I was recently having lunch with a venture capitalist friend in Palo Alto. Talking generally about the merits of technology economics, and sprucing up conversation with quotes from Prof. Paul Romer on the importance of technology transfer etc., we were in vehement agreement at every turn.
Until it came to bragging rights, that is, returns.Now I may not be the third name partner after Kleiner and Perkins (who knows the third name anyway?), but I do have a few venture capital investments myself. So it would be fair for me to call the venture capitalists crap shooters. He took offense at my remarks. Oops. For a moment there, while I was happily eating arugula salad with Valley greatness (you’d know this guy by his first name alone), I forgot to keep my opinions to myself. But you see, much of what I said is not even contested. Top 5% of the firms make outsized returns, and average firm loses money.
J. Lerner. Boom and Bust inthe Venture Capital Industry. Federal Reserve Bank of Atlanta Economic Review 2002
Given the sheer statistics at play with technology entrepreneurship, almost (there is benefit to diversification) the same skewness and kurtosis apply to its investors. One big lucky hit makes the numbers alright. Two big lucky hits make the man, and three make the firm. The so-called best deals come to that firm first, and the man’s calls are returned by everyone who is anyone. If the odds of making a big hit were 1% ceteris paribus, now they are 10% for this firm (Sequoia? Kleiner?). That edge is self-sustaining over the years but even the best of the past can be a victim of the statistics (how many would say Mayfield is in the top these days). Anyhow I digress and back to my lunch.
I was happy to hear that my friend’s fund was in the top quartile with an IRR of around 23% on his 2002 vintage fund. Now I was facing greatness with somewhat impressive returns to back it up. But then I understood why venture capital is a great industry. For venture capitalists. After fees and expenses, net IRR to investor in that same period was about 10%.
As an asset class, venture capital’s top 5% is amazing but you cannot put your money there (unless you were there from the beginning), the rest is a fool’s game. Then again, venture capitalists do not see themselves as an “asset class,” most would not even know how much S&P 500 returns annually.
To avoid ending on a sour note, let me show you how you too can be a technology venture capitalist spurring technology innovation. You will not be able to benefit from the fees, but you can have the ultimate bragging rights. Taking cues from the “Little Book that Beats the Market,” I will give you a free lunch today:
On the first trading day of the month, calculate the PEG ratio of each and every public technology company (GIC=45) using their 5-year growth estimates. Price to Earnings adjusted by growth is one of the most common ratios out there. This exercise gives you one set of rankings. Then also rank these companies by dividing their current price by their 52 week high price. These two simple ratios combined in equal weight ranking would then deliver you a final universe. Eliminate companies that are illiquid, too small, or too low in price (depending on your taste). Essentially you have captured the company’s value and the market’s reaction to it in two simple formulas.
Buy the top 20 companies in this universe spreading your dollars equally. Next month, same day, do your rankings again. If your company is no longer in the universe or is not in the top 50, dump it. If you made 20% on any company during that month, take profits.
Using a sophisticated database (without any look-ahead or restatement biases) we are able to replicate these ratios, do the ranking and follow this strategy on the first days of each month since 2002 to compare to my friend’s fund. Assuming you were slipping half a percent as you executed these trades, and paid 1 cent per share commissions your returns would like this:
So you, the venture capitalist, would have made 14.6% (geometric average) beating my buddy by about 5% and the index by about 7%. You would have probably lived the same highs and lows as well (imagine doubling your money in 2003 on that high flying company vs. losing some the year before and after). Too bad you cannot go out there and raise a half a billion dollar fund to become a “real” venture capitalist.