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Venture Capital and the Finance of
Innovation
Lecture Notes 4: VC Fund Performance
Professor Luke Taylor
Roadmap
This lecture: How should we evaluate the performance of a single VC fund?
Four approaches:
IRRs Value multiples GVM PME
Data on fund performance Next lecture: How should we evaluate the performance of the VC industry?
Evaluating VC Performance Method 1: Average annual return on invested capital Weights each year equally Example: Jan. 1, 2007: $1M investment Dec. 31, 2007: $2M exit & distribution Jan. 1, 2008: $10 M investment Dec. 31, 2008: $6M exit & distribution Return in 2007 = Return in 2008 = (Arithmetic) Average annual return = Any problems with this approach?
Evaluating VC Performance Method 2: Internal rate of return (IRR) The rate of return that implies an NPV of 0 for a given cash flow stream Weights each dollar equally Example from before: Jan. 1, 2007: $1M investment Dec. 31, 2007: $2M exit & distribution Jan. 1, 2008: $10 M investment Dec. 31, 2008: $6M exit & distribution
Any problems with this approach?
5 steps to calculating IRRs for LPs As LPs, there are 3 components that contribute to your net cash flows each year: fees, new investments, and distributions. 1. Calculate fees 2. Calculate distributions to LPs:
Distributions to LPs = total distributions - carry 3. Calculate net cash flows = Distributions to LPs - new investments - fees 4. For the IRR of a fund that is T years into its life and is still alive, the
value of unrealized (i.e., remaining) investments at the end of year T is counted as if it is a positive cash flow. This is an estimate value of illiquid investments and not a market/transaction value.
• Cash flow if final year of IRR calculations = Distributions to LPs - new investments - fees + portfolio value of remaining unrealized investments
5. IRR(year 1,…, year X) = IRR(CF1, …, CFT)
Example 1 The $200M fund CroMem I has completed 6 years of its 10-year life.
Fee = 2.5% of committed capital Carry = 20% of profit after return of committed capital See next slide for its annual investments, portfolio values before and
after exits (if any), and distributions (exits).
Complete the cash flow table for CroMem I. Fill in the grey cells
Example 1 year 1 2 3 4 5 6Investments 20.0 60.0 40.0 20.0 10.0 0.0portfolio value (before exits) 20.0 85.0 146.3 202.8 363.5 328.9Total distributions 0.0 0.0 0.0 0.0 80.4 223.5Total distributions (cumulative) 0.0 0.0 0.0 0.0 80.4 303.9carried interestDistribution to LPscumulative distrubutions to LPsport value after distributionsManagement fee
committed capital 200management fee 2.50%Invested capitalManagement fee (cumulative)Contributed capital
Cash flows to LPscash flows if final year of IRR calculations IRR (%)cash flow stream ending in year 2cash flow stream ending in year 3cash flow stream ending in year 4cash flow stream ending in year 5cash flow stream ending in year 6
Example 1: Solution year 1 2 3 4 5 6Investments 20.0 60.0 40.0 20.0 10.0 0.0portfolio value (before exits) 20.0 85.0 146.3 202.8 363.5 328.9Total distributions 0.0 0.0 0.0 0.0 80.4 223.5Total distributions (cumulative) 0.0 0.0 0.0 0.0 80.4 303.9carried interest 0.0 0.0 0.0 0.0 0.0 20.8Distribution to LPs 0.0 0.0 0.0 0.0 80.4 202.7cumulative distrubutions to LPs 0.0 0.0 0.0 0.0 80.4 283.1port value after distributions 20.0 85.0 146.3 202.8 283.1 105.4Management fee 5.0 5.0 5.0 5.0 5.0 5.0
committed capital 200management fee 2.50%Invested capital 20.0 80.0 120.0 140.0 150.0 150.0Management fee (cumulative) 5.0 10.0 15.0 20.0 25.0 30.0Contributed capital 25.0 90.0 135.0 160.0 175.0 180.0
Cash flows to LPs -25.0 -65.0 -45.0 -25.0 65.4 197.7cash flows if final year of IRR calculations -5.0 20.0 101.3 177.8 348.5 303.1 IRR (%)cash flow stream ending in year 2 -25.0 20.0 -20.0%cash flow stream ending in year 3 -25.0 -65.0 101.3 9.6%cash flow stream ending in year 4 -25.0 -65.0 -45.0 177.8 15.7%cash flow stream ending in year 5 -25.0 -65.0 -45.0 -25.0 348.5 33.6%cash flow stream ending in year 6 -25.0 -65.0 -45.0 -25.0 65.4 303.1 27.2%
Example of a J-curve
Average IRR over time
Source: Cambridge Associates
IRRs are net of fees, expenses, and carried interest. The average is dollar-weighted across funds. Based on sample of 1,401 U.S. VC funds.
-20
0
20
40
60
80
100
120
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
IRR
(% p
er y
ear)
Vintage year
Variation in IRR across funds + over time
Source: Cambridge Associates
IRRs are net of fees, expenses, and carried interest. Based on sample of 1,401 U.S. VC funds.
-40
-20
0
20
40
60
80
10019
8119
8219
8319
8419
8519
8619
8719
8819
8919
9019
9119
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
0320
0420
0520
0620
0720
0820
0920
1020
11
IRR
(% p
er y
ear)
Vintage year
Upper quartile
Median
Lower quartile
-60
-40
-20
0
20
40
60
80
100
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Vintage Year
Net
IRR
Sin
ce In
cept
ion
(%)
VC funds Buy-out funds
.
VC vs. Buy-out funds
Source: Thomson Reuters / NVCA
Evaluating VC Performance Method 3: Value multiples Value multiple = realization ratio = investment multiple = multiple of money
= times money = absolute return Value multiple =
Weights each dollar equally Example from before (assume no fees): Jan. 1, 2007: $1M investment Dec. 31, 2007: $2M exit & distribution Jan. 1, 2008: $10 M investment Dec. 31, 2008: $6M exit & distribution Value multiple, Dec. 31, 2007 = Value multiple, Dec. 31, 2008 = Any problems with this method?
fees management capital investedsinvestment unrealized of value LPs toonsdistributi Total
++
Multiple value multiples Value multiple =
Value multiple = Realized value multiple + unrealized value multiple
Realized value multiple = Unrealized value multiple = GVM (gross value multiple) = GVM = raw investment return gross of fees and carry Value multiple = how much money LPs make net of fees and carry
fees management capital investedsinvestment unrealized of value LPs toonsdistributi Total
++
fees management capital invested LPs toonsdistributi Total
+
fees management capital investedsinvestment unrealized of value
+
capital investedcarrysinvestment unrealized of value LPs toonsdistributi Total ++
Useful transformation of definitions For a fully-invested and completed fund,
capital investedcarry sinvestment unrealized of value LPs toonsdistributi Total ++
=GVM
capital investmentLPs) and GPs (to onsdistributi Total
=GVM
fees management capital invested
sinvestment unrealized of value LPs toonsdistributi Total multiple value+
+=
capital CommittedLPs toonsdistributi Total multiple value =
5 steps to calculating value multiples There are 3 components that contribute to value multiples: Total (cumulative)
distributions to LPs, value of unrealized investments, and contributed capital.
1. Calculate distributions to LPs each year. • Distributions to LPs = total distributions - carry
2. Sum them to date to get total distributions to LPs 3. Get value of unrealized investments (after exits) = portfolio value (before
exits) - total exits in year t. This is an estimated value of illiquid investments and not a market/transaction value.
4. Calculate contributed capital = invested capital + fees to date. 5.
fees management capital investedsinvestment unrealized of value LPs toonsdistributi Total multiple value
++
=
Example of a fully-funded, expired fund year 1 2 3 4 5 6 7 8 9 10
Investments 20.0 60.0 40.0 20.0 10.0 0.0 0.0 0.0 0.0 0.0portfolio value 20.0 85.0 146.3 202.8 263.5 228.9 195.6 88.5 66.4 49.8total returned capital 0.0 0.0 0.0 0.0 80.4 93.5 124.8 35.4 26.6 49.8carried interest 0.0 0.0 0.0 0.0 0.0 0.0 19.7 7.1 5.3 10.0returned capital to LPs 0.0 0.0 0.0 0.0 80.4 93.5 105.1 28.3 21.2 39.8cumulative returned capital to LPs 0.0 0.0 0.0 0.0 80.4 173.9 279.0 307.3 328.5 368.4port value after capital returned 20.0 85.0 146.3 202.8 183.1 135.4 70.8 53.1 39.8 0.0Management fee 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0
commited capital 200 management fee 2.50% Invested capital 20.0 80.0 120.0 140.0 150.0 150.0 150.0 150.0 150.0 150.0Management fees (all years) 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0contributed capital 25.0 90.0 135.0 160.0 175.0 180.0 185.0 190.0 195.0 200.0
What is the value multiple at the end of year 10? What is the GVM at the end of year 10?
Example 2 You’re an LP trying to decide whether to invest in Alpha Ventures or
Beta Ventures. Which do you prefer?
VC firm Historical GVM Historical value multiple Alpha Ventures 4.2 3.5 Beta Ventures 4.0 3.9
True or false: Value multiple is always less than GVM.
Average value multiple over time
Source: Cambridge Associates
Based on sample of 1,401 U.S. VC funds. The average is dollar-weighted across funds.
0
1
2
3
4
5
6
719
8119
8219
8319
8419
8519
8619
8719
8819
8919
9019
9119
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
0320
0420
0520
0620
0720
0820
0920
1020
11
Aver
age
valu
e m
ultip
le
Variation in value multiple across funds
Source: Cambridge Associates
Based on sample of 1,401 U.S. VC funds.
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
519
8119
8219
8319
8419
8519
8619
8719
8819
8919
9019
9119
9219
9319
9419
9519
9619
9719
9819
9920
0020
0120
0220
0320
0420
0520
0620
0720
0820
0920
1020
11
Valu
e m
ultip
le
Upper quartile
Median
Lower quartile
Evaluating VC Performance Method 4: Public market equivalent (PME)* Steps: 1. Choose a publicly traded benchmark portfolio. (We’ll start with the NASDAQ but will find more sophisticated benchmarks next lecture) 2. Invest (or discount) the fund’s outflows using the realized total return on the benchmark 3. Do the same for fund inflows 4. Divide step 2 by step 3. If ratio > 1, then fund outperformed the benchmark Two versions: 1. “Gross” (raw investing ability): inflows = investments, outflows = total exit proceeds (to LPs & GPs) 2. “Net” (what LPs eat): inflows = investments + fees, outflows = total exit proceeds – carry
* For additional details, see Kaplan and Schoar (2005)
PME example
Date InvestmentExit
proceeds
NASDAQ value (with dividends) Investment
Exit proceeds
1/1/2001 13443/12/2001 15 1352 14.91
4/1/2001 25 1300 25.855/20/2001 10 1402 9.59
1/4/2006 40 1691 31.7911/11/2009 15 1220 16.52
Total 50 55 50.34 48.32GVM: 1.1 PME: 0.96
Actual $ amounts Discounted to 1/1/2001 = 15 x 1344 / 1352. To make the $15M
capital call, you would have had to invest
$14.91 in NASDAQ at fund’s inception.
= 40 x 1344 / 1691. By investing $31.79 in
NASDAQ at fund’s inception, you would have gotten $40 on
1/4/2006. The fund did 0.96 times as well as equivalent
investment in NASDAQ.
Any problems with this approach?