The Courage Gap in VC

Why DPI lags and under-performs MOIC in venture returns

In venture capital there are many ways to break down returns that can tell you different things about the ways partners make decisions. For example, LPs often look at a number of metrics of performance evaluation such as:

• MOIC: Multiple on Invested Capital
• TVPI: Total Value to Paid-In Capital
• DPI: Distributed to Paid-In Capital
• IRR: Internal Rate of Return

Fund managers are also navigating a number of levers to generate these outputs, and can optimize for different key performance indicators (KPIs) by making different decisions on the margin. For example, I’ve been part of funds that are early-stage and freshly-raised, and I’ve also been part of funds that are multi-stage, and many years old. Across these two fund archetypes are very different manager behaviors. Neither is good nor bad, but they’re distinct, and astute emerging mangers ought to learn from both schools of thought.

For example, fund managers often talk about “portfolio construction.” In crude terms this might mean thinking about your portfolio’s exposure across sectors, or geography. It might also take into consideration demographics of founders. It also might take into account some “targets” that the fund manager believes accord with their fund model. The fund model is their vision of how the managers believe they’ll be able to generate top quartile, or top decile, fund returns, typically north of 3x net of management fees and recycling to get to 100% committed capital deployed. For many funds this fund model will take into account a singular view of the world, often an inflexible view that should be more nuanced. For example a sample fund might be $100M, and the managers might have a model that says:

• We have 40% reserved for pro rata and follow-ons
• We have 60% for first-checks
• We need a basket of 30 companies to have a statistical chance at outliers
• Therefore we have $60M to make 30 investments
• Therefore our average check size will be $2M
• We plan to invest in 10 companies a year, so our deployment period is 3 years
• We see $100B of exit opportunity per year, so over a 3 year period that’s $300B of potential exit outcome. For us to early 3X on our fund, aka $300M off $100M invested by our LPs, we need to take some portion of that $300B of exits. We believe it's feasible to participate in 1% of aggregate market exits.
• If we target 10% ownership we need to invest $2M at $20M or lower valuations (post-money, not pre-money, something many overlook. Getting $2M into a $5M round at $20M pre is 8% ownership, not 10%).
• If we own 10% of a given company, and we want to generate $300M of outcome, we need to participate in $3B of exits somehow across our 30 investments. Power law will mean probably 1-3 of our companies need to generate $3B of aggregate DPI for us to 3X our fund and be top quartile.

This would be a pretty rationally thought out fund strategy. Any good manager could walk you through the above logic with their eyes closed. But I’d argue that there should be more nuance to this that takes into account a few more things that multi-stage funds think about vis-a-vis emerging managers who are maybe just playing within one thesis or world view. These other factors include things like smoothing returns over time, generating IRR, and harvesting DPI. A fund later in its deployment life might do this by paying higher entry valuations, but into higher velocity companies closer to exit. They might do this because a great company that doesn’t generate DPI in time might leave those fund managers unable to communicate wins to their LPs, and unable to raise a new fund. If they’re right, but at the wrong time, then they’re still out of business. Or a firm might boost IRR by looking at more extension rounds or “top ups” in companies largely de-risked, but maybe in need of another 6 months to get to a new round. They might also look at sectors or stages where secondaries are more possible to harvest DPI earlier.

Managers often use the same tropes like “IRR doesn’t matter” or “entry valuation is all that matters,” or “the way to generate more MOIC is to get in earlier.” IRR can be gamed merely because it’s reliant on the time value of money. So a 2X that happens in a year, or a 2X that happens in a month have wildly different IRRs, but the same MOIC. One surprise to many though is how equally useless MOIC can be in actually communicating DPI outcomes. Those same two identical MOICs though can also have wildly different DPI if the manager wagered a tiny call option on a deal of $50k, or they wrote $5M. In other words on a $100M fund, a 2X MOIC or TVPI on a $50K check returns 0.1% DPI, and that same 2X on a $5M check would return 10% DPI, or $10M/$100M. Thus managers who only point at MOIC or TVPI can be playing as many games as those who point at IRR. IRR can be manufactured by quick flips and step ups in paper valuations. And MOIC can be belie a major surprise in DPI if the manager isn’t being honest about the level of courage they’re taking in writing real checks into contrarian companies.

LPs need to start looking at this “Courage Gap” between MOIC and DPI. The “Courage Gap” exists because managers tip-toe into investments that earn them a paper MOIC, but actually are not sufficiently large to generate material DPI. Thus the short run optimism on performance is higher than realized outcome.

The reason funds underperform where the market thinks they will perform is because of this “Courage Gap” and this difference in MOIC and DPI. Small bets will generate MOIC, but when they materialize they won’t move the needle on DPI.

The way we try to combat this at Everywhere Ventures is by writing a consistent check size. When firms write small checks into cheap deals and large checks into expensive deals, because they’re always buying for the same “ownership target,” they actually dollar cost average into expensive deals and away from cheap ones. Then when the cheap deal has a step up in valuation they run pointing at MOIC. In the long run because they didn’t write a real check into that company there will be an LP surprise when that exit doesn’t generate much in the form of actual DPI.

Fund managers need to apply nuance to portfolio strategy. It is not all a valuation game, and it is not all an ownership target game. Rather, the best fund managers think about portfolio construction and risk taking in a nuanced way, taking into account when it’s good to come in on a very cheap valuation knowing that it might take forever for the company to materialize. This might have a good MOIC, but it will generate poor IRR. If you write a small check it also won’t move the needle on DPI. An expensive valuation will have some balking, because “what about ownership!?” but if that company is high velocity and quick to generate IRR, and if you write a real check, then that might actually more materially move your DPI despite lower MOIC. In other words, optimizing for DPI is what matters.

The best managers are ultimately not playing for vanity metrics of IRR or MOIC. They’re playing for DPI. They back amazing companies, help those founders build enduring, valuable companies, and generate superior returns for their LPs in the form of capital distributed back to those LP’s bank accounts. They’re ultimately doing this by taking big swings in contrarian places, backing founders others are discounting, and getting in on any valuation they can underwrite against as generating an outcome that moves the needle on DPI for their fund and LPs.

There are a lot of VCs logo chasing, tip-toeing into companies where they can point at MOIC and paper gains in bull markets. These VCs will get clobbered by the Courage Gap when their DPI doesn’t come back as strongly as they’d hoped. Enduring mangers are quietly taking bigger bets in stranger places, and trying to optimize for DPI even if in the short run that’s a different playbook. That might mean paying up for a company and making the explicit trade off to optimize for market size and DPI rather than entry valuation and MOIC. It might mean investing in a region others say, “yea but where are the exits!?” If people think you’re crazy, then at least you’re on the right path to being contrarian and right.

The best LPs and fund managers should look at what generates DPI, and make that their strategy. This is the most epistemologically honest approach to as fiduciaries to their investors looking for returns. All else is a vanity metric. Entry valuation, ownership, dilution, MOIC, IRR, are all mere proxies for DPI, and astute mangers need to play all of the levers to generate DPI, not just use one hammer.