Disclaimer: I’m an armchair economist and an armchair VC watcher. Sounds like you have real experience and real numbers to argue from.

Yes, my argument hinges on the presence of supernormal profit. But it’s the VC partners who got it, not the institutional investors. The 3% management fees, the 20% carry–that’s more than what they should have gotten in a perfectly competitive market for financial intermediary services. Why did institutional investors put up with it? If the returns didn’t make up for it, I don’t know why they wouldn’t just go with more liquid and safe investments.

It’s like the hedge funds of today. For the past few years, they’ve been able to demand these outrageous fees because they exploited inefficiencies in the markets and produced above-average returns. Now that so many people are pursuing similar hedging strategies, the opportunities for supernormal profit are being squeezed out and hedge funds aren’t compensating their investors for the costs that those investors pay to invest with them. So, investors are moving on.

Again, I’m basing this on my armchair view of it all. I don’t invest in or run a hedge fund, but I do have a subscription to the Wall Street Journal
I’ll have to read your article when I have more time. I’m very interested in pursuing this analysis further. I’m also interested in what people think is going to happen with Web 2.0 type services–will people just fund them with a credit card and then charge users to create revenue? Is advertising truly feasible as an ongoing revenue generator for say, a newsreader or a mashup builder? I’ve heard Bloglines hasn’t added advertising to their service because they think users wouldn’t stand for it. So how are they making any money to sustain themselves?

Thanks again for the comments, and I’ll look forward to reading your article when I’ve dug through my morning work.

Your fundemental point is based on the assumption that VC firms make a “supernormal profit”. I discuss some about venture capital economics in my post On Being an Angel http://www.lifewithalacrity.com/2006/01/on_being_an_ang.html — if we start with an hypothetical venture capital fund of $500M, it will have 47 losses and 2.5 successes. The fact that that they invested $25M and recieved $250M for the each successes doesn’t show the the losses for the failed ventures. Add in 3% annual management fees, inflation over 10 years, and the 20% carry for the VCs, many VC funds don’t do as well for institutional vendors as the stock marketplace. These numbers are very transparent to the institutional investors, so if the VCs were making too much money, they’d be pushing these numbers significantly down.

Oh yes, and software is dead. This is why VC’s miss every wave, they’re non-technical herd animals driven by fashion.