These seem to be the best of times for Israel’s high-tech industry. Startups are being sold at record high valuations and are raising more money from investors than any time in a decade. Initial public offerings are becoming a routine occurrence after a long dry spell. Chinese and Russian investors are piling into the industry.
Yet Israel’s venture capital funds − the investors who are supposed to be the heart and soul of the industry, not just its wallet − are struggling. And that, in turn, leads to the question of whether they are providing competitive returns to their backers. Unfortunately the data on the VCs’ internal rates of return are one of the best-kept secrets of Israeli high-tech. The funds contend that their backers insist on keeping the information confidential.
“We are a private investment channel. Our advantage is that we maintain the confidentiality of the information. When we start disclosing, it’s a slippery slope,” said one industry source, who asked to be identified as M. It would be a mistake, he said, for venture capital funds to divulge such information.
In rare instances, such as the case of Jerusalem Venture Partners, the funds have taken the initiative on their own to provide at least partial information. Other data appear in reporting by the California Public Employees Retirement System, popularly known as CalPERS, which was investing in Israeli funds until a few years ago.
In an effort to get a broader picture, TheMarker surveyed returns over the past 15 years from about 30 Israeli venture capital funds. The data are from public sources as well as information from sources with access to the information. The survey is also based on background briefings from senior venture capital and institutional investors.
The data do not make for encouraging reading. Israeli VCs have not managed for the most part to profit from the success of the Israeli high-tech sector, providing lower returns than should be expected from the high-risk investments they make. Only four of 29 Israeli funds outperformed benchmarks such at the Tel Aviv Stock Exchange’s TA-100 index, for example. Three of the other four are too new to really get an accurate sense of their performance. Of the funds that raised capital between 2000 and 2007, none showed an internal rate of return − the industry benchmark − that would have made them an attractive investment from the standpoint of an institution. In fact, 14 of the 29 funds showed negative nominal returns.
Among funds established in 2007 and 2008, the JVP Media V fund has been a standout, with an annual net internal rate of return of 17.2%. But JVP IV, which was established nearly 15 years ago, had an IRR of just 3.2%. The Giza III fund, which was formed in 2000, had a minus 11.4% return. The Gemini III and Pitango III funds, which were started the same year, had returns of minus 6.3% and 0.3% respectively. The Carmel V fund, which was formed in 2005, had an annual net internal rate of return of just 1.8%.
Even in good years, the VCs generally had IRRs of just 2% to 3% annually, compared with 7% to 9% for the TA-100 index. The only VCs that performed better than the TA-100 after 2000 were formed after 2008, so the jury is still out regarding how they will have performed over the course of a full decade.
Israel venture funds are not alone on this score. Surveys of United States venture funds’ performance have shown similar results. But as measured against the top 25% of American VC funds, the Israeli funds haven’t been providing IRRs that would justify the risk, says A., a senior executive with a major Israeli institutional investor, who spoke on condition of anonymity. “If we were to have invested in leading funds in the U.S., we would have achieved much better results,” he says. Ironically, however, foreign venture funds, particularly American ones, have been successful in Israel.
For his part, B., another executive at an Israeli institution, says Israeli VCs had a very good run in the 1990s, when the funds were small and built much of their success on the dot.com boom that petered out after 20000. Since then, they have never matched that performance.
“There are exceptions, but in general the sector has been disappointing for a good many years. The consensus of Israeli institutions is negative .... The cumulative yield on venture capital is around zero,” he says, although he says their performance has improved recently.
“Investors expect returns in excess of the benchmark, which is usually the S&P 500 or the Nasdaq, in keeping with the high risk,” says G., a longtime figure in Israeli venture capital. “There [in the U.S.] there are no management fees and total liquidity. Over the years, institutions have come to expect the return on venture capital to be 17% a year.”
Another sign of failure
Another sign of Israeli VCs’ failure, one source notes, is that Israeli funds almost never charge variable management fees, which kick in only when investments are successful. “It doesn’t matter which fund you’re dealing with, the situation is rough. Even if managers have achieved a nice return at a particular fund, that doesn’t mean they’ll do it again with a new fund. That’s the difference between luck and ability, the consistency of the returns,” G. says.
“Venture capital around the world is in trouble, and Israel is considered a place producing worse-than-average results. There are several reasons for this, the main one being that the average exit for an Israeli company (when there is an exit) is smaller than for an American company,” G. says.
That is critical because one giant exit − a Facebook or a Google − will more than compensate for the many flops, enabling the VC to show double-digit returns over the entire portfolio. Ironically, it has been foreign, mostly American, VCs that have cashed in on Israel’s biggest tech success stories.
“Israeli startups produce returns that arouse envy even in New York and other hot areas,” says D., an Israeli venture capital executive who also asked not to be named. “If you take the big exits in Israel over the past five years, you can see that there are funds in the top quarter or top 10% that are consistently making money. All of them are foreign funds, such as Sequoia Capital, Bessemer Venture Partners and Benchmark Capital. There are funds that manage to generate returns in Israel. Why aren’t the Israeli funds there? Does a new generation of funds need to arise?”
Israeli VC executives acknowledge their limited rates of return up to now, but they also point an accusing finger at Israeli institutional investors, who they say prefer to engage in risky real-estate investments in Romania, for example, rather than invest in a critical section of the Israeli economy.
In fact, most of the sources of money invested in Israeli startups comes from overseas.
According to the IVC venture capital research center, the number of Israeli VCs that have made first-time investments in startups is static, at about 40 a year. But the number of first-time investments by foreign firms investing in Israel rose to 84 last year, from 26 in 2009. VCs that identify opportunities early and provide their portfolio companies with the support they need to grow have enjoyed a substantial payback. And that means that Israeli institutional investors that manage to gain access to the world’s leading funds active in Israel will increase their prospects of successful investing.
Highlighting a difference between Israeli and American institutional investors, G. says that American institutional investment in venture capital is done primarily by public entities and universities. They are serving the public interest, which makes it difficult for them to say they won’t invest in initiative and innovation. But, he adds, they invest small amounts relative to their total assets, so underperformance by the VCs doesn’t have a big impact on their returns. By contrast, institutional investors in Israel are corporate entities, reporting to investment banks, insurance companies and the public.
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