Power Law in VC Returns too

The Venture Capital Math Problem.

That’s right, it’s the power law again (I recently discussed with regards to iPhone apps and Twitter users).  Fred Wilson is saying that there was still too much money in VC in ’08 (agree) and he’s trying to figure out how big the VC asset class should given the returns we are seeing (and I agree with his approach).

So here’s the venture capital math problem. We need $150bn per year in exits and we are getting about $100bn. That $100bn produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor’s capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.

The issue that I suspect most people will have (I haven’t read the comments on his post yet) is that this is largely an academic exercise if you don’t calibrate the assumptions.

But Fred’s result is important because he tells us what VCs admit to each other but not to the public:

The venture capital asset class does not scale. You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage.

If you want an example of funds that can scale, compare VC to hedge funds and private equity funds.  Sequoia realized this a while ago and looked at starting a hedge fund.

“Less money, more personal attention.”  – Jerry

I guess Fred is the Jerry Maguire of venture capital.

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One thought on “Power Law in VC Returns too

  1. Totally agree with your part regarding the main importance of it centering around the fact that LP’s are admitting it doesn’t scale.

    Personally, I see the solution as more funds, less size. Rather than less funds, more size.

    Everyone has their own solution to the problem, but at least the top vc’s and LP’s recognize there is indeed a problem.

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