U.S., and more importantly, everything was a year or two later, which meant that the scope for making high returns by getting into bubble-type companies and out of them again in time before the market collapsed was much more limited.
Second, there is no doubt that the absence of anything like the Nasdaq was a severe drawback for European venture capital firms, and had a definite negative impact on their returns. In retrospect, Europeans should have invited (even implored) Nasdaq to come to Europe with a view to creating a global exit market for venture-backed companies. Instead, the Europeans decided to try to create Easdaq, which was a sad failure, only ever attracting a handful of companies.
Research suggests that it is extremely difficult for any two consecutive funds managed by the same venture firm both to out-perform.”
As I hope will be clear from what I have said already, I have no intention of understating the scale of the achievements of the U.S. venture community during the 1990s. This was truly staggering performance, and the level of skills required to deliver it was equally impressive. However, when comparing them with European returns, another thing that is frequently overlooked is that the startling levels of reported returns were actually made by a relatively small proportion of the available universe of U.S. partnerships, for which I coined the term “Golden Circle” some years ago.
There is general consensus on who is or is not likely to figure on the list, and it may be as few as a dozen names, and certainly no more than a couple of dozen. I am not suggesting that the funds managed by these firms consistently out-perform time after time. On the contrary, what research has been done suggests that it is extremely difficult for any two consecutive funds managed by the same venture firm both to out-perform. It is more a general pattern of out-performance, probably about two funds out of every five, and it seems self evident that it is the absence of this annual cluster of Golden Circle type returns that has been one of the major factors in the differential between historic U.S. and European returns.
One of the many challenges facing the venture industry in other parts of the world, such as Europe, is to grow such a Golden Circle. It is as yet too early to come to any definite conclusions on how this process is developing, but there are some encouraging signs. Recent data from VentureOne shows that of the eight $1 billion-plus venture-backed company exits worldwide since 2002, four were European. Moreover, if one excludes Google, then the European exit multiples have been dramatically higher (presumably reflecting lower entry valuations). It remains to be seen whether this can be translated into the sort of regular out-performance that characterizes a Golden Circle.
I would, however, venture a further contrarian thought. Just as the challenge is for the venture industry worldwide to develop its own Golden Circle, the challenge for the existing Golden Circle in America is to develop worldwide. Few would argue that the venture business has become global, so can it really be a valid policy any longer to back only those companies within an hour’s Ferrari drive of Sand Hill Road? While there have been some very honorable exceptions (Accel and Benchmark are two obvious examples), most firms in the Golden Circle have shown little inclination to spread their operations to other parts of the world. I would suggest that they have already missed out on a hugely attractive opportunity, and that the gravity of this strategic mistake will become more apparent with very passing year.
The preceding article was extracted and adapted by Guy Fraser-Sampson from his new book “Private Equity as an Asset Class.” Fraser-Sampson may be reached at firstname.lastname@example.org or his website at http://www.guyfs.com.