Batten Bulletin: March, 2011
Reports about the state of U.S. venture capital are alarming. IPOs are few and far between, returns are down, and risk aversion is up. The future is uncertain, at best—what looks like a market correction to one observer is the demise of the entire VC industry to another.
Researchers, such as Darden professor Susan Chaplinsky, who want to get beyond the media accounts for a more-detailed picture of returns to VC investments face many challenges. Transparent measures of performance do not exist; instead, outcomes are self-reported, so successes seem to outnumber failures. Fund-level returns—which industry observers frequently cite—do not expose deeper trends and patterns in the form of exit because they represent an aggregation of outcomes. As Chaplinsky notes, “It’s called ‘private’ equity for a reason.”
In a recent study, Chaplinsky and Swasti Gupta-Mukherjee, an assistant professor at Loyola University, have provided the first detailed account of VC returns from 1985 to 2008, supporting and expanding the current understanding of the industry’s worrisome trajectory. They have also developed a measure that sheds light on VCs’ investment decisions and their increased risk aversion in the face of diminishing returns.
In the study, Chaplinsky and Gupta-Mukherjee estimated returns for 1,222 M&A exits and 1,436 IPO exits over the 23-year period, which they divided into three eras: pre-dotcom (1985 through 1997), dotcom (1998 through 2000), and post-dotcom (2001 through 2008). Tracking returns by type of exit—IPO, M&A, or write-off—yielded a particularly valuable view. As expected, across the study period IPOs generated extremely high “home run”-type returns more frequently than M&A exits, which have long been considered the exit of last resort for VCs. Consistent with the reports of deteriorating returns to VC investments, the period is marked by an increase in M&A, from 25.4% of total exits in the pre-dotcom era to 41% during the dotcom era and 63.4% in the post-dotcom period, during which 68% of those exits resulted in negative returns. Indeed, the researchers found a relatively high incidence of M&A and IPO investments with nearly 100% loss of capital, a stark reminder of the risks VCs face, not just in challenging economic times. They write, “That VCs lose almost all of the capital invested in a significant number of exits cautions against the frequent practice of equating an exit with ‘success.’”
The frequency of large losses also underscores the importance of home-run returns. As part of their study, Chaplinsky and Gupta-Mukherjee developed the exit-to-failure (EXF) ratio, which captures how many failures are covered by exits on average. The two researchers have computed EXF ratios across various industries, month by month, and have found that the ratio provides important signals about how VCs use recent exit returns in an industry to guide their investment decisions. When EXF levels in an industry are high, the upside offered by returns is large relative to the downside of failed investments. “Higher levels of EXF imply greater failure coverage and a lower penalty for mistakes, and therefore potentially higher VC risk appetite,” the researchers write. The reverse is also true: Low EXF levels in an industry indicate an environment in which VCs are unlikely to find lucrative exit possibilities and so will have little cushion to protect them from failed investments. Without that cushion, risk aversion naturally increases.
The picture that emerges from the study is of a vicious cycle: VCs adapt to lower returns by moving away from early-stage ventures—the kind that represent substantial risk but also could be capable of generating outsize returns. Instead, they invest in more-developed businesses, from which they are likely to exit with an M&A. And so they decrease their odds of achieving home-run IPO exits—and turning around the declining performance of the VC industry. Escaping this downward spiral will take time, given the ten-year commitment of most VC investments.
The shift to M&A exits, the deterioration of returns, and the decreased appetite for risk raise questions about the nature of the U.S. VC industry, which built its reputation by supporting high-risk, high-growth ventures. A willingness to take risks, Chaplinsky argues, has long been a defining characteristic of the U.S. economy and business environment. “Without healthy returns, it’s hard to sustain a VC industry that’s willing to take chances on promising ideas,” Chaplinsky says. “VCs have little coverage for failures, which leads them to feel they have no margin for error. Right now, the economics of the industry make it hard to swing for the fences.”