I had the opportunity to talk with a couple of venture capitalists on a recent trip to the UK (part of "Silicon Valley comes to Cambridge"). I found the numbers interesting: a typical VC will look at several hundred prospects each year, seriously consider perhaps 10%, and fund 2-3. The lifetime of an average company is 6 years before the VC will exit, which means a relatively small steady state portfolio.
I wonder about the welfare effects of this approach to capital allocation. Essentially a single decision maker investigates an investment in the setting of a VC, and the variance of return on any given investment is quite high. I'm curious whether an economy that increasingly employs venture capital to fund innovation is essentially choosing a huge increase in variance on its return on investment.
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It's interesting that you mention venture capital and efficient capital allocation in the same sentence. I think the main reason why venture capital is so profitable is because the venture capital market is so inefficient.
David Swenson makes this point in his book Pioneering Portfolio Management. In Table 4.4 on page 77, he lists the returns for 1st, 2nd, and third quartile managers in different asset classes. For venture capital, 1st quartile managers earned 25.1% from 1987 to 1997 while third quartile managers eaned 3.9%. In contrast, 1st and 3rd quartile managers in US equity earned 19.5% and 17.0% respecitively.
The implication is that US equity markets are so efficient that skill doesn't add much value while venture capital markets are so inefficient that skill makes a huge difference.
Perhaps if society invested more in venture, the additional capital would make the markets more efficient and decrease the variance.
Nice! Thanks for the reference, that's a cool statistic.
It would be interesting to develop a comparative model for this. I'll have to see if the finance folks have already done something like this already.
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