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. 2. 3. 4. Calculate fees Calculate distributions to LPs: Distributions to LPs = total distributions - carry Calculate net cash flows = Distributions to LPs - new investments - fees 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 IRR(year 1,, year X) = IRR(CF1, , CFT)

5.

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 Investments portfolio value (before exits) Total distributions Total distributions (cumulative) carried interest Distribution to LPs cumulative distrubutions to LPs port value after distributions Management fee committed capital management fee Invested capital Management fee (cumulative) Contributed capital Cash flows to LPs cash flows if final year of IRR calculations cash flow stream ending in year 2 cash flow stream ending in year 3 cash flow stream ending in year 4 cash flow stream ending in year 5 cash flow stream ending in year 6 1 20.0 20.0 0.0 0.0 2 60.0 85.0 0.0 0.0 3 40.0 146.3 0.0 0.0 4 20.0 202.8 0.0 0.0 5 10.0 363.5 80.4 80.4 6 0.0 328.9 223.5 303.9

200 2.50%

IRR (%)

Example 1: Solution
year Investments portfolio value (before exits) Total distributions Total distributions (cumulative) carried interest Distribution to LPs cumulative distrubutions to LPs port value after distributions Management fee committed capital management fee Invested capital Management fee (cumulative) Contributed capital Cash flows to LPs cash flows if final year of IRR calculations cash flow stream ending in year 2 cash flow stream ending in year 3 cash flow stream ending in year 4 cash flow stream ending in year 5 cash flow stream ending in year 6 1 20.0 20.0 0.0 0.0 0.0 0.0 0.0 20.0 5.0 200 2.50% 20.0 5.0 25.0 -25.0 -5.0 -25.0 -25.0 -25.0 -25.0 -25.0 2 60.0 85.0 0.0 0.0 0.0 0.0 0.0 85.0 5.0 3 40.0 146.3 0.0 0.0 0.0 0.0 0.0 146.3 5.0 4 20.0 202.8 0.0 0.0 0.0 0.0 0.0 202.8 5.0 5 10.0 363.5 80.4 80.4 0.0 80.4 80.4 283.1 5.0 6 0.0 328.9 223.5 303.9 20.8 202.7 283.1 105.4 5.0

80.0 10.0 90.0 -65.0 20.0 20.0 -65.0 -65.0 -65.0 -65.0

120.0 15.0 135.0 -45.0 101.3 101.3 -45.0 -45.0 -45.0

140.0 20.0 160.0 -25.0 177.8

150.0 25.0 175.0 65.4 348.5

150.0 30.0 180.0 197.7 303.1

177.8 -25.0 -25.0

348.5 65.4

303.1

IRR (%) -20.0% 9.6% 15.7% 33.6% 27.2%

Example of a J-curve

Average IRR over time

120 100 80

IRR (% per year)

60 40 20 0 -20

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. Source: Cambridge Associates

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
Vintage year

Variation in IRR across funds + over time

100
Upper quartile

80 60

IRR (% per year)

Median

40 20 0 -20 -40

Lower quartile

IRRs are net of fees, expenses, and carried interest. Based on sample of 1,401 U.S. VC funds. Source: Cambridge Associates

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
Vintage year

VC vs. Buy-out funds

100 80
Net IRR Since Inception (%)

VC funds

Buy-out funds

60 40 20 0
19 84 19 86 19 88 19 90

.
19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06 20 08

-20 -40 -60

Vintage Year

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 = Total distributions to LPs +value of unrealized investments

invested capital + management fees

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?

Multiple value multiples

Value multiple =

Total distributions to LPs +value of unrealized investments invested capital + management fees

Value multiple = Realized value multiple + unrealized value multiple Realized value multiple = Unrealized value multiple = GVM (gross value multiple) =
Total distributions to LPs invested capital + management fees value of unrealized investments invested capital + management fees

Total distributions to LPs +value of unrealized investments + carry invested capital

GVM = raw investment return gross of fees and carry Value multiple = how much money LPs make net of fees and carry

Useful transformation of definitions

GVM = Total distributions to LPs +value of unrealized investments +carry invested capital
Total distributions to LPs +value of unrealized investments invested capital + management fees

value multiple =

For a fully-invested and completed fund,

Total distributions (to GPs and LPs) GVM = investment capital

Total distributions to LPs value multiple = Committed capital

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. Total distributions to LPs +value of unrealized investments 5.
value multiple = invested capital + management fees

Example of a fully-funded, expired fund

year Investments portfolio value total returned capital carried interest returned capital to LPs cumulative returned capital to LPs port value after capital returned Management fee 1 2 3 4 5 6 7 8 0.0 88.5 35.4 7.1 28.3 9 0.0 66.4 26.6 5.3 21.2 10 0.0 49.8 49.8 10.0 39.8 368.4 0.0 5.0 20.0 60.0 40.0 20.0 10.0 0.0 0.0 20.0 85.0 146.3 202.8 263.5 228.9 195.6 0.0 0.0 0.0 0.0 80.4 93.5 124.8 0.0 0.0 0.0 0.0 0.0 0.0 19.7 0.0 0.0 0.0 0.0 80.4 93.5 105.1 0.0 0.0 0.0 0.0

80.4 173.9 279.0 307.3 328.5 70.8 5.0 53.1 5.0 39.8 5.0

20.0 85.0 146.3 202.8 183.1 135.4 5.0 5.0 5.0 5.0 5.0 5.0

commited capital 200 management fee 2.50% Invested capital 20.0 80.0 120.0 140.0 150.0 150.0 150.0 150.0 150.0 150.0 Management fees (all years) 5.0 10.0 15.0 20.0 25.0 30.0 35.0 40.0 45.0 50.0 contributed 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
Youre an LP trying to decide whether to invest in Alpha Ventures or Beta Ventures. Which do you prefer?
VC firm Alpha Ventures Beta Ventures Historical GVM 4.2 4.0 Historical value multiple 3.5 3.9

True or false: Value multiple is always less than GVM.

Average value multiple over time

7 6

Average value multiple

5 4 3 2 1 0

Based on sample of 1,401 U.S. VC funds. The average is dollar-weighted across funds. Source: Cambridge Associates

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

Variation in value multiple across funds

5 4.5 4 3.5
Upper quartile

Value multiple

3 2.5 2 1.5 1 0.5 0

Lower quartile Median

Based on sample of 1,401 U.S. VC funds. Source: Cambridge Associates

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

Evaluating VC Performance
Method 4: Public market equivalent (PME)* Steps: 1. Choose a publicly traded benchmark portfolio. (Well start with the NASDAQ but will find more sophisticated benchmarks next lecture) 2. Invest (or discount) the funds 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
Actual $ amounts Discounted to 1/1/2001 Exit proceeds NASDAQ Exit value (with proceeds dividends) Investment 1344 1352 14.91 1300 25.85 1402 9.59 40 1691 15 1220 55 50.34 1.1 PME:

Date Investment 1/1/2001 3/12/2001 15 4/1/2001 25 5/20/2001 10 1/4/2006 11/11/2009 Total 50 GVM:

= 15 x 1344 / 1352. To make the $15M capital call, you would have had to invest $14.91 in NASDAQ at funds inception.

31.79 16.52 48.32 0.96

The fund did 0.96 times as well as equivalent investment in NASDAQ.

= 40 x 1344 / 1691. By investing $31.79 in NASDAQ at funds inception, you would have gotten $40 on 1/4/2006.

Any problems with this approach?