Venture Capital and the Finance of Innovation

Lecture Notes 4: VC Fund Performance Professor Luke Taylor

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How should we evaluate the performance of a single VC fund? Four approaches:  IRRs  Value multiples  GVM  PME Data on fund performance

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How should we evaluate the performance of the VC industry?

2007: $2M exit & distribution Jan. 2008: $6M exit & distribution Return in 2007 = Return in 2008 = (Arithmetic) Average annual return = Any problems with this approach?  . 2008: $10 M investment Dec.Evaluating VC Performance Method 1: Average annual return on invested capital  Weights each year equally  Example: Jan. 1. 31. 31. 1. 2007: $1M investment Dec.

2008: $6M exit & distribution  Any problems with this approach? . 1. 2007: $2M exit & distribution Jan. 1. 31.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. 2007: $1M investment Dec. 31. 2008: $10 M investment Dec.

year X) = IRR(CF1.fees + portfolio value of remaining unrealized investments IRR(year 1. This is an estimate value of illiquid investments and not a market/transaction value. new investments. 4. 2.new investments . • Cash flow if final year of IRR calculations = Distributions to LPs new investments .5 steps to calculating IRRs for LPs As LPs.e. the value of unrealized (i. remaining) investments at the end of year T is counted as if it is a positive cash flow.. and distributions. there are 3 components that contribute to your net cash flows each year: fees. 1. Calculate fees Calculate distributions to LPs: Distributions to LPs = total distributions . CFT) 5.fees For the IRR of a fund that is T years into its life and is still alive. 3. .…. ….carry Calculate net cash flows = Distributions to LPs .

Complete the cash flow table for CroMem I. portfolio values before and after exits (if any).5% of committed capital Carry = 20% of profit after return of committed capital See next slide for its annual investments.    Fee = 2. Fill in the grey cells . and distributions (exits).Example 1  The $200M fund CroMem I has completed 6 years of its 10-year life.

0 328.4 80.0 0.0 4 20.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 20.3 0.5 80.9 200 2.0 146.4 6 0.0 2 60.0 363.50% IRR (%) .0 0.0 0.0 85.0 0.0 20.8 0.0 3 40.0 0.0 202.0 5 10.9 223.0 0.5 303.

0 15.0 0.0 5.0 -45.4 80.5 65.3 101.0 3 40.0 20.0 2 60.0 -65.0 0.0 -25.0 135.0 5 10.9 20.0% 9.4 5.4 0.0 -25.8 202.5 150.5 80.0 0.0 20.0 6 0.0 0.0 363.4 348.0 202.0 85.0 0.0 -25.0 0.0 101.4 303.7% 33.9 223.5 303.0 0.0 -65.0 146.0 -25.0 0.7 303.7 283.0 -65.6% 27.0 0.0 0.2% .0 25.0 0.0 -25.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 0.1 177.1 105.0 -25.1 5.0 5.0 200 2.0 175.0 -65.0 348.8 5.1 IRR (%) -20.50% 20.3 -45.8 -25.0 0.0 80.0 120.8 150.0 30.0 25.6% 15.0 0.0 -45.0 20.3 5.0 177.4 283.4 80.0 0.0 328.0 160.0 0.0 146.0 -25.0 -65.0 -45.0 10.0 90.0 0.3 0.0 5.0 65.0 202.0 20.8 0.0 0.0 140.0 4 20.0 85.0 20.0 -25.0 197.0 -5.0 180.0 80.

Example of a J-curve .

S. and carried interest. expenses. 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 Vintage year .401 U. Based on sample of 1.Average IRR over time 120 100 80 IRR (% per year) 60 40 20 0 -20 IRRs are net of fees. VC funds.

Based on sample of 1.401 U.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. VC funds. and carried interest. 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 .S. expenses.

VC vs. 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 . 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 .

1.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. 2008: $10 M investment Dec. 2008 = Any problems with this method? . Dec. 31. 2007: $1M investment Dec. 2008: $6M exit & distribution Value multiple. 31. 31. 2007 = Value multiple. Dec. 1. 2007: $2M exit & distribution Jan. 31.

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 .

value of unrealized investments.5 steps to calculating value multiples There are 3 components that contribute to value multiples: Total (cumulative) distributions to LPs. Calculate contributed capital = invested capital + fees to date. and contributed capital. Get value of unrealized investments (after exits) = portfolio value (before exits) . Sum them to date to get total distributions to LPs 3. 1.carry 2. Calculate distributions to LPs each year. value multiple = invested capital + management fees .total exits in year t. Total distributions to LPs +value of unrealized investments 5. 4. • Distributions to LPs = total distributions . This is an estimated value of illiquid investments and not a market/transaction value.

0 5.0 175.1 5.3 202.0 200.0 150.3 328.0 45.0 40.0 0.0 150.0 20.0 85.0 15.0 35.0 0.0 20.5 70.0 20.0 50.0 25. 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 0.0 160.0 0.5 124.0 10.8 5.0 185.8 183.0 5.0 30.0 146.0 0.0 146.0 66.0 80.0 80.3 9 0.4 93.5 228.0 0.0 0.4 26.0 10.0 0.0 0.0 150.0 0.0 150.9 279.0 5.1 28.0 5.4 93.0 90.0 20.0 commited capital 200 management fee 2.0 5.5 105.0 0.0 180.50% Invested capital 20.Example of a fully-funded.0 135.0 19.8 10.8 49.0 190.0 20.7 0.9 195.0 39.0 85.2 10 0.0 0.0 150.0 0.0 What is the value multiple at the end of year 10? What is the GVM at the end of year 10? .0 contributed capital 25.0 Management fees (all years) 5.1 0.0 0.0 39.8 263.0 5.6 0.8 0.0 0.0 150.1 135.0 40.3 202.4 7.0 307.4 173.0 80.0 60.0 88.0 0.4 5.8 5.6 5.0 195.0 0.3 21.0 53.5 35.0 120.4 0.0 80.0 49.0 140.8 368.

Example 2 You’re an LP trying to decide whether to invest in Alpha Ventures or Beta Ventures.0 Historical value multiple 3. .2 4. Which do you prefer? VC firm Alpha Ventures Beta Ventures Historical GVM 4.5 3.9 True or false: Value multiple is always less than GVM.

S. 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 . VC funds.Average value multiple over time 7 6 Average value multiple 5 4 3 2 1 0 Based on sample of 1. The average is dollar-weighted across funds.401 U.

401 U. 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 .S. VC funds.5 2 1.5 0 Lower quartile Median Based on sample of 1.Variation in value multiple across funds 5 4.5 Upper quartile Value multiple 3 2.5 4 3.5 1 0.

Invest (or discount) the fund’s outflows using the realized total return on the benchmark 3. then fund outperformed the benchmark Two versions: 1. outflows = total exit proceeds (to LPs & GPs) 2. Do the same for fund inflows 4. outflows = total exit proceeds – carry * For additional details. “Gross” (raw investing ability): inflows = investments.Evaluating VC Performance Method 4: Public market equivalent (PME)* Steps: 1. Divide step 2 by step 3. “Net” (what LPs eat): inflows = investments + fees. If ratio > 1. see Kaplan and Schoar (2005) . (We’ll start with the NASDAQ but will find more sophisticated benchmarks next lecture) 2. Choose a publicly traded benchmark portfolio.

32 0.96 times as well as equivalent investment in NASDAQ. By investing $31.PME example Actual $ amounts Discounted to 1/1/2001 Exit proceeds NASDAQ Exit value (with proceeds dividends) Investment 1344 1352 14.59 40 1691 15 1220 55 50.79 in NASDAQ at fund’s inception.91 1300 25.1 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 / 1352.52 48.96 The fund did 0. 31. = 40 x 1344 / 1691. To make the $15M capital call.34 1.79 16. Any problems with this approach? . you would have gotten $40 on 1/4/2006.85 1402 9. you would have had to invest $14.91 in NASDAQ at fund’s inception.