Venture Capital and the Finance of Innovation [Course number]

Chapter 3 VC Returns

Professor [Name [School Name]

Fund-level returns: Data

Venture Economics
Collects data from GPs, publishes vintage-year specific quartile performance data while keeping anonymity of individual funds

Freedom-of-Information-Act (FOIA) requests

Forces public pensions to disclose performance of their fund holdings

Private Equity Performance Monitor

Collects, packages and sells fund-specific performance data for a fee. Assigns quartile rankings to funds

IRR (%)
20.00 40.00 60.00 80.00 100.00 120.00 -20.00 0.00 1980 1981 1982 1983

1984
1985 1986 1987 1988 1989 1990 1991

1992
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Median IRR top quartile IRR

VE Benchmarks

Return Definitions (1)

Internal rate of return = a rate of return that implies an NPV of 0 for a given
cash flow stream

Value multiple = realization ratio = investment multiple = multiple of money = times money = absolute return
Value multiple =
Total distributi ons to LPs value of unrealized investments invested capital management fees Total distributions to LPs invested capital management fees value of unrealized investments invested capital management fees

Realized Value multiple = Unrealized value multiple =

5 steps to calculating value multiples

There are 3 components that contribute to value multiples: Total (cumulative) distributions to LPs, value of unrealized investments, and contributed capital. Calculate distributions to LPs each year.
Distributions to LPs = total distributions - carry

1.
2. 3.

Sum them to date to get total distributions to LPs Get value of unrealized investments (after exits) = portfolio value (before exits) - total exits in year t. This is an estimate value of illiquid investments and not a market/transaction value.

4. 5.

Calculate contributed capital = invested capital + fees to date. Calculate

value multiple Total distributions to LPs value of unrealized investments invested capital management fees

5 steps to calculating IRRs for LPs

As LPs, there are 3 components that contribute to your net cash flows: fees, new investments, and distributions. Calculate fees Calculate distributions to LPs
Distributions to LPs = total distributions - carry

1. 2. 3.

4.

Calculate net cash flows = Distributions to LPs - new investments - fees For the IRR of a fund that is T years into its life and is still alive, the value of unrealized (i.e., remaining) investments at the end of year T is counted as if it is a positive cash flow. This is an estimate value of illiquid investments and not a market/transaction value.
Cash flow if final year of IRR calculations = Distributions to LPs new investments - fees + portfolio value of remaining unrealized investments

5.

IRR(year 1,, year X) = IRR(CF1, , CFT)

The IRR is not perfect

Cannot be compared to time-weighted returns

Compounding of periodic returns

Realized vs. unrealized investments Difficult to make risk adjustments

Example of a J-curve

Carried interest
Contributed capital = invested capital + management fees that have been paid to date
For a fully-invested and completed fund, contributed capital = investment capital + lifetime fees = committed capital

Carried interest timing

Return all call carry basis (committed or investment capital) first (25%) Return all contributed (or invested) capital plus priority return first (45%) Return only part of contributed/invested capital
Often distinguishes between realized and unrealized investments Fair value test (14%)

Other (16% of sample)

GP Clawback
Given the often complex formulas for distributions, GPs could end up with more than their share of profits (excess carry) at the end of the funds life. Clawback ensures that LPs get back what is promised to them in the agreement by requiring GPs to return any excess carry.
Most funds have a clawback clause.

Many top-quartile funds raised in the late 90s enjoyed early carry distributions during the boom years, but then had the clawback kick in in later years.

Clawback is not perfect

Enforcing clawback is easier said than done.
Potential disagreements between LPs and GPs over what is owed GPs are often not obligated to return taxed part of distributions Some partners may have retired or died; need to have joint and several liability to go after the other remaining partners Only 33% of funds make other partners liable

Two remedies sought by GPs and LPs:

Escrows: keep early carry distributions in escrow accounts till the end Annual true-ups: dont wait till the end, re-calculate the right amount owed each year, and seek speedy repayment.

Industry Returns
Industry returns are constructed as time-weighted returns (e.g., annualized compound returns)
Nice for comparison with market indices Nice for making risk adjustments

3 sources:
Sand Hill Econometrics (SHE): portfolio comp level Cambridge Associates (CA): fund level Venture Economics (VE)

Return Definitions
Periodic returns =
Rt ( Pt Dt ) 1 Pt 1

Compound returns = (1+R1)*(1+R2)* *(1+RT) - 1 Annualized return =

R = (1+ compound return)(1/T) - 1

Gross returns = returns before subtracting fees and carry Net returns = returns after subtracting fees and carry Realized returns = historical returns

Expected returns = returns forecast for the future

(To practice these definitions, try Exercise 3.1 in the textbook)

A Gross-Return Index

2500

5000

1000

250

500

100

25 50

Note: 1. 1981 Q1 to 2008 Q4. 2. 1988 Q4 to 2008 Q4.

Nasdaq

A Net-Return Index

CA index

1981 Q1 1982 Q1 1983 Q1 1984 Q1 1985 Q1 1986 Q1 1987 Q1 1988 Q1 1989 Q1 1990 Q1 1991 Q1 1992 Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1

9.0%1, 7.9%2

13.0%1, 16.2%2

Kleiner Perkins Returns

1Only

$170M of Fund VII was ever drawn.

Note: There have been no publicly available updates of KPCB funds since December 2004. Fund IXs performance as of March 2004 (-23.3% IRR) does NOT reflect its subsequent profit from the investment it made in Google.

Gross vs. net value multiple

GVM (gross value multiple) = Total distributions to LPs value of unrealized investments carry invested capital

Value multiple = Total distributi ons to LPs value of unrealized investments invested capital management fees GVM is the raw investment return; value multiple is how much money LPs makes, net of fees and carry
If GPs report their track records in terms of GVM, what would that imply about value multiple?

GVM, value multiple, and GP%

Suppose the fund is fully-invested and completed.

Total distributions = GVM*investment capital Carried interest = carry%*(total distributions carry basis)
Value multiple Total distributi ons to LPs Committed capital

GVM * investment capital - carry% * (GVM * investment capital - Carry basis) Committed capital

GP%

Carried interest Total distributions carry% * (GVM * investment capital - Carry basis) GVM * investment capital

GP% is the percentage of the total distributions that gets paid to GPs as carried interest.