Thursday, March 7, 2013

The Question(s) of VC Returns PART 2

I mentioned in part I of this two part series that there are two questions you need to separate out if you want to look at published VC returns and draw some conclusions set against the performance of public market equities. The data source being Cambridge Associates.

First are VCs making good investments? i.e. what do their gross returns look like vs. other equity categories? Here we can’t answer directly from the CA data but the answer it seems to be “not really” especially adjusting for higher risk. Second are the realized net returns achieved by LPs competitive with public market alternatives? Here the answer seems to be more of a “No” on 1, 3 and 10-year time horizons and “Yes”, but not by much on a 5 year horizon.

1. Looked at on a like for like gross return basis are VCs making good investments? The good news for VCs: by taking the VC numbers net of fees ... their actual achieved gross investment returns are materially understated in the Cambridge Associates numbers. For example, adding back VC carried interest and management fees the overall CA VC index probably matched the S&P 500 (as opposed to lagged by approx. 200bp) over the last 10 years.

In the context of generally disappointing performance there are a couple of important sub questions that you can't pull out of the high level data:
i)  Are VCs actually good at picking winners vs. losers (hence demonstrating investment skill.)
ii)  Are they over paying (hence hurting their returns because exits valuations are unable to deliver a decent IRR?)

2. After fees are the returns LPs get from their VC investments competitive with public market alternatives?
The CA numbers can be used to answer this question ... and as Fred pointed out ... things don't look great. Of course this is the answer that matters to the investors in any VC fund. LPs might see the gross returns reported but they can only take their net returns to the bank.

Clearly net to investor returns over 10 years say are disappointing and an important part but not all of the answer is fees. In fact the numbers would look even worse if you accept that VC investments should earn a premium for risk, not least liquidity risk. Hard to say what that risk premium should be but add a few 100bp and gap between a target risk adjusted return and actual achieved returns grows commensurately. (For example if the S&P earned returned a return of 8% over 10 years and you take the view that, to be compensated for risk, should have earned 10%+ as an LP … then overall VC returns of 6% are even more adrift.)

Interestingly the conclusion that these private investment pooled vehicles (taken on average, clearly individual funds did much better - and worse) have had a hard time in recent years "beating the [public] market" is pretty much the same finding as for the two big classes of public market equity investment vehicles ... hedge funds and mutual funds.

In particular hedge fund returns having fallen off as their number and size has grown - hence their ability to outsmart “the market” has eroded as they have effectively become “the market”.

A key reason neither public equity mutual nor hedge funds on average beat the public market indices over time is most likely that the underlying public markets are "efficient" enough to mean security selection (aka stock picking) doesn't add much value. And certainly not enough value to overcome the drag caused by the level of fees these vehicles charge. This of course explains the dramatic rise in interest in Exchange Traded Funds (ETFs) in recent years.

While it is tough to apply the same concept of market efficiency to private equity investments perhaps a similar story applies in early stage private investment land? Namely that angel and VC investments are, on average, pretty fully and fairly priced. If that is the case then individual fee-free angel investments could well have a decided advantage!

Footnote on benchmarks
As an aside it is worth noting that, while tech investors love to talk about the NASDAQ index, it isn't representative of anything other than the companies NASDAQ gets to list there. In my view it only really makes sense to benchmark against a broad index. We can debate which one, but the Russell 2000 probably makes most sense of the ones CA lists. i.e. how have VCs done vs. the alternative of diversified investments in a smaller US public companies? And if you do are a tech investor and want to judge performance with a more representative public market tech index then S&P has plenty to choose from.