Lots of money chasing too many bad ideas

All investors would like to think they make good decisions. Many think that by performing the right type of analysis or due diligence, they’ll be able to get more information about an investment target and so make a better assessment about whether or not to invest. So what about venture capitalists?

Hare and tortiseA recent article in The Economist reports investors have a voracious appetite to throw money into venture capital (VC) funds focussed on promising start-ups. Marc Andreessen, one of the founders of Netscape Communications, announced in early July 2009 that he and his business partner had raised over $300m to invest in start-ups and it was oversubscribed. What’s interesting is that a month earlier, the Kauffman Foundation released a study concluding the US venture capital industry must shrink for it to be viable in the long-term. It found the industry has been stagnating, producing declining returns, and has grown far too big.

Although firms such as Google, Home Depot, Microsoft, and Starbucks were venture-backed, less than 20% of the fastest-growing comanies in the US had venture investors. In fact, only 16% of around 900 companies in the sample had venture capital backing. Further, the returns from the venture industry is 10% below a leading listed small-cap index on a ten year timeframe.

So there you have it, too much money trying to find the next big idea. Once investors wake up to the fact that the industry has not been producing spectacular returns, and has been charging a small fortune as a management fee, it’s inevitable they will reallocate their investments to other asset classes. The question is how long will it take?