5 questions with Paul Kedrosky

Paul Kedrosky, a senior economist with the Kauffman Foundation, last week released a report called “Right-Sizing the U.S. Venture Capital Industry.” In it, he argues that to remain viable, the industry needs to shrink in line with the dwindling capital requirements and opportunities of the startups it funds.

PE Week Senior Editor Constance Loizos talked with Kedrosky about the report and why it’s relevant.

Q: Why write this paper now?

Because we’ve finally reached a point when [right-sizing] can happen. [Many] funds are at the end of their life span, 10-year returns are going to turn negative at the end of this year, and as they re-up, LPs have a choice to make.

Q: Are LPs responsible for helping to grow funds too fat and dragging down returns as a result?

It’s a little like buying IBM [shares] circa 1980; no one got fired for buying IBM. And no LP ever got fired for putting money into Kleiner Perkins Caufield & Byers and Sequoia Capital.

It’s not their fault, per se, but LPs feel like it’s the only place to put money, so they beat on the door until Kleiner takes it, then that’s how we wind up with funds that are too large. VCs are just doing what they’re naturally going to do. I think it’s better to put the blame at the feet of the LPs and ask: ‘What are you doing putting all this money into these massive funds?’

Q: What would prompt LPs to look elsewhere? As you say, no one gets fired for getting into Kleiner, despite how enormous its funds have grown in recent years.

LPs don’t have a choice anymore. The market has helped solve the problem by forcing LPs to reallocate. I also think that when 10-year returns drop from 35% on an end-to-end basis to negative territory later this year [when fund performance is no longer propped up by exits from the go-go dot.com era], that unbelievably precipitous drop will kick the last leg out of long-term horizon arguments.

Q: Do we need mammoth funds?

People will see that the last 10 years have been an experiment in megafunds and it clearly didn’t work. I think they’ll conclude that the solution is to allocate money to new funds that are investing smaller amounts of capital, such as First Round Capital [which raised a $125 million second fund last year].

Q: How would the absence of mammoth funds affect early stage investing?

A: A software startup today probably only needs a quarter of the amount of funding that they it 15 years ago to go from nascent business idea to viable business. Today, $100 million can do what $500 million did then. $100 million can carry a fund.

Where you need larger funds are in biotech. But you don’t need a giant fund just so that you can pour 25% of it into cleantech every year.

VCs often overdiversify to deploy the capital, or they become driven to find companies that need $10 million. It’s like trying to find a hole big enough to hold all the dirt you have. It’s a crazy way to invest.