Paul Kedrosky: Don’t Blame Greedy VCs for Industry Bloat, Blame LPs

Paul Kedrosky, a senior economist with the Kauffman Foundation, is releasing a report on Wednesday titled “Right-Sizing the U.S. Venture Capital Industry.” In it, he argues that to remain viable, the industry needs to shrink in line with the shrinking capital requirements and opportunities of the startups it funds.

I talked tonight with Kedrosky about the paper (get it here) — and why it’s relevant right now.

Funds have long been accused of having grown too fat and dragging down returns as a result. Why write this paper now?

Because we’ve finally reached a point when [right-sizing] can happen. [Many] funds are at the end of their life span, 10-year returns are going to turn negative at the end of this year, and as they re-up, LPs have a choice to make.

LPs are responsible for the bloat?

It’s a little like buying IBM [shares] circa 1980; no one got fired for buying IBM. And no one ever got fired for putting money into Kleiner and Sequoia. It’s not their fault, per se, but LPs feel like it’s the only place to put money, so they beat on the door until Kleiner takes it, then you wind up with funds that are too large. VCs are just doing what they’re naturally going to do; I think it’s better to put the blame at the feet of the LPs and ask: what are you doing putting all this money into these massive funds?

What’s going to prompt LPs to look elsewhere, though? As you say, no one gets fired for getting into Kleiner, despite how enormous its funds have grown in recent years.

LPs don’t have a choice anymore. They accidentally overallocated; since then, the market has helped solve the problem by forcing them to reallocate. I also think when 10-year returns drop from 35 percent on an end-to-end basis to negative territory later this year [when fund performance is no longer propped up by the go-go dot.com era], that unbelievably precipitous drop will kick the last leg out of long-term horizon arguments.

You’d think, though I sometimes wonder if it will take the likes of John Doerr and Mike Moritz either doing business differently, or eventually retiring.

Succession is definitely a big problem at the marquee funds. Even now, if you were to look under the hood, many of them of them look stovepipeish. They may have one or two interesting people, but the rest of the team has gone elsewhere or retired.

You’re never going to see Kleiner starve to death, but I do think people will say: the last 10 years has been an experiment in megafunds and it clearly didn’t work. I think they’ll conclude that the solution is allocate money to new funds that are investing smaller amounts of capital, like First Round Capital.

You don’t think we need any mammoth funds? Who does the later-stage deals for the seed-stage funds if exit opportunities don’t open up?

In software, you probably need a quarter on down of the amount that you needed 15 years ago, in order to go from nascent business idea to viable business. Today, $100 million can do what $500 million did then; $100 million can carry a fund.

Where you need larger funds are in biotech and the like. But you don’t need a giant fund just so that you can pour 25 percent of it into clean tech every year.

So let’s emphasize portfolio theory a little bit less?

Definitely. VCs often overdiversify to deploy the capital, or they become driven to find companies that need $10 million. It’s like, I need to find a hole big enough to hold all the dirt I have. It’s a crazy way to invest.