The VC model is not broken. It's just working too well ... - Pham Capital

To venture, or not to venture.? The venture capital business is going through one if its periodic Hamlet cycles, which seems to happen historically every decade or so.

Since the publication of the Kauffman Foundation report on venture capital last month?which famously declared that the traditional ?investment model is broken??VC has been taking its share of lumps. The Kauffman report places most of the blame on the fundamental structure of VC today, arguing that incentives are not properly aligned between fund managers and limited partners (i.e., investors in venture funds).

Such misalignment almost certainly exists, but I believe it is only part of the story.? I?m not going to wade into all the arguments, many legitimate, about problems in the ways that funds are structured.? Yes, the model can be improved.? But?I believe there are bigger, systemic causes at work.? Therefore, let?s step back and take a bigger picture view.

When we look at the venture industry as an entire ecosystem, rather than as a bunch of individual firms or a portfolio of deals, we can draw a surprising conclusion: lower returns are probably what we should expect when the VC industry is performing efficiently, rather than inefficiently.? Over a series of three columns, I will try to explain why, what it means, and how to seek better returns for investors.

Argument #1: The risk premium does not function in practice as it does in theory.

Theoretically, in finance, higher risk means higher reward.? This is a basic proposition of modern portfolio theory.? This principle seems to hold true across most types of capital.? For example, risk-averse retail bank lending?which requires secured assets and strict capital ratios?tends to generate small returns.? Meanwhile, high-risk private equity (the artist formerly known as leveraged buyouts) tends to generate relatively high returns.? It?s what we call the?risk premium?investors get rewarded for risk.

But in the venture capital business, everything seems to go haywire.? Risk and reward are not correlated, as a blackboard economist might expect.? As one invests in earlier stages of company growth, the risk premium basically disappears, if not completely inverts.? Here is a diagram from my new book on innovation ecosystems, The Rainforest: The Secret to Building the Next Silicon Valley.

In the left graph, we see what theory says should happen: the earlier you invest, the riskier it gets, and the more money you should make.? In the right graph, however, we see what happens in reality?the risk premium starts to diminish in early-stage venture capital, and then completely vanishes in seed-stage investing.? There is a marked divergence between theory and practice.

Ask most practicing venture capitalists, and they?ll basically affirm the notion that, at a certain point, investing at earlier stages of company development is not rewarded commensurately.? Ask yourself why the world isn?t flush with more seed-stage investors, if the risk premium actually exists?? Moreover, why don?t private investors sink money into basic RD, rather than run away from it?? At a system level, curiously enough, investing in the earliest stages of enterprise formation seems to obey its own laws.

The surprising result from this perspective is that more efficient venture capital markets?in terms of healthy, robust?competition among skilled firms?will naturally see poorer returns, as more firms fight over the deals in a given sector.? Modern portfolio theory says it shouldn?t happen.? Yet it does.

But how could this possibly be?? How could so many brilliant economists get it wrong?? Does this mean that modern portfolio theory is flawed?

Well, I?ll save those answers for my next column.? The answers go to the heart of what makes some venture ecosystems like Silicon Valley generally thrive, while others languish.

Article source: http://www.forbes.com/sites/victorhwang/2012/06/27/the-vc-model-is-not-broken-its-just-working-too-well-part-i/

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