Lecture 3 Venture Capital Returns Stylized facts • Gross VC returns slightly outperform but net VC returns slightly underperform the market index (more on this later). • The returns of VC funds are very persistent: Good funds continue to perform well and bad funds continue to perform poorly. – This evidence is largely inconsistent with the evidence based on mutual funds where persistence of (especially) good performance is very uncommon. – Important question: Skill or access to better deals? – If skill, not clear why better performing GPs are not charging higher fees! • Larger funds and funds with experienced GPs perform better. • Fund inflows to the sector increases after good performance. New funds can raise funding in boom times but most of these funds tend to perform poorly. • Better performing VC funds are more likely to raise follow up funds and larger funds. How to calculate fund returns? • Example: Imagine that you are an LP in the ABC fund and have committed $11m to the fund. Assume fees and carry are zero. – On January 1, 2007, ABC calls for $1m of your investment – On December 31, 2007, it exits the investment and returns you $2m – On January 1, 2008, ABC calls the remaining $10m for another investment – On December 31, 2008, it exits the second investment for $6m. • What is the return on your investment in ABC? – First year return is 100% and second year return is -40%. – You could compound these returns and find (1+1)*(1-.4)-1=20%. The annualized return is (1.2)^0.5 – 1 = 9.5%. – This calculation is economically misleading, because you gave the fund $11m and it returned to you only $8m. So you lost money, but based on the above calculation you appear to have earned 9.5% on an annual basis. – The problem with the above computation is that you are weighting each year equally although you don’t invest equal amounts each year. Internal Rate of Return (IRR) • A better way to calculate fund returns is IRR that effectively weights each dollar (not year) equally. • What is the IRR for the previous example? – Let’s start (for simplicity) by combining the cash inflow of $2m on December 31, 2007 and cash outflow of $10m on January 1, 2008 (a net of $8m cash outflow) – The equation we have to solve for is the following: – $6m = $1m (1+IRR)^2 + $8m (1+IRR), IRR=? – When we solve for this quadratic equation, IRR = -31% • Weakness of the IRR measure: – If an investments is not realized or liquidated yet, a subjective valuation for that investment is inserted as a final period cash flow in IRR calculations. So, IRR might be a misleading performance measure especially early in the life of the fund (J-curve or hockey stick). Value Multiple • Below is a snapshot of the $200m ABC Fund in Year 7 of its 10-year life. Let’s compute the IRR and value multiple for ABC. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Investments 20.0 30.0 40.0 40.0 30.0 0.0 0.0 Portfolio value 20.0 56.0 112.8 186.6 188.1 195.7 203.5 Total distributions 0.0 0.0 0.0 65.0 37.6 39.1 40.7 Carried interest 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Distributions to LPs 0.0 0.0 0.0 65.0 37.6 39.1 40.7 Cumulative distributions to LPs 0.0 0.0 0.0 65.0 102.6 141.7 182.4 Port value after capital returned 20.0 56.0 112.8 121.6 150.5 156.6 162.8 Management fee 4.0 4.0 4.0 4.0 4.0 4.0 4.0 Solution: IRR • To compute the IRR we need to collapse investments, fees, and distributions into a single cash flow to LPs as: CF to LPs = Dist. to LPs – new investments – management fees Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Cash flows to LPs -24.0 -34.0 -44.0 21.0 3.6 35.1 36.7 • The future value of these cash flows at the end of Year 7 is equal to the portfolio value (after capital returned) or $162.8. • When we do the math using a spreadsheet, we find that IRR=23.8% Solution: Value Multiple • Value multiple = (Total distributions to LPs (all years) + Value of unrealized investments) / (Invested capital + Management fees) • We know from the table that: – Total distributions to LPs (all years) = $182.5 – Value of unrealized investments = $162.8m – Invested capital (sum) = $160m – Management fees (sum) = $28m • Value multiple = ($182.5+$162.8m)/($160m+$28m) = 1.84 • Realized multiple = $182.5/($160m+$28m) = 0.97 • Unrealized multiple = $162.8m/($160m+$28m) = 0.87 Riskiness of VC investments • So far, we have reviewed alternative ways to compute returns to VC investments. However, we need to know the riskiness of those investments to determine whether the returns are attractive or not. • The simplest way to decide whether VC returns are attractive is to estimate their alphas based on an asset pricing model. CAPM is one example of such models: Ri,t – Rf,t = αi + βi (RM,t – Rf,t ) + ei,t • βi measures the riskiness of fund i and αi measures its risk-adjusted (abnormal) return. • Nowadays, people use an adjusted version of CAPM that accounts for SIZE, B/M, liquidity, and stale prices. Risk Adjusted VC Performance • There is an on-going debate on how to measure VC funds’ risk and performance and so whether VC funds outperform the market on a net and risk-adjusted basis. • There seems to be a consensus that VC investments are riskier than the market portfolio. For example, a recent study estimated VC funds to have (on average) a beta of 1.6. • Since unadjusted net VC returns are less than the return on the market index and VC funds tend to be riskier than the market, there is some evidence that VCs underperform the market on a risk adjusted basis.
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