AGILEVC My idle thoughts on tech startups

October 23, 2012

The VC industry (both the GP part and the LP part) pays attention to the sector’s returns, but the broader tech ecosystem only occasionally tunes in.  Typically it’s when Cambridge Associates releases their benchmark data on the VC asset class (here’s a 2010 example article from TechCrunch) or an organization like the Kauffman Foundation publishes a white paper (a 2012 example article from Business Insider here).  And to be fair, the sector overall has done poorly in terms of returns in the last 10-12 years despite the fact that some funds (both established and new) have done very well.

But the reality is that average VC industry returns don’t really matter to many people.  This is true for both LPs and GPs for several reasons:

1) No Tradable Index – VC funds are private investment vehicles, making investments in private companies.  LPs investing in venture hold a subset of all the funds in the VC universe by design (see #4 & 5).  And even if they wanted the index return, there is essentially no way to buy (or sell) a broad-based basket of VC funds in the way you can trade the S&P 500 or Russell 2000 or other public equity index.

What about fund of funds (FoF), you ask?  Aren’t they a form of bundled investment into the VC asset class?  It’s true that FoFs provide LPs a way to purchase VC funds in a basket, but by design these are comparatively narrow actively-managed investment funds rather than broad-based passive vehicles.  FoFs have a range of strategies of course, but broadly speaking LPs that invest in FoFs pay them a management fee and carried interest (on top of the fee & carry of underlying VC funds they invest in) for access, diversification, active management or a combination of all three.  Access in the sense that some FoFs have relationships with top-performing funds that aren’t open to new would-be investors.  Diversification in that a small investor (by large institutional standards), say a foundation with $25M in assets that wants to commit $1M (4%) of their assets to VC, can get exposure to 10+ individual VC funds through a FoF but might only be able to inveset in 1-2 if they tried to do it directly.  And active management in the sense that many institutional investors feel that they are better served with having a specialist manager overseeing their allocation to VC rather than trying to do it with their in house staff.  But no matter how you slice it, FoFs don’t really represent a broad-based way to invest in VC.

2) No Synthetic Alternative – If an LP can’t “buy” VC as an index, could they replicate the returns of an index some other way?  For example, if there were no S&P 500 ETFs or index mutual funds an investor could easily buy a “synthetic” equivalent by buying shares of all the S&P 500 stocks in proportion to each company’s weighting in the index.  The same is not true for venture capital of course, since the underlying startups VCs invest in aren’t publicly selling their equity.  Yes accredited investors can theoretically buy shares in a small number of very late stage startups through secondary exchanges, but these are a tiny slice of the VC-backed startup ecosystem and of course the largest returns accrue to the earliest investors in these companies not the latest ones.

3) GP’s Care About Absolute, Not Relative, Returns - Of course most GPs pay attention to the broader returns of the market, but at the end of the day absolute returns are what matter.  They matter in the sense that GPs only earn carried interest if they generate absolute gains on their portfolio, regardless of how their fund does relative to other VC funds or even other asset classes.  Even if you’re top decile for your vintage year (e.g. in comparison to all other VC funds raised in a given year) or you blow away the S&P index over the same time period, a 1.0x fund or marginally profitable fund doesn’t generate any carry for the GPs that are investing it.

4) Venture Is Driven By Exceptional, Not Average Outcomes - The entire VC business is based upon outlier outcomes, not the average.  This is acutely true at the underlying startup investment level… across a broad range of vintage years and fund sizes, the bulk of VC fund returns are driven by a small minority of the portfolio companies that produce 10x+ returns for their investors.  By definition, the “average” investment in a VC fund that produces a “good” return (2.5-3.0x+ cash on cash) is profitable.  But the median investment is almost certainly a middling return if not a modest loss.  Startup outcomes are a power law distribution rather than a standard distribution.

This impact of exceptional returns is diluted some at the fund level due to portfolio effect, so the distribution between the best and worst funds is far narrower than the distribution of startup outcomes.  The best startup investments are routinely 50-100x+ returns whereas a grand slam fund return is something more like 5-10x.  So LPs aren’t necessarily trying to pick the one or two VC firms that will have the standout return of a given vintage year.  But most typically are trying to assemble a roster of VC managers and select those groups that they believe have a disproportionate advantage for sourcing, selecting, and winning the underlying startup investments that are exceptional “head end” outcomes.

5) Long Term Alpha-Seeking LPs - A good majority of LPs actively investing in venture take a long-term view of the asset class.  Yes, some investors come and go (tending to sell low and buy high) and over the decades some new categories of LPs may enter the investment category.  Within a large institution, the VC asset class may be “competing” for allocation with a very broad range of investment types.  And even long-term LPs committed to investing in venture will periodically rebalance their VC portfolio, swapping out underperforming managers for better ones or shifting allocations between different segments of the VC sector (different industries, stage focus, geography, etc).  But these long-term LPs are by definition using active managers in search of alpha (i.e. better than the market average), rather than trying to achieve an index return within the VC asset class.

So the average returns of the venture industry don’t have a meaningful impact on either GPs or LPs, and in reality they probably have little direct impact on entrepreneurs.  In the very long term (5-15+ years), sustained increases in average VC industry returns may attract more capital in aggregate into the system just as bad returns may decrease the total capital committed to the asset class.  But even though it’s episodic, the ecosystem seems to pay more attention to average VC industry returns than is probably warranted.

  • Ed Boyle

    Like most things in life, averages only matter when formulating opinions about categories.  Recognizing the great variance in VC returns, Index publishers should drop the table and instead show distribution curves, which would likely show that few VCs are actually ‘average’ in performance…that most underperform or outperform by a significant margin.   And, as stated above, LPs know this and hope to invest with the outperformers.   

    • leehower

      Indeed, an anonymized chart of distribution of returns would be more informative.

  • Ashish Datta

    Regarding #2, GSV Capital ( claims to be trying to create an
    “index” of venture companies but of course it isn’t clear how the
    returns produced by GSV’s holdings would be distributed back to

    #4 – Are there any other asset classes (discarding private equity in general) that produce outsized returns like VC?

    • leehower

      Ashish – GSV Capital has sought to create a publicly traded fund of private companies, though there are some other recent examples of private funds that employ the exact same strategy.  All of these are just buying shares in very late stage startups which are available for trading on secondary exchanges like SharesPost, SecondMarket, etc.  This set of companies represents a tiny sliver of the overall universe of VC-backed startups.  And buyers at this stage typically have very limited return potential because of the high valuations whereas the earliest investors have far higher multiples.  

      To put in in perspective, the Series A investors in LinkedIn realized more than 200x return (at the time of LinkedIn’s IPO in May 2011 – the stock has appreciated since then) on their initial investment.  People who bought LinkedIn on secondary markets in 2010 and 2011 generally saw 1.5-3x return which is still good but a tiny fraction of the multiple for earlier investors.  And late stage secondary investments are still pretty risky… just ask people who bought Groupon or Zynga at $20-30B valuations or Facebook at $100B valuations who’ve seen their investment lose 50-90% of it’s value.  So regardless of how these products are marketed, they’re really very far from being an “index” of VC returns.

      I have less direct experience in other asset classes to offer an informed perspective.  I suspect that there are some others which have broad distribution of returns, especially in highly speculative areas like distressed assets or certain natural resource development (where you can literally strike gold).  But my guess is few probably exhibit as broad a distribution as venture.

      • Ashish Datta

        I didn’t realize they were specifically targetting late stage companies via regular secondary markets, thanks for the clarification.

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