Monday, July 25, 2011

The magnitude of the performance gap between US and UK venture capital funds

The importance of a vibrant venture capital industry in supporting growth is widely recognized, and consequently governments across the world have sought to promote the industry. But the development of the VC industry in the UK (and in many other countries) has been hampered by the low returns it delivers to its investors.

Understanding how the UK venture capital market compares to more successful ones, particularly the US market, is the first step towards improving the performance of the UK VC industry.

This report, entitled Atlantic Drift, sheds further light on the magnitude of the performance gap between US and UK venture capital funds, its evolution over time, and what the likely drivers of the performance differences are. It uses a novel database that combines data on VC fund performance and their investments in the US and UK for 791 funds raised between 1990- 2005. Therefore, it not only reports differences in aggregate performance across countries, but in addition it compares like-for-like funds, with the same focus, vintage year and experience, but located on opposite shores of the Atlantic.

The report is analyzed in an aiCIO article :

A new report has discovered that the performance gap in venture capital between the United States and the United Kingdom -- once a significantly large divide -- has gradually narrowed over the last decade.

The research by the National Endowment for Science, Technology and the Arts (NESTA), titled ‘Atlantic Drift: Venture Capital Performance in the UK and the US’, found that the reason for the convergence was largely due to average returns in the US declining rather than a noticeable improvement in the performance of UK funds.

“The convergence of returns has not been driven by UK funds becoming better, but by the worsening performance of US funds,” the report stated.

According to the research, the gap in fund returns between the average US and UK fund has fallen from over 20% before the dot-com bubble (funds raised in 1990-1997) to 1% afterwards (funds raised in 1998-2005). Furthermore, average returns for funds raised after the bubble in both the UK and the US have been relatively poor, but venture capital performance is likely to move upwards as venture capital funds begin to cash out their investments in social networks (particularly in the US). Thus, according to the author of the report, Josh Lerner of Harvard Business School, US funds -- better positioned to profit from the emerging social media boom with generally superior investment opportunities -- may forge increasingly ahead of UK funds in performance.

As outlined in NESTA's research, the strongest quantifiable predictors of venture capital returns performance are (a) whether the fund managers’ prior funds outperform the market benchmark; (b) whether the fund invests in early rounds; (c) whether the fund managers have prior experience; and (d) whether the fund is optimally sized (neither too big nor too small). Moreover, historical performance has been higher for funds located in one of the four largest investor hubs (Silicon Valley, New York, Massachusetts and London) and for investments in information and communication technology...

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