VC Funds Caught Between a Rock and a Hard Place

Venture capital firms continue to struggle to return cash to investors, raising concerns about the long-term prospects of obtaining funding from limited partners.  The 10-year return for VC funds dropped to -4.2 percent in the first half of this year, down from 14.3 percent a year ago and below the S&P 500 average return of -1.6 percent, according to a report from the National Venture Capital Association.

The numbers come from the NVCA’s Cambridge Associates U.S. Venture Capital Index, which reported on VC performance through the second quarter of this year. While performance has outpaced market indices over the 3-, 5-, 15- and 20- year horizons, the 10-year return reflects the ongoing challenges in producing worthwhile exits for investors. Even with a recent modest rebound in IPOs and mergers and acquisitions — there have been 21 IPOs in the first half of this year — venture-capital returns have not been significant for limited partners. This marks a full decade without positive returns collectively from venture firms, a crunch that will likely winnow out some firms. The last vintage year to return more than the capital paid in by investors was 1998, when investors made back $1.30 for every dollar they invested.

This difficulty in returning capital is likely to increase the pressure on venture-capital firms, as they try to raise money from increasingly skeptical investors. VC fundraising has slid from about $16 billion last year and $28 billion in 2008 to about $9 billion through the first three quarters of this year.

Venture firms are increasingly getting used to working with less money, placing more early bets on cash-efficient startups like Internet and software companies. A drop in VC fundraising may not be critical in the short term if firms learn to make do with less. But with the rise of angel investors, VCs are facing even more pressure to compete for early seed startup deals. A longer-term drought in fundraising could also leave VC firms unprepared to take advantage of larger opportunities that require more capital. The hope for the VC industry is that IPOs and mergers continue to grow, following in the footsteps of Skype and Demand Media — although, as Stacey noted, even a few public offerings are not likely to return the industry to the headier days of a few years ago.

There are also plenty of companies like Facebook, Zynga, Yelp and Twitter that are forgoing big exits as they make do with more private equity investments, which allow them to remain private and avoid some of the headaches of being a public company. Looks like the industry will have to continue to hunker down and focus its energies on becoming more efficient as it waits for the market to recover.

Related content from GigaOM Pro (sub req’d):

Post and thumbnail photos courtesy of Flickr user Darrren Hester.