Top-Quartile Venture Capital Outperforms S&P 500 by Over 7% Annually, While Average VC Returns Lag

A recent tweet from Diego Basch has sparked discussion within the investment community, questioning the true efficacy of venture capitalists. Basch's post challenges whether VCs are "ultra capable of beating the SP500 to the test or if you were just locally optimal in taking money from LPs while giving them a worse return than the bond fund their money was previously in." This statement highlights a critical debate regarding venture capital performance compared to traditional market benchmarks like the S&P 500 and even bond funds.

Historical data from Cambridge Associates indicates that top-quartile venture capital funds have consistently delivered strong returns, averaging between 15% to 27% annually over the past decade. This significantly outperforms the S&P 500's average annual return of approximately 9.9% during the same period. Over a 25-year horizon, US Venture Capital has shown a 14.3% compound annual growth rate (CAGR) versus 7.4% for the S&P 500, resulting in nearly 5x more value from an initial $1,000 investment.

However, the picture changes for average VC funds. Many analyses suggest that the average venture capital fund has underperformed relative to expectations and public market benchmarks, particularly for those in the bottom quartile, where returns can be in the low single digits. Limited Partners (LPs) typically expect VC funds to significantly outperform public markets due to the higher risks, illiquidity, and longer holding periods associated with startup investments.

Comparing venture capital to bond funds introduces another layer of complexity. While bond funds, such as money market funds like Vanguard VMFXX, offer lower volatility and can provide steady income, their returns are generally much lower than equity markets over the long term. For instance, a $100 investment in 10-year Treasuries from 1928 to 2023 would have grown to about $7,300, whereas the same investment in the S&P 500 would have yielded over $787,000. Bond funds are also susceptible to interest rate fluctuations, with projected Fed rate cuts potentially lowering yields.

The tweet underscores the importance of manager selection in venture capital. Only top-performing VCs justify the fees and illiquidity, offering the potential for outsized returns. LPs face the challenge of identifying these top-tier funds, as average or below-average VC performance can indeed result in returns that are less favorable than more conservative bond investments or broad market indices.