By Marcus Leach

A new report published by the National Endowment for Science, Technology and the Arts (NESTA) takes a comprehensive look at the performance of UK and US venture capital funds.

The report, ‘Atlantic Drift: Venture Capital Performance in the UK and the US’, reveals:

· The performance gap between US and UK has narrowed — but not because UK funds are doing better. Before the dot-com bubble, US venture funds enjoyed average internal rates of return (IRR) 20 percentage points higher than their UK counterparts (33% vs 13%). The average returns of UK and US funds raised since 1998 have been very similar. However, this is because average returns in the US have fallen rather than because UK performance has improved (-0.2% vs -1.2%). It is possible that the performance gap may reappear as US returns improve.

· The historical UK-US gap cannot be explained by the characteristics of the funds alone. Even when we compare funds with similar characteristics, the long-standing UK performance deficit persists. And when UK funds invested in the US, they did well. This suggests that an important cause of the performance gap was the existence of better investment opportunities in the US.

· The gap in returns between good and bad performing funds within a country was much larger than the gap in the average returns across countries. Selecting the right fund manager is more important than choosing the right country.

· The strongest quantifiable predictors of VC returns performance are: (a) past performance: whether the fund managers’ prior funds outperform the market benchmark; (b) whether the fund invests in early rounds; (c) extent of fund managers’ prior experience; and (d) whether the fund is optimally sized (being too small is very bad for returns, but once funds become larger than $365m, size is no longer an advantage).

· UK government backed funds have historically underperformed their private counterparts, but the gap between public and private returns has narrowed. This suggests that in later years governments have become savvier when designing new VC schemes.

Josh Lerner of Harvard Business School, a leading academic authority on venture capital, and co-author of the report, says: ‘Whilst our data shows a convergence in performance of US and UK venture capital funds over the last few years, this could be short-lived. Once again, US funds seem better positioned to take advantage of the emerging social media boom — fuelled by recent exits of LinkedIn and Skype - which threatens to widen the gap once more, leaving the UK sector behind.’

The research shows the progress that the UK has made over the last two decades and highlights the challenges that lie ahead. Whether the UK venture capital industry will be able to match, or even surpass, the performance of the US venture capital industry in the next decade will depend on the decisions taken by investors, fund managers and policy makers. The report makes three key recommendations for UK policymakers:

- Remember venture capital activity does not exist in a vacuum. The environment that UK startups faced was a major contributor to the UK historical gaps in venture capital returns. There are encouraging signs that the UK is becoming a better place for entrepreneurial ventures, but this cannot be taken for granted. Efforts to improve the conditions faced by those young innovative companies that could become the giants of tomorrow should be stepped up.

- Resist the temptation to over engineer public support schemes. In many instances, government requirements that limit the flexibility of entrepreneurs and venture investors have been detrimental. Recent programs appear to have mostly overcome the temptation to micromanage the entrepreneurial and venture capital process, but pressures to do so in the future should be resisted.

- Avoid initiatives that are too small. Policymakers must be sure that their venture initiatives have critical mass. Too often, UK efforts have led to the creation of undercapitalized funds which do not have the staying power to back their companies through development.

Stian Westlake, director of policy and research at NESTA, says: ‘Venture capital is widely perceived to be an engine of growth for the economy, acting as the driving force behind the development of innovative, high growth firms. This research gives us a critical insight into the performance of the UK market and the factors associated with fund performance which allows us to develop frameworks for developing and supporting this sector.’