Myth Busted - All Venture Caps Make Money

Tickers in this article: FB INPIX JAMFX
NEW YORK ( TheStreet) -- It's an accepted fact in the market that venture-capital firms, angel investors and private-equity firms are the participants that clean up during an IPO. Or do they? Usually when a company goes public, these are the parties that look as if they've made a bundle. The headlines shout how much a small investment has paid off. It makes the average investor feel as if he didn't get the same opportunity for the big payday.

When Facebook(FB) went public, some of the hype generated was due to the parade of early investors that made millions on their relatively small investments. This made small investors figure it was a deal they wanted to get in on. If the smart money liked it, it must be good; if they made millions, so will I.


The facts, however, contradict the myth. It turns out that venture-cap returns haven't significantly outperformed the market since the late 1990s, according to a study by the Kaufman Foundation. Since 1997, less cash has been returned to investors than has been invested. Only four of 30 venture-cap funds with over $400 million in committed capital delivered better returns than a publicly traded small-cap common stock index.

Kaufman analyzed 100 different funds and found that a majority of the funds -- 62 out of 100 -- failed to exceed returns that investors could have gotten in the public market after fees and carry costs were paid. Fees are a sticky subject. Typically VCs earn 2% per year for a management fee for the first five years of a fund. On top of that, they also take 20% of the profits of each deal when it is sold; this is commonly known as the 2 and 20.

Most people believe that VCs are paid by performance. However, two different studies determined that they earn one-half to two-thirds of their revenue from the management fees -- essentially making them very handsomely paid asset managers. If the VCs are so good at making sweet deals like Facebook, then why, a smart investor might ask, are they so dependent on these fixed fees?

Of course, most people are more than willing to pay for performance if their investment can beat the market. Kaufman's data looked at the years between 1989 and 2010 and found that only 25 of 96 funds beat the market by 3%. So maybe the grass isn't greener on the other side, unless you are in with the popular crowd. It seems the great returns are concentrated in a small number of select firms. Cambridge Associates noted there are about 50 "top-performing" VC funds. So if you are hoping to beat the public odds with a venture-cap manager, then only go with the top tier names.