How do you compare your VC returns to the market?

The length of time it takes for a venture capital fund to reach the positive territory on the J-curve can vary depending on a number of factors, such as the fund's investment strategy, the industries in which it invests, and the overall economic conditions. The VC return curve is a powerful tool for investors, but it is important to use it in conjunction with other information, such as the fund's investment strategy, the team's experience, and the track record of the fund's management team. The VC return curve is also a valuable tool for venture capital firms, as it helps them to set realistic expectations for their investors and to manage their portfolios more effectively.

The VC return curve is also used for strategic decisions like whether to diversify more or focus on specific sectors. It can also indicate if you should change your investment thesis or strategy based on past performance.

I remember a review from Harvard Business Review stating that roughly 65% of startups fail or merely return invested capital. This means the remaining 35% need to generate substantial returns to compensate for additional performance and cover the bets that went bust. What's interesting here is that only a mere 6% of the investments represent over 60% of the returns in a typical VC portfolio! What this means is naturally that the ability to select those 6% winners is impedent. However, it is equally if not more important that the overall risk of the portfolio is managed prudently.

A good way to compare VC funds is versus their peers. Is it a top-quartile fund? If so, that is great. What metric is used for this comparison matters, though. Besides the standard ones (IRR, MOIC), there are some more holistic measures, such as PitchBook's manager scoring system.

Comparing VC returns to the market involves assessing various factors. Firstly, we evaluate our portfolio's performance by tracking metrics like ROI and IRR. We also consider industry benchmarks to gauge our relative success. Additionally, we analyze the broader economic environment, examining market trends, interest rates, and overall investment sentiment. Diversification across sectors and stages is another critical aspect. We aim to outperform market indices and achieve superior risk-adjusted returns by investing in innovative, high-potential startups. Continuous evaluation and adaptation of our investment strategy are essential to ensure our returns remain competitive in the dynamic venture capital landscape.

The Public Market Equivalent (PME) method provides a valuable benchmark by assessing how your VC investments would have performed in a liquid public market context. It offers a practical way to gauge the relative success of your VC portfolio by factoring in the risks and opportunities associated with illiquid and volatile assets, helping you make more informed investment decisions.

While the PME method is a great tool, it's essential to understand its limitations. It assumes that you could invest the same cash amounts in a public market index as you did in your VC investment, which might not be the case due to minimum investment requirements in venture capital. Additionally, venture capital investments often have a much longer time horizon and can't be easily sold like stocks, a factor the PME doesn't always capture.

PME is a vital tool as it places VC returns in the context of a broader market, creating a relatable frame of reference. However, one must remember that VCs and public markets operate on different time scales and risk profiles. Hence, while the PME provides a comparative measure, it should be viewed alongside other metrics to gauge true VC performance.

Comparing VC returns to the market requires a deeper understanding of the market cycles and the macroeconomic environment. For example, VC investments made during a market downturn might take longer to mature but could potentially yield higher returns due to lower entry valuations. Therefore, contextualizing VC returns within broader economic cycles is key to making accurate comparisons with market returns.

Imagine you invested $10,000 in a startup, and five years later, you sell your shares for $30,000. You calculate an IRR of 25%. Sounds great, right? But say one of the years had an unusually high return due to a one-off event, like the company landing a big contract. This outlier could make the IRR look better than it really is over the long term. Two projects could have the same IRR, but one could be a $100,000 investment and another could be a $1 million investment. The latter obviously carries more weight but you wouldn’t know it by looking just at the IRR. Additionally, sometimes an investment can have more than one IRR, particularly if there are multiple periods of cash inflow and outflow.

I am a big fan of IRR calculation to show the return of the portfolio. In addition to the pure number, it is from my perspective to add some lenses: 1) How much is realized versus not realized. this is key in particular in current market environment to differentiate between what gains are on the books versus actually realized/ returned (exits) 2) accounting methods make a difference. In particular if you compare different structures as some are required to take for example liquidity discounts as buffer on their books, others dont.

IRR provides a time-weighted return measure, vital for long-horizon investments like venture capital. Yet, as highlighted, IRR's sensitivity to outliers and specific cash flow timings can sometimes be misleading. While it's a standard metric, using it in isolation can be deceptive, especially when comparing funds with different vintages.

A critical aspect often overlooked is the temporal dimension of VC investments. Unlike traditional equity markets, VC returns are not just about the magnitude of returns but also about the time taken to realize them. The timing of exit strategies, whether through acquisitions, IPOs, or other means, plays a significant role in the final return profile. For instance, an early exit might yield a high IRR but a lower multiple, while a longer hold could result in a significant multiple but a lower IRR. Understanding and navigating this trade-off is crucial.

IRR is a metric that can be manipulated by several assumptions. Typically LPs will trust the MOIC for new funds. After the fund proves itself, then the LPs will look more toward the IRR as the relevant metric. LPs will compare IRR across funds with similar styles. And LPs will compare IRR across different sectors of their allocation (VC, PE, real estate, public markets, bonds, etc.).

MOIC is easy to calculate and understand but is a 'snapshot' metric. It tells you how well you're doing at a specific moment but doesn't consider how long it took. Two investments with the same MOIC might have very different attractiveness if one took 2 years to mature and the other took 10 years. Also, MOIC doesn't factor in the volatility or risk associated with an investment. An investment with a high MOIC might have been super risky, and you just got lucky, while another one might be steadily growing and less of a gamble.

MOIC is more trusted and less easily manipulated by the fund. For this reason, it is more trusted by LPs, even if it is less relevant. LPs will MOICs for similar funds with similar styles.

MOIC offers a straightforward glance at the return generated per unit of capital invested. Its simplicity is both its strength and weakness. While it provides an immediate understanding of capital efficiency, the lack of time-weighting makes it less nuanced than other metrics.

Risk-adjusted returns are particularly crucial in venture capital because VC investments are often more volatile and riskier than traditional investments like stocks or bonds. They can help you understand if the additional risk you're taking on with a VC investment is 'worth it' in terms of extra returns. Also, metrics like the Sharpe ratio, are often better suited for assets where you have a lot of historical data to analyze. In venture capital, where each investment is unique and data may be scarce, calculating a reliable risk-adjusted return can be even trickier.

Venture capital inherently deals with asymmetric risk profiles, making the task of risk adjustment both crucial and complex. Traditional metrics like the Sharpe ratio can sometimes be ill-suited for VC returns due to the non-normality of return distributions. However, assessing risk-adjusted returns is paramount, as it isolates the 'skill' from the 'luck' in performance. Despite challenges in its computation, striving to understand it can set a VC apart in terms of sophistication.

You can measure the performance of VC fund using two metrics: TVPI shows how the current asset value compares to its purchase cost DPI tracks the returned capital relative to the initial investment While fund managers may emphasize TVPI as an indicator of success, it can be misleading. It only reflects current asset values and is affected by the illiquid nature of VC investments. DPI is more relevant for LPs, as it indicates the amount of capital that has been returned. Comparing DPI between funds enables investors to assess the effectiveness of their GPs in generating returns and realizing exits. The best GPs demonstrate DPI during the investment period of a fund, reflecting their ability to manage investments and deliver returns.

The lifecycle of a VC fund, typically spanning a decade or more, means the surrounding economic landscape can change dramatically over its tenure. It's essential to contextualize performance within these macroeconomic shifts. Furthermore, VC returns should also be evaluated in terms of non-financial metrics, like impact on industry innovation, job creation, and more. Portfolio companies' success stories and post-exit trajectories can also provide rich insights beyond mere financial returns. Lastly, the qualitative aspects of a VC's role in mentoring, networking, and guiding startups play a significant role in overall value creation and should not be overlooked.

Beyond TVPI, DPI and IRR. Metrics worth to consider: 1. Time to DPI. The time it takes for you to return the first $ to LPs. 2. For seed funds - conversion from Seed to Series A (how well you pick) 3. NPS by founders (are you a great partner?) 4. Most commonly, aside from traditional financial metrics, impact created by a fund portfolio is another metric that LPs benchmark. For example funds in climate. 5. Consistency of returns - do you have big var between fund vintages and you can consistently win / deliver return 6. Also, measuring performance in quartiles - most VC's claim they are in the top quartile or decile for a given vintage. This is another way of benchmarking a particular vintage.

An interesting point that has come out publicly recently (from Columbia University, MIT, Stanford, University of Virginia, and others) is that different funds are reporting different valuation for their portfolio companies. The difference can be up to 2x. The valuations directly affect the performance metrics. So LPs are questioning the assumptions behind the performance numbers.