SAN JOSE, Ca. – Three years ago Venture Capitalist Timothy Draper graced the cover of a financial-industry trade magazine wearing a wide grin and a Captain America costume. Draper, the tagline said, had joined the “League of Extraordinary VCs” for his smart investments in Chinese search service Baidu and free PC phone service Skype. Both picks earned Draper’s firm, Draper Fisher Jurvetson, and one of its affiliates millions in profits.
Baidu and Skype are today highlighted prominently in DFJ’s press materials, and since late 2000 the firm and its affiliates have raised an estimated $3 billion for traditional high-tech investments as well as forays into new markets like Brazil and India. All that money has enriched DFJ’s partners: In the last ten years they’ve likely earned tens of millions in annual fees, Forbes magazine reports.
Lots of DFJ’s investors, though, are still waiting for their payoff. Many of the big universities, foundations and rich individuals who parked money in the firm’s flagship funds have yet to see a dime of profit from Baidu or Skype. Those homerun investments were made from a DFJ affiliate called Eplanet Ventures, in which only some of DFJ’s investors participated. (DFJ declines to say how many.)
The investors in other big DFJ funds raised around the same time as Eplanet have come up empty. The return on the DFJ’s $640 million Fund VII, raised in 2000, is a sickly – 2 percent as of Sept. 30, according to quarterly statements sent out to the fund’s investors. So far it has paid back only $115 million to its investors, even though the fund is entering the ninth year of its ten-year life and should be realizing more gains. Many investments have been marked down significantly. Investors would have been better off buying the S&P 500 index, which is down 0.4 percent annually in the same period.
The venture capital industry is staring at the most vicious shakeout in its history. Returns are pathetic for most funds, the public offering pipeline on which venture depends for its exit strategy is clamped shut, and with the shares of many big publicly traded tech companies swooning, those firms are less likely to buy up promising upstarts.
Tim Draper can find plenty of sympathy on Sand Hill Road, that rarefied stretch of pavement in Menlo Park, Calif. that is home to the world’s premier VC firms. The median annual return for all venture funds raised in 2000, the peak of the dot-com craziness, is -1 percent, according to research firm Cambridge Associates. By that measure DFJ doesn’t look so bad.
Where Draper won’t find much sympathy is with the pension funds, foundations and well-heeled investors who make up the base of venture firms’ investors. These so-called limited partners have always looked to venture as a way to sweeten conservative portfolios with some concentrated bets in high-flying software and biotech upstarts. The venture firms earn between 2 percent and 2.5 percent of their capital under management and retain 20 percent to 30 percent of any profits. In exchange for their fees, VCs were counted on like heroes to spot and nurture the next Ebay, Google, Genentech and Cisco, firms that have made the U.S. the world’s incubator for innovation.
Heroes of capitalism they’re not. It has been 11 years since the venture industry has returned more cash than it has plowed into investments, according to the National Venture Capital Association. The industry is now managing $257 billion, up from $64 billion in 1997.
“There are way too many people in the business,” says Kenneth Goldman, the chief financial officer of VC-backed Internet security company Fortinet and an investor in other venture capital funds. A shakeout in the industry has been a long time coming but could finally be at hand.
Joshua Lerner, a professor at Harvard Business School, recently analyzed returns, net of fees, for 1,252 U.S. venture funds going back to 1976. The median return for top-quartile firms was 28 percent. That included the huge profits of the tech boom, which aren’t likely to recur. The median return for all venture funds was just under 5 percent, or worse than what Treasury bonds would have given you.
“If you’re not with the good guys, it’s not worth playing,” Lerner says.
It would be helpful if there were some way of knowing in advance which firms are going to be the good guys. Apart from those in the very top tier, which consistently outperform, it’s difficult to know.
That’s always been the case in venture. But since equity markets cratered earlier this year, many big investors are scrutinizing all their holdings more closely. Illiquid investments like venture-backed startups don’t look so hot. VCs “have been living off fumes for a long time now,” says one prominent Silicon Valley investor. “If you have any money, the last thing you’re going to do is put it into an asset class that hasn’t generated a return for ten years.”
Research firm Private Equity Intelligence unearthed other dismal figures: Menlo Ventures’ 1999 fund had a – 13 percent annual return as of the end of 2007. Menlo Managing Director H. DuBose Montgomery says the 1999 fund “has not completed its performance cycle and has several promising portfolio companies with large revenues, which are still private.”
The data also show that Mayfield’s 2000 fund is off an annualized 7.4 percent over the same period. (That firm declines to comment.) Sevin Rosen Funds in Dallas is in even worse shape: Its 1999 fund had lost an annualized 23.4 percent as of March 2007, and a fund raised one year later in 2000 was down at 17.6 percent per year as of the end of 2007. Partner John Jaggers says the 1999 fund had improved slightly, with a compound annual return of – 17 percent. He adds:
“None of the interim [return] numbers mean anything until the end of the fund.”
Some investors are belatedly voting with their feet, shifting future allocations within their private equity portfolio out of venture capital or dumping existing stakes in venture portfolios entirely. In February the $129 billion California State Teachers’ Retirement System changed its allocation goal and now aims to invest only 0.5 percent of its total portfolio in venture capital, down from 1.3 percent previously.
The collapse of the public stock markets and other asset classes means many traditional VC investors, like pension funds and university endowments, are having to ratchet back their holdings in private investments like venture capital. Christopher J. Ailman, in charge of investments for the California teachers�?? fund, says that much of the drop in his venture allocation is the result of the fund’s bigger relative position in private equity buyouts. But a September consultants’ report also noted that “the difficulty of gaining access, and making material commitments, to the top-performing venture capital funds has contributed to the decline in venture capital exposure.”
Is it possible that VC firms are in it for the annual fees as much as for the 20 percent to 30 percent carry? They raised $36 billion in 2007. At the standard management fee of 2 percent, that yields $720 million a year even if there are no gains.
Draper’s firm, in written responses to questions, says, “The vast majority of our compensation comes from the investment performance of our funds.” Draper’s Fund VII from 2000 has made small chunks of money selling companies such as Mobile 365 and Xfire to larger acquirers, but there have been no public offerings from the portfolio to date. Eighteen companies are worth less than the firm paid for them, and 13 companies have been written off completely, according to the September report. The firm adds that it’s too early to judge the success of this fund, which could contain “many winners.”
DFJ’s $375 million Fund VI from 1999 posted a 2 percent annual return as of September and has returned only $135
