Venture Capital’s Regression To The Mean

When I come across a great blog post, I attempt delay any thoughts on it immediately. Instead, I print the article out, read classic investment books, observe the market, reflect on it, and then I post my thoughts.

So I’ve had the chance to apply this methodology with Fred Wilson’s post recently regarding venture capital as an asset class.

He notes that one of his limited partners has declared the asset class to generate a return around 9%

Why would anyone want to invest in such a risky asset class with such an underwhelming rate of return?

Upon reflection, this really isn’t anything to be surprised about. Many people view the holding period of venture capital investments as 10 years. In reality it’s much shorter than that. I’d say 4-7 years. On average, 5 years. Why? Investments are made over time, not instantly.

Regression to the mean:

Regression to the mean is the historical occurrence of the market overreacting to short-term news and then under-reacting while awaiting new short term news. This pretty much sums up the dot-com era and what we’re in right now.

A while back, Morningstar published a report on the performance of different types of funds over a five year period:

5 years to March 1989

• International stocks: 20.6%
• Income: 14.3%
• Growth and income: 14.2%
• Growth: 13.3%
• Small company: 10.3%
• Aggressive growth: 8.9%
• Average 13.9%

5 years to March 1994

• International stocks: 9.4%
• Income: 11.2%
• Growth and income: 11.9%
• Growth: 13.9%
• Small company: 15.9%
• Aggressive growth: 16.1%
• Average: 13.1%

This is a perfect example: as you can see, the three groups that dominated in the first segment did worse than average in the second.

I believe we’re experiencing the same occurrence in the venture sector.

So what does this mean?

Bottom line: as a long-term asset class, venture capital is nothing special, really. On average it performs much like any other asset class; however, it has much more risk flowing through its veins. Perhaps, way back in 1953, Georges Doriot, the founder of venture capital, was correct when he declared, “venture capital is not fashionable anymore.”