A VC - Latest Comments in Venture Fund Economics: Gross and Net Returns

Re: Venture Fund Economics: Gross and Net Returns

Ted Rogers — Wed, 13 May 2009 14:27:49 -0000

This and the 1st post on Venture Fund Economics are my #3 All-Time VC posts. Once again, thanks Fred.

http://vc-brazil.com/blog/2...

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Fri, 10 Apr 2009 08:25:35 -0000

They are assumptions

Re: Venture Fund Economics: Gross and Net Returns

Vivek Aggarwal — Wed, 08 Apr 2009 22:04:59 -0000

Can you please explain , how you got the value for average initial investment and average total investment

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Mon, 25 Aug 2008 09:40:13 -0000

Management fees are paid regardless of profits in the fund

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Mon, 25 Aug 2008 09:39:19 -0000

Nothing usually

The fund manager might include a subset of the partners but usually its the same thing

Re: Venture Fund Economics: Gross and Net Returns

Venu — Sun, 24 Aug 2008 21:14:40 -0000

How does a fund manager gets compensated ? is it in the same manner of 2&20 ? The carried interest comes only when an exit happens and that too its a profitable exit/ What if there is no profits in the exit or what if the exit takes more than the anticipated timeframe ? Till then how does the partners get compensated ?

Re: Venture Fund Economics: Gross and Net Returns

Venu — Sun, 24 Aug 2008 20:40:07 -0000

Whats the difference between a Fund Manager and Partners in a VC Fund.

Re: Venture Fund Economics: Gross and Net Returns

blakeborgeson — Mon, 18 Aug 2008 02:02:00 -0000

Thanks for that back-of-the-napkin math. Puts things in perspective.

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Fri, 08 Aug 2008 03:41:04 -0000

That's for the first 4-5 years during the ³investment period² then it steps
down gradually to reflect less work and less companies under management

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Fri, 08 Aug 2008 03:40:07 -0000

2-2.5% per year

Re: Venture Fund Economics: Gross and Net Returns

Scott — Fri, 08 Aug 2008 01:16:00 -0000

Are management fees usually that frequent?

I thought that for a fund's life, 2-3% mgmt fee was for the life of the fund?

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Thu, 07 Aug 2008 06:16:05 -0000

We have a recycle provision in our fund but its limited to the amount of our management fees. The goal of it is to get the full amount of committed capital invested

Re: Venture Fund Economics: Gross and Net Returns

Steve_Sch — Thu, 07 Aug 2008 02:01:57 -0000

Many funds now have what is called a recycling facility. This allows the GP to put back to use into companies any realisations it has up to the fees that have been taken out (in some cases even more!) so that all the money can be put to use into companies. In your above example, a GP can then use all $100 million to generate $300 million which after a 20% hurdle pays back $260 million, so 3x gross to get 2.6x net, which is somewhat easier than 4x gross to get 2.5x net. Of course, timing must work out that you have some early exits to recycle fees for later rounds...

Re: Venture Fund Economics: Gross and Net Returns

Preston Sumner — Wed, 06 Aug 2008 20:04:19 -0000

And we've seen how Wall Street has used those predictive models to great effectiveness! I do like your point about baseball GMs - it suggests an inefficient market resistant to change. Since Billy Bean's success there may not be much new advantage to be gained. Read Taleb's "Fooled by Randomness" and "Black Swan" for some great insight into the pitballs of expert predictions.

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Tue, 05 Aug 2008 20:27:08 -0000

I would never blame the entrepreneurs. Without them, we've got nothing to invest in

Re: Venture Fund Economics: Gross and Net Returns

Jim Freidell — Tue, 05 Aug 2008 11:06:25 -0000

When you promise 30% annual net returns, the only way you can attain it is by cutting from both ends - the success side and the entrepreneur side.
Not true Carl, at least not historically. The VCs of the 1980s and early 1990s helped immensely in creating 30%+ IRR wealth. Often, they individually had personal home-run experience: starting a company and taking such through IPO; creating a highly profitable free-standing and self-supporting billion-dollar corporation. Today's breed of VC doesn't generally have that experience. Instead most VCs at best have personally started a software or Internet startup and sold it before much in the way of net profits were ever produced. While that was the miracle of the bubble era, such strategy rarely succeeds today. Hence, VC profitability post-bubble is generally in the tank. Last year, Cambridge Associates opined that, of approximately 750 VC firms, at most 55 had a current fund that was not under water.

There is a huge difference between building a self-sustaining multi-billion dollar home run from a start-up, compared to building an R&D or development division, masquerading as a start-up, effectively for a large suitor.

Fred and other VCs may tell us that the current crop of entrepreneur is to blame. All want to create quick wealth exploiting their technical ideas, certainly not invest the time, money and effort to build real self-sustaining companies from their technical ideas. They may also tell us that their LPs impose constraints regarding what the VCs may invest in. Both may be true. But in the end, it is the VC that gets to pick its LPs and its portfolio companies. Their success or failure depends on their wisdom, experience, energy and commitment. So far this decade, the prognosis is not good (except with perhaps 10 or so VCs out of today’s 650 or so firms).

Re: Venture Fund Economics: Gross and Net Returns

fredwilson — Tue, 05 Aug 2008 07:07:05 -0000

I can't argue with your math

Or your point

Re: Venture Fund Economics: Gross and Net Returns

Eben Thurston — Mon, 04 Aug 2008 19:05:50 -0000

These posts and comments are incredibly interesting and informative. I'm looking forward to the rest of the series and conversations. Thanks for pulling back the curtain, Fred.

Re: Venture Fund Economics: Gross and Net Returns

Steve Kane — Mon, 04 Aug 2008 18:30:51 -0000

amen

but if truth be told the vast vast majority of funds and vc partners are basically earning little or no carry while making humungous gobs opf compensation on managment fees

i mean, heck - with just $500MM under management, a firm is taking in around $10MM in managament fees per annum. that firm probably has 5-6 partners making investments

but the firm pushes off the cost of closing deals (legal costs) onto the LPs (via the portfolio companies) so whats left?

maybe a dozen support staff (at say $175K/each on average all in, or $2MM/year)

plus rent and utilities (maybe $500K/year)

plus T&E (maybe $500K/year)...

totals $3MM/year.

say i'm way off and toss in another $1MM/year -- new total $4MM total costs/year

and that still leaves $6MM year in management fees for the 5-6 partners to split... whether or not they ever earn LPs any return at all, let alone carry for themselves

this is the typical VC firm these days. sure the top decile are making great returns for LPs, and ergo earned fortunes for themselves. but, just like the mutual fund business, the typical manager is earning huge comp while investors get fair or poor returns

Re: Venture Fund Economics: Gross and Net Returns

Carl Wimmer — Mon, 04 Aug 2008 14:56:40 -0000

Add to the "cut" that a VC gets, a further impediment to the VC model as being viable.

The VC is one step removed, both from the technology and the investor. Imagine the power your real estate agent would have if you turned over your money and your decision to him in picking a personal house, or ... doing the same with a car salesman to buy you a car..... how about picking a wife through a matchmaker - well ... that is actually being done.

Unless a VC can read tomorrow's newspaper (and looking at the average VC portfolio, you know for certain that they can't or don't do just that) , in order to coerce a return, a VC is required by definition to make a deal that leans to destroying what an entrepreneur has created. When you promise 30% annual net returns, the only way you can attain it is by cutting from both ends - the success side and the entrepreneur side.

Maybe the VC earns his fees after all by being willing to get his hands bloody

Re: Venture Fund Economics: Gross and Net Returns

JoeDuck — Mon, 04 Aug 2008 14:07:44 -0000

2014! But my new improved onliner attention span is only 14 minutes....

Don Dodge had some IRR detail also - very impressive numbers if you continue to manage and pick companies so well.

Re: Venture Fund Economics: Gross and Net Returns

kenberger — Mon, 04 Aug 2008 12:23:13 -0000

The "no-risk" factor for VC partners is a major point that's widely misunderstood.

When defending VC's, Bill Gurley once told me "I can't think of a group less worthy of your sympathy!"
Despite this, here goes:

It sure sounds like a good gig to get guaranteed the 2% per year regardless of performance. But partners all must put "skin in the game", and the nuances boil down to the math. I know personally a VC partner who closed a $100m fund, and due to the nature of the closing and other factors, he actually had to *PAY* $400k out of his pocket first couple years just to start.

Re: Venture Fund Economics: Gross and Net Returns

Jim Freidell — Mon, 04 Aug 2008 12:08:00 -0000

Fred,

The definition of venture capital success has changed radically in the past 10 years.

Used to be (ca. 1980s-early’90s) that “winners” were defined as returning no less than a 10x money multiple, preferably in 5 years or less. That works out to a minimum 58% gross annual return.

Looking at Thomson Reuters’ rather extensive (and expensive) VenturExpert database, your readers might be interested in knowing that vintage year 1995 VC funds (all funds started in 1995) statistically provided the following net returns to their LP investors:

Mean Net IRR: 46% (≤44x Net Money Multiple*)
Median Net IRR: 21% (≤6.7x Net Money Multiple*)
So-Called “Pooled Average” Net IRR: 60% (≤110x Net Money Multiple*)

(* Calculated as if all money were pulled down on day zero and returned on the last day of year 10.)

As with your analysis, net refers here to returns to LP investors, net of management fees and carried interest.

The 1995 vintage year funds are noteworthy because they “straddled” the bubble up and down cycle. Plus most all are fully closed out by now, so final results are in.

LP investors tend to look at investing in the top quartile of VC fund performers. The top quartile of the 1995 vintage funds returned 65% Net IRR (≤150x Net Money Multiple*).

Carrying this a step further, the top decile of these funds returned 129% net IRR (≤3,966x Net Money Multiple*).

The moral of this analysis is that exceptionally few VCs provide most all the venture returns to their LP investors (and disproportionately enrich themselves and their portfolio entrepreneurs in the process). They all succeed by finding and fostering home runs and grand slams, not base hits. This can be proven historically by analyzing vintage year funds prior to 1995.

Today, most VCs struggle finding and fostering technology “quick-flip” base hits that, on average, return 4-10x gross, mostly through M&A exit. Your “planned” 6.5x “winner” average clearly validates that.

The National Venture Capital Association has published a series of now 3 studies illustrating that most historical home runs have not been in high-tech, but rather in low-tech to no-tech start-ups fostered into substantial sustaining corporations.

Everybody’s knee jerk is to blame the pubic markets for the downturn in IPO exits.

Yet, the fraction of M&A exits eclipsed IPO exits way back in 1997 – back when the IPO market was red hot, even for new issues built more on hype than substance (no profits in sight, let alone 4 trailing quarters).

Thus, it appears that most VC firms and professionals are in effect still operating on 10-year-old bubble dynamics: Technology-based quick flips. Surviving VC firms will find a different space in which to focus – maybe by rushing back to the future.

Investors serious in seeing a new home run opportunity can reach me at j.freidell at ieee.org – Jim.

Re: Venture Fund Economics: Gross and Net Returns

iamverytall — Mon, 04 Aug 2008 11:41:48 -0000

A couple comments below. Overall, I'm not exactly in disagreement - VC's could certainly (and almost certainly do) do some modeling to help them figure out their potential ROI. However, I think that there are some considerations that should be taken into account.

1. Predictive modeling is useful only up to a certain point. As I'm sure you've heard many, many times by now, the current credit crisis (as well as other crises, e.g. the LTCM implosion) can largely be attributed to blind, unwarranted faith in the power of predictive models. You could potentially argue that this was just because the models weren't powerful enough - perhaps they failed to take into account what Soros calls the "reflexivity" of market behavior. But things like that are essentially black swans - you don't know that they exist until your investment has gone belly up.

2. What most major Wall Street firms are spending their money on is risk management, i.e. figuring out how much money they could possibly lose on a given investment, as opposed to what they are likely to gain. The models that tend to work best are the ones where there is a significant/huge amount of historical data to test against, e.g. corporate default data for corporate bonds. As the amount of data decreases, the reliability of the model begins to break down. This is why Moody's had no real business rating CDOs and other recent structured products - there simply was no way that they had enough data to accurately model the risk on those instruments.

There are a couple of points here. First, because risk models look at established structures, they should (theoretically, at least) have a fairly solid amount of quantifiable information about the underlying asset. Credit analysts can look at audited financial statements, etc. for use in their analysis of a company's credit-worthiness. It's not immediately clear that a VC can do the same, especially for early-stage companies that are unlikely to have detailed financials.

Moreover, it strikes me that a lot of the "secret sauce" in venture capital investing is not in the quantifiable aspects of the investment, but rather in more qualitative views on macro-trends, management teams, the potential for disruptive change in established business sectors, etc. While it is not impossible to ascribe a value to these elements and place them in a model of some sort, the degree of accuracy that you'd expect to see is so low that you might as well just toss the whole thing out and pick your final number out of a hat. Garbage in, garbage out.

3. It's not necessarily clear that VC firms have the resources to do this sort of thing on their own. Major Wall Street firms are much, much larger than major venture capital firms.

I'd say more, but this is getting really long for a comment. Again, I'm not saying it's impossible. I'm just saying that it would be hard to build a model that you could rely on to accurately predict the ROI on a particular investment. You can (and probably should) put a handful of assumptions into a model that might give you a view on the likelihood of your investment's success. But in my view, these models should always confirm hypotheses, rather than drive them.

Re: Venture Fund Economics: Gross and Net Returns

Scott — Mon, 04 Aug 2008 11:23:01 -0000

Don't most funds have some sort of preferred return for the LP's (i.e. 6 to 8 percent)?