Beating the Stock Market is the Goal, not Beating Sequoia
You may have seen the front page Wall Street Journal article late last week entitled “Andreessen Horowitz’s Returns Trail Venture-Capital Elite”, as well as Andreessen Horowitz’s rebuttal authored by Scott Kupor.
I wanted to weigh in with some data because I believe the issues raised are critical for our industry at large. A misunderstanding about how to interpret VC performance, particularly early in a vintage, is a widespread issue that impacts not only press reports but also LP capital allocation among funds.
The reality is this: funds change their quartile rankings within their vintage up until late in their fund lives. Early fund reported marks do have some correlation with ultimate performance, but the signal is noisy. Fundamentally, I would argue that what really matters is whether or not a given fund handily beats a stock market equivalent on a net basis.
As a brief summary of the back-and-forth, the WSJ article reported that Andreessen’s total returns for its 2009, 2010, and 2012 funds (2.6X, 2.3X, and 1.7X respectively) were lower than returns reported by a few specific funds: Sequoia (2003, 2006, and 2010), Benchmark (2011), and Founders Fund (2007, 2010, and 2011). Scott responded that how VC firms mark unrealized investments can be highly subjective and that, ultimately, the most important factor is the cash and stock distributed, not the interim unrealized marks.
We obtained a copy of a Cambridge Associates paper from 2014 related to this topic entitled “A Framework for Benchmarking Private Investments”. They concluded that private investment funds, including U.S. VC funds, “require a surprisingly long period of time before they provide any (strong) indication of ultimate performance.” The graph below plots the number of years after the start of a vintage for just one half of U.S. VC funds to settle into their final quartile ranking. The analysis showed that it took between 6–9 years for half of the funds to settle into their ultimate quartile, with an average of about 7 years.
The signal is noisy early in a fund life in part because of the following underlying facts:
- VC fund returns are driven by a relatively small number of realized portfolio company outcomes (the “winners”);
- The winning portfolio investments often ripen late; and
- Unrealized returns (“marks”) can be weak predictors of ultimate realized returns (“cash”).
Those specific funds mentioned in the WSJ article may very well outperform the Andreessen funds. But therefore what? Selectively comparing against a few funds who retrospectively hit the ball out of the park — particularly when including funds of different and earlier vintages — misses the point.
The true measure of a fund’s success should be whether that fund’s realized net returns (i.e., after fees, carry, and expenses) sufficiently outperform public equities to justify the risk and illiquidity inherent in that investment. The goal is beating the stock market, not Sequoia.
We would need Andreessen’s specific cash flows and marks to formally calculate it, but I would be surprised based on Andreesen’s reported returns if they were not consistently outperforming a matched stock market equivalent. Scott’s implication that 100% of their LP’s re-upped in their latest fund indicates that their LP’s certainly think so.
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