Wednesday, February 27, 2013

The Question(s) of VC Returns PART 1

As an investment analyst working in the public equity markets for many years and now an active early stage investor I know that comparing investment returns is a tricky business. For early stage investors that challenge is increased because what we put money into - an individual angel investment or a Venture Capital (VC) fund - is of course private. very limited public disclosure required. Researchers like the Center for Venture Research at the University of New Hampshire do a great job in trying to bring data and discipline to bear. But it remains a challenge vs. the tsunami of numbers investors in the public markets have to work with.

Bottom line ... early stage investors in my view need to be pretty careful when return numbers are bandied around. So many variables come in to play from sample size and composition to time periods etc. etc. And, if you invest in a fund, similar to other investment products you need to be careful about the impact of fees …, which can eat up a sizeable chunk of your returns.

In this context I was intrigued by the lengthy discussion on VC returns generated by a recent Fred Wilson blog post. With 375 comments on Fred's own blog alone the last time I checked!

The start point is publicly available data compiled by Cambridge Associates (CA). In particular look at the table on P3, which dissects VC returns over multiple time periods. Elsewhere the report also analyzes returns by fund specialty (biotech, internet e-commerce etc.) CA is a well-regarded source so I will take it as a given that the numbers they present are pretty accurate. (Although they are drawing on private data that is not amenable to outside verification.)

While comparative data in the report stacks up public market returns vs. VC returns if you look a little more closely you will see that you need to tread warily. This is because they position apples vs. oranges:
  • The CA VC numbers are a: "Pooled end-to-end return, net of fees, expenses, and carried interest"
  • The public market numbers are gross and ignore potential fees and/or transaction costs
Clearly given typical VC fee structure (2% management fee/20% carried interest) that can make for a big difference when you go from the gross return to the net amount actually realized by investors in a fund, namely the Limited Partners (LPs).

So two questions need to be separated out if you want to look at these as published VC returns and draw some conclusions vs. the performance of public market equities:

1. Looked at on a like for like gross return basis are VCs making good investments?

2. After fees are the returns LPs get from their VC investments competitive with public market alternatives?

I take a deeper dive into each of those questions in my next post.