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Who is the Real Enemy? Thoughts on the Kauffman VC Bombshell

May 11, 2012

Brad Svrluga

The VC business has been in a bit of a tizzy over the past few days in response to a bombshell of a report that the Kauffman Foundation released on Monday.

The report, dramatically entitled “We Have Met the Enemy … And He is Us” (link to a summary and download of the full report here; or, better yet, Felix Salmon’s scathing summary), details the rigorous analysis that Kauffman recently completed of their own experience investing more than $650MM as an LP in over 100 venture capital funds (managed by 60 separate general partnerships) over the past 27 years.

The Kauffman Foundation, self described as “the world’s largest foundation devoted to entrepreneurship” is a leader in thinking and research on entrepreneurship. Through its research efforts, it’s Kauffman Fellows program and its activities as an LP has made important contributions to the cause of entrepreneurship in America for decades.

In this week’s report, they make a bold effort to tackle some long term, systemic issues in the way the venture capital industry works. More simply, they call out the industry, and the relationships between Limited Partners (the individuals and institutions who invest in venture funds) and General Partners (the venture capitalists themselves), as being fundamentally broken.

Kauffman ultimately places blame on themselves and their peers in the LP community, saying that they have collectively lacked the courage to do the right work to fix some known flaws. Fred Destin, one of the best thinkers I know in the GP community, has provided some valuable thoughts about a path forward for LPs. Fred Wilson, on the other hand, quipped (after offering some constructive thoughts) that as a last resort, “We can just retire.”

In the days since the report was released it has dominated the dialogue in the industry, and there’s certainly been a lot of understandable jumping on the Kauffman bandwagon. It’s been cool for awhile, after all, to say that VC is broken. I agree with much of the commentary – particularly the following:

  • Industry returns are ultimately driven by a small number of the best funds
  • Large funds, on the whole, struggle mightily to perform
  • Industry dynamics have created incentives for aggregating assets under management rather than driving for asset appreciation
  • Management fees are a black box that often result in bloated GP W-2’s
  • Industry data and standards for performance reporting are deeply flawed and likely misleading

But after a collection of interesting discussions about the report in recent days with a handful of sophisticated, experienced LPs (whose confidentiality I shall respect here), I’m left with a couple key questions.

First, what was Kauffman’s motivation in writing the report? Certainly there are issues in the industry, and questions that need to be brought to the surface of the discussion about the relationship between LP & GP. But were they actually interested in discouraging investment in the asset class? Clearly that’s part of what’s going to happen, as asset managers on the margin view this as the clear invitation to stop worrying about venture.

For someone who is by their very mission focused on supporting the nation’s entrepreneurial ecosystem, this aggressive stance against a critical component of that ecosystem may be counterproductive, despite being on point about a number of the issues.

Of course, as one LP pointed out to me, every LP out there probably wishes that a lot more LP capital would leave the market. After all, nobody questions that industry returns are indeed driven by a handful of the best funds. And those funds are VERY difficult to get into. So it follows that if a bunch of LP capital left the market, access to top funds would, on the margin, improve. I doubt that was Kauffman’s motivation, but as I spoke with a few LPs, there was an undeniable twinkle in their eye as they thought about that effect, and the opportunities it might open for them.

Regardless of their motivations, there seems to be a material issue in that Kauffman chose to only look at their own data, but then make sweeping statements about the entire industry and asset class. Sure, they have a lot of data over a long period of time, but is it truly representative? Any proper academic study would have made a point of working with data from multiple LPs and to build a representative data set. After speaking in the past couple days with LPs representing 5 other large, experienced venture portfolios, it sounds like the Kauffman venture portolio is both not representative and, in fact, a really poor performer.

In fact, one of these LPs shared with me their own detailed data, presented exactly the way the Kauffman analysis was presented (they were scrambling together a private rebuttal to use with their clients and prospects). The difference in performance was staggering. It kind of felt like I was looking at Tom Brady’s passing stats after spending 2 days digesting a damning report on the passing game based on Mark Sanchez’s stats. Sure, both guys play quarterback for good NFL teams. If Mark Sanchez was your quarterback, you might conclude that a heavy emphasis on the passing game wasn’t that good an idea. But if you had Tom Brady, well. . .

Having now seen an array of data from multiple LPs, it seems like we might have had a Mark Sanchez report dumped on us this week.

I hope some group of thoughtful LPs out there will have the courage to write something of a public rebuttal to the Kauffman Report. But I have little confidence that it will happen, because nobody has real incentive to do it.

It’s hard to imagine a public pension fund doing it – they don’t want to wade into a debate like this. And it’s hard to imagine a fund of funds manager doing it – they’re in the business of aggregating assets of their own, and are probably better served doing the sorts of analyses I saw this week, but then keeping it to themselves and using it in their sales efforts. That leaves the foundations, university endowments, and private pensions. Will they feel more motivation to support the reputation of the asset class or to make a rational choice to sit back and let some of their competition fall away? Probably not, as their self interest is maximized by dollars leaving the asset class.

It will be interesting to see where the discussion goes from here. As I said earlier, I do very much agree with many of the remedies Kauffman has proposed for challenges in the industry. Smaller funds, greater GP commitments to the funds (where practical), and rethinking management fee structures and other efforts to better align GP-LP interests. Their suggestion that LPs get into direct investing strikes me and others as rife with challenges, but that’s a story for another post.

Kauffman has done us a service, at some level, by shining a bright spotlight on a set of issues that people have been talking quietly about for quite awhile. And maybe this will help push some solutions that help the industry in the long run.

But I’m also concerned that the alarmist and less-than-scientific way in which they chose to present their analysis will likely get a number of good babies thrown out with the bathwater. That’s both a shame, and a bad thing for our economy.

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3 Comments

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  1. marksbirch #
    May 13, 2012

    I was with you until the Tom Brady/Mark Sanchez analogy. That was just cruel and uncalled for…

    I do agree though and that was my first thought on reading the report, it was only one organization’s data. While a more expansive view of the industry would be fascinating, I imagine that self-interest would keep the players from openly sharing.

  2. May 15, 2012

    Brad. How many venture funds spend 20% of their time (every day) looking 30 years back and 20 years forward? For example, doing so in my sector would reveal that the arbitrage between the retail cost per bit and underlying economic cost per bit is the widest it has been and be investing in infrastructure in transport and broadband. Investment in this area is the lowest I can remember. Using this approach typically results in a contrarian investment position. But I see funds focused on the flavor de jeur across most sectors. I would be more than happy to go through a dozen portfolios and qualitatively and quantitatively substantiate this claim. One way around this is for VCs to develop well structured ecosystems around long-term trends and nurture them through academia, govt and industry information exchanges, as the public markets are driven by the crowd and next quarters’/years’ results. As a public equity analyst I always said that a good stock picker needed to look 3-5 years out. Why? Because the 12 month price/valuation is based on perception of things to come in 6-12 months. “Things to come” in 18-24 months will be shaped by market and company events resulting from management planning decisions in years 3-5. VCs should be doubling or tripling that perspective. Do you and your brethren have that perspective or the informational structures to support that beyond word of mouth and back slapping driven relationships and blogs? Michael

    • May 15, 2012

      I certainly agree, Michael. There’s definitely too much chasing of the flavor du jour. That said, I also see an increasing number of firms working to develop the sort of focused, trend/thematic driven investment approaches. Time will tell how they do. We are certainly working hard at High Peaks to become increasingly theme driven, and are actively avoiding the more ephemeral consumer web stuff. In doing so, i know we’re going to miss some great opportunities, but as a team, we know we just don’t have the ability to pick ‘em.

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