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.

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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.

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10019

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IRR

(% p

er y

ear)

Vintage year

Upper quartile

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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

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719

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Variation in value multiple across funds

Source: Cambridge Associates

Based on sample of 1,401 U.S. VC funds.

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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?