Thoughts from A VC on Venture Capital as an Asset Class

Pretty Interesting blog posts and discussions from Fred Wilson (www.avc.com), a partner at early stage VC fund- Union Square Ventures) on venture capital as an Asset Class. The comment from his LP –Lindel Eakman of UTIMCO is also pretty interesting…

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What Is A Good Venture Return?

Lawrence Aragon at PE Hub used the news that Cisco paid $590mm (in stock) for Pure Digital the maker of the super popular??Flip Cam??to ask??this question.

it sounds like a pretty good deal, but you have to understand that the VCs put $95 million into Pure, which makes the Flip digital video camera. Assuming they own half of the company, that???s a return of just over 3x their money. For a middle-of-the road VC firm, that would be a decent return, but for big name backers Benchmark Capital and Sequoia Captial that???s pretty much a dud.

It's a good question and worthy of a discussion. That's what blogs are for, so let's have it.

My friend??Mike Feinstein??points out in the comments to Lawrence's post that the VCs probably made well over 3x on their money:

I???ve got no knowledge of the specifics of this deal, but once $95M is into a deal, you can be pretty sure that the VC???s own 70-80% of the company. So, the VC???s probably took at least $440M of the exit value. It???s still about a 4.5x, so your sentiment may be right in the aggregate. But, the early investors may have done better than that because they probably had a lower average share price than the later stage investors.

So let's move away from the Pure Digital story. Anytime you turn $95mm into ~$450mm in the span of three or four years, I'd say that was a good return.

But is 3x a good venture return? It depends entirely on the stage you invest in and your "batting average".

Most people know that "batting average" is the percent of times you get on base (based on the number of times at bat). In VC parlance, the batting average is the number of times you make a successful investment divided by the total number of investments you make.

Let's call a "successful investment" one that you get at least your money back. That's not really accurate, but let's do it anyway.

If you are a late stage investor, like IVP or TCV (two of the better known Silicon Valley late stage firms), then your batting average is very close to 100%. You wait until the early stage risk (technology, team, market) is wrung out of a deal and you invest on a set of price and terms that almost insures you'll get your money back and you attempt to make three to five times your investment if everything works out right. Since there are very few total losses in the portfolio, a 3x on average would be a good return for someone with a 100% batting average.

If you can return 3x on your portfolio before management fees and carry, you can deliver 2.25-2.5x net to your investors and over a ten year period (with an average investment duration of 5 years), that is an acceptable return to the LPs (18-20% IRR).

However, if you are an early stage investor (like our firm??Union Square Ventures), then it is a different story. I've said many times on this blog that our target batting average is "1/3, 1/3, 1/3" which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments.

If you do the math with that batting average, and assume the return is 1.5x on the middle third, then you need to average 7.5x on the 1/3 of the investments that make the bulk of the returns.

So does that mean that early stage investors who get a 4-5x on a "good deal" are not going to deliver for their LPs? Not exactly. It depends on how you think about that portfolio of "winners" (the 1/3 that produces the bulk of the returns). I've also said on this blog a bunch of times that we look for one investment to return the entire fund. In the case of our 2004 fund, that would be a $125mm return on one single investment.

If we have $10mm in that investment that returns $125mm, that is a 12.5x on our best deal. So if you need to average 7.5x on the portfolio of winners, you can certainly have some 4-5x deals in that basket as well.

The way I like to think about this is one deal returns the fund, another 3-4 deals returns it again, and the rest return it a third time to get to the 3x gross that a fund must hit to deliver good returns to the LPs.

Going back to the Pure Digital deal to wrap this up, if Sequoia and Benchmark are investing funds of roughly half a billion, and they each took out roughly $100mm in this deal, then Pure Digital is most certainly in the winner category that will produce the bulk of returns for the fund. It's not the deal that will return the fund outright, but its in the next category. It's an investment that worked out well for the investors and I am sure they are quite happy they made the investment and with the returns.

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Comment by Lindel from UTIMCo

http://disqus.com/people/1c2e86934f24cf83bc738859c78dbee2/

A thoughtful discussion. Sorry I'm late to the game.??

If taken from an LPs perspective, you should layer in OUR slugging percentage as well. It has proven very difficult for LPs to realize strong returns in any sort of venture on a portfolio level. Just for fun, suggest that we get it right about as often our all of our wonderful venture partners. That seriously dilutes your total projected return on a portfolio of venture investments.??

Let's take a real life example. Over the past ten years, we have a return of roughly 9% to show for our venture capital investing. Is that enough? NO, is my initial reaction and I think the final answer but I think it takes some consideration.??

We certainly don't seek to return an absolute 9% return when we invest with venture funds. However, when you take the cash flows and compare them to what we might have earned in the public markets, the return starts to become more attractive. Venture outperformed by a great margin and represents $XX million more in total returns for the portfolio. Right? I mean it did outperform the Nasdaq???

The relative return starts to sound pretty good but then you consider that we earned a total diversified portfolio return slightly higher over this same period. This means that venture was, at best, not a drag on the portfolio. I thought venture was supposed to be the "juice" in our portfolio? (there I did work in a baseball analogy) An institutional investor has to consider all of the possible investment exposures and, unfortunately, it does not appear that we were rewarded for our venture investments over this same period.??

In our minds, we need to be rewarded for the illiquidity (yes we do have to budget for cash flows and retain a slightly higher cash drag than optimal), and the technology/execution risk we are taking at the portfolio company level. As it turns out, we have also experienced a fair amount of business risk with some of the GPs as well.??

A couple of other issues:
1) The length of investment makes it difficult to measure your own (LPs) staff ability to pick managers and you may be throwing new commitments at bad managers.
2)Access to the best, most proven, funds is difficult and not scalable
3)VCs are proud of their fees and often themselves.

Though having been an active investor in both early and late stage VC, we do struggle to justify the allocation of bandwidth and capital. We think that LPs need to be more selective in their commitments and not try to push too much money into a portion of their portfolio that requires high returns. Venture is less an asset class as an opportunistic, high returning investment for LPs.??

We still believe that, done properly, venture capital can be one of the highest returning investments for the portfolio. On one end, we've concentrated on smaller funds where a single deal can return a meaningful portion of the fund (homeruns). At the other, we've invested with late stage or growth equity players that should have a higher slugging percentage. We are focused on multiples expecting that the early stage guys return a NET multiple with a 3 handle and that the Growth equity guys should be in the high 2's, though the IRRs should work themselves out based on holding periods. Maybe our return expectations are too high? Or our slugging percentage is too low? It just seems that we need to seek these returns or you'll end up back in bonds. And nobody likes Bonds.

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Venture Capital – Thoughts On The Asset Class

I wrote a post a week or so ago??thinking outloud about what a good "venture return' is. Yesterday, one of our investors, Lindel Eakman of UTIMCO, stopped by this blog and left??a very interesting comment on that post.

Lindel pointed out that UTIMCO's portfolio return on all VC funds over the past 10 years was in the range of 9pcnt and that he thought that wasn't very good. He did point out that VC is well ahead of the public equity markets in their portfolio and so to the extent they have their equity dollars in VC (or other private equity), that is better than public equity right now.

The punch line to Lindel's comment is important. He wonders if VC can't do better than 9pcnt across a diversified portfolio, would UTIMCO simply be better in bonds given the illiquidity and greater risk of the VC asset class?

And sadly, it may well come to that. VC has not proven that it can scale as an asset class since the mid 90s. The vast amount of money that has come into the sector from public pension funds in the past fifteen to twenty years has not been put to work very well and returns for the asset class as a whole have come down. It may well be the case that the public pension money (and other money) may leave the asset class as CIOs and the investment committees ask the hard questions that Lindel is asking.

Peter Parker, a long time VC and entrepreneur,??replied to Lindel??with the observation that a downsizing of the VC business would be a good thing for the LPs that remain because the best firms in the business are doing very well and are generating returns well above the 9pcnt which may well be the average performance for most investors in the VC asset class over the past 10 years.

I note that the industry returns??I posted on this blog a month or two ago??show a 10 year average return of 17.3pcnt so UTIMCO's portfolio is in theory below the average, but those 10 year returns are heavily influenced by the late 90s internet bubble and also the phenomenal returns delivered by KP and Sequoia on their Google investment. I would not be surprised to see that 9-10pcnt returns are the average for funds that did not take advantage of either of those big return generators.

Many will argue that this is not good news for entrepreneurs. And that may well be true. But I think entrepreneurs in the web sector have done a great job of figuring out how to build companies on much lower capital needs and we also have a vibrant angel and early stage (pre-VC) market developing. So it may be that the real problem is that there is simply too much money looking to get put to work in the VC
asset class (certainly that is true in information technology) and that as money starts to leave the sector, we'll have a smaller and healthier VC business to operate in.

I don't know what this means for biotech and cleantech and it may well be that those sectors can handle larger sums of venture capital and still generate acceptable returns. I'll leave it to those who know something about them to comment.

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