Sunday, December 12, 2010

It IS broke!

I was referred to an article written by 2 professors and published recently in The Journal of Applied Corporate Finance.  Made me wonder how anyone can make a living as an economist?  You get 3 of them in a room and you can get 3 different opinions about virtually anything.  Most of the time all 3 of them are wrong.  It is titled "If it ain't broke:  The Past, Present and Future of Venture Capital".  Check this out if you have the stomache to get through it.

http://faculty.chicagobooth.edu/steven.kaplan/research/kaplanlerner.pdf

In the spirit of their econometric black box analysis I offer the following rebuttal:
  • In 1960 business capital spending in the US was $30B and ITC represented 9% of that or $2.7B.
  • In 2001 business capital spending in the US was $877B and ITC represented 39% of that or $342B.
  • In that period business capital spending increased at a CAGR of 8.8%, ITC spending increased at a CAGR of 14%.
  • Over 100% of venture capital returns came from ITC between 1960 and 2001 (other sectors showed overall negative returns).
  • After significant declines ITC capital spending in 2008 recovered to the level of $300B, a decline of 14% since 2001.
  • Total capital spending during that period remained nearly flat at $810B.
  • ITC declined as a percentage of total capital spending to 37%.
  • After 40 years of outperforming the economy by nearly 50% per year, ITC spending, the engine of Venture Capital has significantly underperformed since 2001. (Who can't make money investing in a sector that is outperforming the economy by 50%?)
  • Do you wonder why the venture fund returns since 2000 have been negative?
  • With ITC running at 37% of the total capital spend, future ITC spending will approximately track the economy and will not outperform it.
  • Venture capital thrives in immature markets with lots of white space. Mature business sectors present significantly smaller venture capital opportunities because the scale and coverage of the incumbents is overwhelming and they control the paths to market.
  • The "historical results" of the Venture Capital industry occurred during a completely anomalous period when the investment sector was hugely outperforming the economy as a whole.
  • That period is definitively OVER.
  • The Venture Capital Industry in 2001 was (over)sized to reflect a bubble.  that bubble has popped.
  • There is, at the moment, no replacement investment area which can be leveraged to provide similar "rising tide" returns for the industry.
  • The past only predicts the future until something changes and then it doens't any more.
"If it ain't broke.."???

It IS broke!

 

4 comments:

  1. What does ITC stand for? Thanks

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  2. So what will replace it? Who will be the LPs of the next wave of funds?

    Or will the alternative asset strategy currently employed by so many institutions fall by the wayside as pension funds and endowments try to manage the wreckage on their own front?

    Who will finance the next wave of biotech, high tech, etc. startups?....

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  3. Does ITC=information technology & communication? In any case, it makes sense that information technology spending drove VC returns in the past, but cannot continue to play such an outsize role in the future.

    If there's any hope for VCs, it's that they can latch onto another sector poised for immense, secular growth in the not-too-distant future. It's hard to identify such a sector right now -- they all have certain flaws. My best guess is mobile devices. In any case, until such a sector is identified, the VC industry ought to be right-size -- but it won't happen without a buyer's strike (i.e., LPs cut down their investments). But considering most LPs are institutions that tend to double-down after VC losses (rebalancing!), I wouldn't count on it.

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  4. I just love the way you work. Thanks for sharing this great and interesting stuff. Fabulous post! I really enjoyed that.

    ReplyDelete