Outperform! Metrics for VC Funds
“Price is what you pay, value is what you get” — Warren Buffet
Venture Capital industry is like a baseball game, where Venture Capital’s funds are the hitters, and the entrepreneurs are the pitchers. The batter (investor) stands on base waiting for a good pitch (startup) to connect. He must be patient and not waste swings in vain, his goal is to hit the ball with a home run or at least get a hit. According to Marc Andreesen “The venture capital business is a 100% game of outliers- it’s extreme exceptions”. A good hitter seeks to have the highest batting percentage, for Venture Capital funds this translates into performance metrics.
Any Limited Partner (LP), investor in a VC fund must take into consideration performance metrics of the different General Partners in order to make an investment decision. Vinod Khosla, founder of Khosla Ventures mentions: “maybe some percentage that’s substantially larger than 95 percent of VCs add zero value. I would bet that 70–80 percent add negative value to a startup in their advising”. Selecting the best fund managers is important to really have a financial return. The worst thing that can happen to you is contributing capital to any fund and having to wait ten years to see the negative performance. Thus, take into consideration the following qualitative and quantitative metrics when selecting or monitoring the performance of your fund manager.
- Internal Rate of Return — IRR (Gross & Net)
Measures the fund manager’s ability to generate a return over time on equity (contributions and distributions).
It is divided into gross and net. The gross IRR is the one that measures the total return of the portfolio based on the invested capital and the net return is the one that does so considering the capital committed by the LP’s minus all the costs and expenses associated with the fund. The net realized IRR of the fund can also be considered based on distributions to investors.
The desired net IRR in Venture Capital for an early-stage fund is 30%, for a later stage fund it is 20% and for a growth fund it is 18% in an average period of eight years.
2. Multiple On Invested Capital (MOIC)
This is a simple indicator that measures the multiple or return of money invested in startups. It shows the total value of the portfolio without considering the value of money over time. The MOIC can be computed by taking into account the actual distributions of the startups in the portfolio (realized) or considering the book value or net asset value of the startups in the portfolio (unrealized).
3. Total Value to Paid In Capital (TVPI)
It expresses the return of money committed by investors to the fund considering the portfolio distributions. The TVPI can be computed as a gross metric, taking into account the realized and unrealized distributions by the startups in the portfolio, or net, considering the realized and unrealized distributions from the fund to the Limited Partners. At any time in the life of the fund, TVPI = DPI + RVPI
4. Distributions to Paid In Capital (DPI) & Residual Value to Paid In Capital (RVPI)
The DPI is the indicator of the distributions made from the fund to LPs in relation to the capital contributed by investors to the fund. This metric is also known as realized Cash on Cash (CoC).
On the other hand, the unrealized distributions of the fund to the LPs are represented by the RVPI multiple, which represents the virtual value of the distributions that will be generated with the investments that are still active in the portfolio.
Other indicators to consider, just as relevant are:
5. Exits, exits with loss and write-off’s
The purpose of a fund is to have liquidity events in the investments in order to have a financial performance. The number and quality of the exits, as well as the number of write-offs determine the performance of the fund manager. For example, if out of 20 investments the fund had 19 write-offs and only one large exit (which returns 3x the value of the fund), then the metrics will be skewed, and the manager overvalued. A manager who returns the same multiple on the portfolio through more consistent exits, even if these are not that large, will be preferable.
In addition, the role of the fund manager in the growth of the startup and its exit must be considered to determine their contribution in those events. The quality of the fund manager is not only determined by the number of exits but also by its participation or lack of it in startups that fail in its portfolio.
6. Limited Partners quality and ticket size
Venture Capital funds are funded by Limited Partners. Understanding the quality, reputation, and investment tickets of the LP base in a fund is essential to make a value judgment on the fund manager. In addition, it is important to validate that the Limited Partner has contributed capital for the future performance of the fund, and not for the friendship or prior relationship that may exist between the parties, as there may be different conflicts of interest between them. Also, it is relevant to understand which of these LPs are part of the fund’s advisory board.
Venture Capital is an asset class that can be compared to other industries such as Private Equity, Equity, Debt, etc. According to Cambridge Associates, when compared to other assets and indices, the historical performance of Venture Capital funds is as follows:
For all the above, some recommendations for Limited Partner looking to invest in VC funds are the following (You can read more about the subject in our article: “How to eagle eye a star VC fund: the ultimate guide for future LPs and VC fund managers”):
- Distribution of returns: Research who are the main Venture Capital funds by geography and by fund size on each vintage year and focus on those whose returns are in the first quartile, or even better in the first decile. If the manager does not have a track record as a fund, focus on his individual track record as an angel investor or as a champion in other investment vehicles.
- Diversification: Build a diversified portfolio by vintage, investment stage, geography, and industry. This will give you the opportunity to mitigate risk and perceive the returns on innovation in different verticals.
To invest in a Venture Capital fund, you must be patient and carry out a comprehensive research, do not get carried away by the marketing of the funds or intimidated by the pressure of their administrators. Remember that you are building a relationship for the next 10 years or more. The role of investors is to grow the Venture Capital ecosystem in a fair way by seeking inclusion and diversity in its investor base.
Hector Shibata Salazar, adjunct Professor at EGADE Business School and Director of Investments and Portfolio at AC Ventures Fund
Gonzalo Soriano, VC Investor at AC Ventures
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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