The rhetoric from institutional investors in VC/PE funds about the lack of performance from most of their investments has been growing over the past few years. Some amount of self-flagellation on the part of the so called Limited Partners (or “LPs” — institutions that invest in VC and PE funds) is well deserved. A particularly good report from the Kaufmann Foundation placed the blame on the LPs’ own shoulders for creating a system with warped incentives.
But before we get into complaining about performance, those of us in the entrepreneurial community who have to endure the repercussions of these unmet expectations, are probably curious about how such performance is measured. So here is my little primer on how an institutional LP decides how we as investors are doing.
If you are a typical Limited Partner — generally, an endowment, an insurance company, a pension fund, or a family office — you are managing a pool of money that is allocated to various classes of investments: large cap public equities, small cap public equities, fixed income securities etc. This is not dissimilar to an individual picking a set of investments for his/her own retirement such that you diversify your exposure (and hence risks) across a number of asset classes. A small portion of such an “allocation model” goes towards investing in VC/PE funds and depending on the risk appetite can be as high as 25% to 30% of some LP portfolios. Most elements of an allocation model are easy to measure performance for — simply compare your holdings against the broad market index that the asset class represents (e.g. S&P 500 Index for large cap US stocks, MSCI Emerging Markets Index for a fund focused on Brazil, etc.) and you know whether your fund managers are beating the market. Most investors pay 2% of their assets deployed by a fund as fees (annually) so their minimum expectation their VC/PE fund investment is 3% to 5% over a comparable market portfolio. For investments in small companies that VC/PE funds typically invest in, the Russell 2000 is the typical comparable index.
What makes VC/PE Funds different?
A VC/PE fund has a defined life, to which an LP commits a certain amount of money, say $150M of a $1B VC fund which includes contributions from other LPs . The VC investment team (typically called General Partners, or GPs) issue “capital calls” on a per-investment basis or in tranches called “draw downs” such that the LP actually invests the money over three to four years. At the same time the GPs may generate cash returns which get distributed as the occur. This makes it difficult to compare the investment directly to an investment in the index.
Consider the $150M as invested in a public market index that moves over three years as follows:
Now consider the same $150M when committed to a fund with a three year life cycle. The cash flows would probably look like the table below.
The cash flow schedule (when the LP actually invested the money) in both cases is so different that that it is unreasonable to say the fund performed better on an IRR basis without some qualification. The other glaring difference is that in the case of a liquid index investment the investor can get out whenever he/she pleases, but in the case of a fund the timing of capital calls and capital returned to an investor is beyond his/her control.
Makings apples out of oranges
When the first capital call arrives on 1/1/13, the index is at 100, and the investor creates a shadow PME fund valued at $100M (same as cost of the investment). In Year 2, when the VC/PE fund returns $50M in capital, the investor liquidates $50M worth of his holdings in PME, but meanwhile the index has moved from 100 to 120. The initial investment of $100M went up to $120M but the liquidation of $50M of assets, results in a PME NAV of (120M — 50M) = $70M for the year. We repeat the same process for each of the two subsequent years to end up at a PME NAV of $112.90 when the VC/PE fund is wound down and hence we liquidate our PME shadow fund. The cash flows of the PME fund are quite different at liquidation from case above where we invested $150M up front and liquidated it at the end of 3 years — the PME IRR now has gone down to 4.9%.
Comparing Apples to Apples
Now that the LP has a means to compare a fund manager’s performance relative to a public index, he/she can also use the same measure to find relatively better performers among several funds.
The PME metric is normalized across funds as follows:
- If a fund matches an underlying public index (usually the Russell 2000) then it is assigned a PME Index of 1.0
- Every additional 1% IRR of the fund above (or below) the PME IRR adds (or subtracts) 0.1 from the index. Hence in our example the hypothetical fund beat the PME NAV by (16.9–4.9) = 12%; so the PME Index for this fund would be 1.0 + + 1.2 = 2.2.
So why are the LPs complaining about VC fund performance?
See the chart below (click to enlarge) from the Kauffman Report that paints their view for you.
And then the quote below from the report says it all:
This PME chart reveals the distribution of venture funds in our portfolio that delivered the 3 percent to 5 percent annual returns above the public markets that we expect from VC. A fund that delivered 3 percent above the Russell 2000 index over ten years would generate a PME of about 1.3, while 5 percent excess returns would yield a PME of about 1.5. Over twenty years in our portfolio, only sixteen funds out of ninety-four delivered a PME of at least 1.5, and only twenty funds out of ninety-four exceeded a PME of 1.3. Of the funds with PMEs greater than 1.5, ten of sixteen (nearly two-thirds) were launched prior to 1995. Our experience shows that since 1995 it is improbable that a venture fund will deliver better net returns than an investment in the public markets.
(source: the report from the Kaufmann Foundation titled “WE HAVE MET THE ENEMY… AND HE IS US” Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience)
In the real world the PME method is adjusted slightly for cases where the PME NAV can end up negative based on timing of cash flows and market conditions, but the mechanics are the same. Also note that the cash flows used for calculation are net of fees, transaction expenses and carried interest (the share of profits retained by the fund manager).
Follow my blog [blog.kamadolli.com] where this post first appeared on Feb 10, 2014
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