By: Konstantin Danilov, AllAboutAlpha.com Editorial Board.

In his recently released paper, Paul Kedrosky of the Kauffman Foundation discusses current state of the U.S. venture capital industry and ponders whether its burgeoning size is limiting investors’ returns from the asset class. LPs have continued to allocate increasing amounts of capital to VC funds, despite the precipitous decline in performance over the past five years: the 10 year returns for the industry, as calculated for the author, are barely ahead of the Russell 2000 Index, and will turn negative in 2010 as dotcom bubble returns are excluded. The lackluster performance is a fairly recent phenomenon – the string of low to negative returns began in 2004 – which Kedrosky attributes to three potential causes.

Maturing Sectors

First, the “bread and butter” sectors for VC, IT and Telecom, have vastly matured over the past two decades. While open source technology and vastly lower networking costs have decreased the barriers to entry for IT startups, venture investments in the sector have yet to show a commensurate decline. In 2008, tech-related investing still accounted for more than half of VC investment on a dollar amount basis.

No Cash-Flows, No Thanks

Some point to the decline in IPOs in a post-Sarbanes-Oxley world as the main culprit behind the recent performance woes. While, in the past five years the annual number of VC-backed IPOs has declined to almost half of the late 90s average, it is still in line with pre-dot-com levels. Kedrosky argues that, relative to the late 90s, the market has become less willing to stake early-stage companies with negative cash-flows – a phenomenon which should not be expected to reverse. The problem, it seems, lies not with the exit market itself, but with VCs ability to bring attractive offerings to the market. More…