Venture returns build momentum, will LPs rush back in?

In picking strategies within private equity, investors largely got it right betting heavily over the last three decades on leveraged buyout funds. That said, venture capital firms have staged a significant comeback since the woebegone years following the Internet bubble, and they could pose competition for dollars in the months ahead.

VCJ affiliate publication Buyouts analyzed returns generated by 13 different categories. That study revealed that domestic and international buyout funds were among the best-performing private equity funds (see accompanying chart). The sample of 588 domestic buyout funds (excluding turnaround funds and growth equity) generated a bottom-quartile IRR of 4.9 percent IRR, median of 10.4 percent and top-quartile of 17.7 percent. The comparable figures for Buyouts’ 206-fund international buyout sample come very close to that, at 4.3 percent, 8.9 percent and 17.3 percent.

Altogether this year Buyouts gathered return data on more than 2,000 individual private equity funds, most of it current as of year-end, with vintage years covering nearly three decades ranging from 1981 to 2009. The data comes from nearly three dozen pension funds and related organizations, including California Public Employees’ Retirement System, California State Teachers’ Retirement System and New York State Common Retirement Fund.

Other strong-performing categories, based purely on absolute return numbers, include domestic turnaround and distressed debt funds, domestic growth equity funds, secondary funds, co-investment funds and private debt funds. On the weaker side are real estate, funds of funds and domestic venture capital funds. International venture funds, by contrast, have done reasonably well.

Of course, the absolute return numbers say nothing about how much risk fund managers operating in the different sub-strategies take to achieve these returns. They say nothing about how much illiquidity investors have to endure, nor how returns vary from year to year. Case in point are mezzanine firms, which invest higher in the capital structure than buyout firms (taking less risk) and which start returning money to investors almost immediately (providing greater liquidity). In light of those factors, many investors would applaud the bottom-quartile, median and top-quartile IRRs of 6.4 percent, 8.6 percent and 11.5 percent achieved by domestic mezzanine firms.

Venture capital firms pursue an especially risky strategy, backing unproven startups in fast-moving industries such as technology and healthcare. Investors expect to be compensated for that risk with higher absolute returns. That they haven’t been for much of the last dozen years contributed to a mass exodus of institutional money from the asset class. But as the charts below show, venture capital has plenty of momentum, based on a sample of 447 domestic venture funds.