The Risk-Return Profile of Venture Capital
Remembering your time in finance classes, you probably recall that the expectation of risk and return is on a simplified level a mostly linear function stating that more risk requires more return. Looking at the business model of banks and traditional financing institutions, this model holds true — higher risk is remunerated with higher interest rates. My experience has taught me however, that this theory is not valid in Venture Capital, which I will explain by discussing how and why the idea of returning 3x to limited partners (LPs) has become market standard.
Early stage Venture Capital is a high-risk investment segment, with high default rates on an individual company basis. Given this risk profile, university says that average return rate expectations of venture funds should be just as high. I had the chance to review some private placement memoranda (PPM) and my basic return expectations were met. Fund managers implement a hurdle rate for their carried interest participation in the range of a 6% to 8% interest or IRR (representing their minimum level of confidence and success). Furthermore, they provide fund models allowing for an average of 3x on the invested capital. This also holds true when looking at some empirical studies, which merely come to the same conclusion*.
However, when analysing actual fund performances the result is substantially different. I did this analysis and results ranged from -50% IRR to over 200% IRR with an average of 6%. A surprising result given that frankly, I would have expected a portfolio of less risky assets to return 6% and much more from Venture Capital. By the way, it does not become prettier when looking at the median performance that is -6%. In context, this means that a majority of venture funds loses money, with a small number of funds delivering very strong returns**. A simplified distribution can look like this:
These findings really start to raise questions with regard to the linear function you would expect as a former business student. In fact, I believe when looking at Venture Capital the typical function does not sufficiently weigh probabilities of possible returns and to me should rather look like this:
So, why would anyone do investments in venture capital (yes, I am neglecting strategic investments here)? In order to understand this better, time becomes an important factor. Or in greater detail, the idea that a fund manager has to raise a new fund every four to six years — always at the end of an investment period. My hypothesis is: If LPs do a VC investment once and realize that it does not return what they would expect, they will not invest again in the same fund manager. Thus, I started analysing the age of fund managers (meaning the years active under one brand) and was able to gather some interesting insights: The average fund manager is active for seven years, with a median of four years — mostly coherent with the time of raising a second fund. Yet, there is a smaller number of managers in the market for a substantially longer period of time, just like there are some funds that perform substantially better. Without getting too scientific, there is not just coincidence but a strong correlation.
I believe, the conclusion that performance is influenced by age, would however be wrong because it would mix up cause and effect. In fact, I believe that the age is influenced by the performance, or in other words, the better a fund manager performs, the longer he will remain in the market (e.g. the more funds he will be able to raise). To me, a fund manager is successful if he is at least able to raise three funds. Only then at least one fund (the third one) was raised based on real performance. Given the correlation between age and performance (I know, I really am simplifying to make the point), ten years of age “require” an IRR performance of around 19%, which represents a money multiple of 3x over a six-year time horizon. I have prepared a small sheet to exemplify and make it a little easier to follow the calculation here.
So, this is where the thinking and rationale behind the magical number of 3x fund managers talk so much about comes from: VCs have to return in line with the classical risk-return expextation if they want to become successful and that is why everyone wants to reach 3x. Historically however, only a very small group of fund managers has been able to do this.
In my next article, I will put the 3x into context by translating it to the portfolio level. As this is where the day-to-day business happens and where investment professionals and start-ups interact, it will be much more practical.
*Talking about empirical studies, Mulcahy did an interesting one on return expectations in “We have met the enemy… and he is us”
**With regard to the number of funds performing substantially better or worse, I certainly was neither the first, nor the only one to come up with this finding — for instance Schwienbacher found a similar correlation between performance and age of fund managers in “An empirical analysis of Venture Capital exits in Europe and in the United States”.