The Reason Venture Capital Is Not Building What Society Needs

The venture capital industry is relatively small compared to other facets of financial services and it has some restrictions on how it can invest.

And while flying taxis or dinner-scheduling apps have plummeted in significance compared to a cure for Covid or social injustice, the reality may be that it just isn't big enough or important enough to address global or even national issues. But it would be helpful if its very opinionated libertarian prognosticators would show a tad more humility. JL

Jamie Powell reports in ft Alphaville:

Venture capital invested $133bn in the US in 2019. The 6 largest S&P 500 by capital expenditure - including Alphabet and Amazon - spent $132bn. US venture capital ended 2019 with $444bn of assets under management. Hedge fund assets were $3.2tn. It could be argued the industry does often invest in things we need, but perhaps things we know we don’t need yet. Venture has the highest cost of capital of any alternative investment. Its institutional investors expect mega-returns on their money. This means that venture chases industries that have yet to scale, or simple industries that have yet to be disrupted.

Venture capital is an industry that’s got used to being in the line of fire.

Whether it’s the outrageous wealth it creates for its largely white male employees, the questionable sources of its capital or the sometimes comical failures of the ventures it funds, the media loves to dunk on those that invest in high-growth start-ups that aim to change the world.

Some of these critiques are, of course, fair. For instance venture capital does, as we know, have a serious diversity problem. A 2018 NVCA-Deloitte survey found that just 14 per cent of VC partners are female, and just 3 per cent are Hispanic or latino. Almost four-fifths of employees are white.

But for every fair critique there are ones that lurch over to into the unreasonable. So it was with a lengthy MIT Technology Review article titled “Why venture capital doesn’t build the things we really need”, published over the weekend.

Although hard to summarise concisely, the 4,000-word article follows the fortunes of an admirable healthcare start-up named Ophelia as it navigates the well-trodden path to venture capital investment via the YCombinator accelerator (a sort of school for start-ups). Along the way it pointedly asks: why is venture capital so obsessed with software, social media and biotech when there are so many problems — from renewable energy to education — that need fixing in the world?

It’s a tricky question, and the article comes to some good conclusions. But there’s also an elephant in the room — when you think about it, that’s not venture capital’s remit. Let us explain.

First, it’s important to take step back and look at venture capital as part of a much wider universe of capital allocation across the financial and corporate sector.

US venture capital ended 2019 with $444bn of assets under management, according to the NVCA. By way of comparison, Blackstone, the world’s largest private equity firm, manages $538bn alone. On a sector level the difference is even more pronounced: hedge fund assets were just under $3.2tn at 2019’s end, according to BarclayHedge, seven times that available to venture capital’s US general partners. In short, in the world of alternative investments it’s a relative minnow. That makes funding change hard.

It’s not just alternative assets that make venture capital’s apparently big splashes look like rain drops in a puddle. According to PitchBook and NVCA data, venture capital invested $133bn in the US in 2019:

That may sound like a lot but consider this: the 6 largest S&P 500 constituents by capital expenditure — a list that includes tech names like Alphabet and Amazon — spent $132bn alone over the past year, according to S&P Global data. Zoom out and you’ll find the top 100 cash-splashers from the US’s premiere index spent $587bn, more than quadruple the entire US venture capital ecosystem. If we’re expecting venture capital to fund the things we need, then why not also harangue the chief financial officers of those with the deepest pockets?

Smaller amounts of capital to deploy also means that venture capital seeks industries that aren’t going to eat it all up: namely software and biotech. As Ben Thompson of the Stratechery blog has noted, both these industries have high fixed costs and low marginal costs, which means when you’ve put the required amount of capital in to scale, little additional investment is needed. Critics of this view may point to Tesla as an example of a start-up in a capital-intensive industry that scaled, but the majority of the cash it’s eaten through — circa $18bn and counting — came after company listed back in 2010.

There are also plenty examples of venture capital getting involved in capital-intensive businesses that claim to be “tech”, and then losing their shirt. Think of asset-liability mismatch experiment WeWork, the previously mentioned Juicero or even Uber and it’s unremarkable underperformance since IPO. It’s not only difficult to continually back these businesses with limited capital, but when you do, it can be a painful process. You can understand some reticence, then, to entering sectors that operate in the world of hard assets.

But capital isn’t the only limiting factor in where it can invest: venture also has the highest cost of capital of any alternative investment. In other words, its institutional investors — from pension funds to endowments — expect mega-returns on their money. This naturally means that venture chases industries that have yet to scale, or simple industries that have yet to be disrupted. Software just about ticks this box today. Biotech definitely does. Education, renewable energy and transportation? Arguably less so.

That’s not to say venture capital isn’t adventurous; it just isn’t adventurous in fields where capital requirements are high, and possible returns are low. Take New York-based Lux Capital as an example. It’s funded several successful companies in fields that might be considered beneficial to mankind, including a brain-control company, a nuclear-waste specialist and robotic surgeons. It could be argued the industry does often invest in things we need, but perhaps things we know we don’t need yet.

Maybe the problem with venture capital isn’t so much what it does but how it acts. Canvass the talking heads of the venture world (which, admittedly, are a loud minority) and you’ll find a thin-skinned group who write long blog posts on how to reshape America, believe venture capital has contributed to 30 per cent of the US economy, and post philosophical tweets like they’re Zarathustra coming down the mountain. Sure, early funding for high-growth start-ups is important, and it can make you richer than God but, in the end, it’s just fees paid on other people’s money. Let’s not pretend otherwise.

We’ll offer our answer then as to why venture capital has failed to “build the things we really need” — simply, that’s not its job. So if it’s not its job, then whose is it? The libertarians among the venture capital community might be uncomfortable with the obvious answer (it rhymes with bluvernment).