Great to have hard numbers, but I doubt many are surprised at this result, or the primary reasons—"misalignment of incentives and overcapitalization." In short, VCs have an incentive to raise ever-larger funds from their limited partners since the bulk of their compensation is management fees calculated as a fixed percentage of the size of the fund. The carried interest incentive, a percentage of the portfolio gains, is a shrinking fraction of the management fee compensation. A VC has a greater incentive to raise more money than to manage it well. "The incentive becomes raising larger funds rather than generating stronger returns."
There's also an interesting corollary.
As VCs have raised ever-larger funds, the challenge of putting that money profitably to work has gotten harder. Larger funds have directly impacted the ability to sustain outsize portfolio gains. While Frankel doesn't say so explicitly, it's obvious that the VC herd instinct, combined with ever-larger funds, creates a situation of too many dollars chasing too few good deals. Hence the growing valuations and diminished returns. It also creates more me-too investing where VCs feel compelled to invest in each hot new investment area, even if they are picking up the second or third tier player.
One of the reasons angels have done better is that they invest in a much more diversified portfolio of businesses in a much broader array of industry sectors.
As I have argued for years, VC returns (and investor returns generally) would be improved by more daring investment behaviors, particularly breaking out of the software rut and taking the time to learn about new industries and the relatively untapped opportunities they afford to back truly game-changing technologies and companies in sectors mostly not explored by software-besotted professional investors. Also, as Frankel notes, there are better returns in focusing more on seed stage companies and in diversifying geographically. The valuations are lower, the competition for deals is less intense, and the upsides are eye-catching.
Smaller funds, focused on the angel space, with deep resources for due diligence and an ability to help their companies get to the next level, should outperform... [The ff Venture Capital] strategy [of being an institutional player in the angel space] is one that very few others follow... The firm grew out of my personal angel investing, and, rather than grow into a standard venture firm, we have taken the stance of hacking the venture model by staying in the angel space. We invest in early stage companies all over the country as well as internationally, combining the rigor and resources of a venture capital firm with the market strategy of an angel. We deliberately run relatively small funds.
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