Greed and VC Math

An entrepreneur which I have been dealing with recently, drew my attention on a 2009 blog post of Fred Wilson, a fellow NYC based US Venture Capitalist http://www.avc.com/a_vc/2009/10/the-we-need-to-own-baloney.html .

Fred is not only an excellent Venture Capitalist but also a terrific blogger with whom I find myself in agreement most of the time…. But, guess what, not this time. His point is that too often, he believes, Venture Capitalists claiming to “need to own” a certain % of a perspective portfolio companies are wrong and greedy.To support such thesis he mentions notable landmark investments in companies such as “Google” as an example of a deal in which a much smaller stake has been sufficient to generate an excellent return for VCs.

On another post referring to Fred’s http://redeye.firstround.com/2009/10/company-math-vs-vc-math.html another colleague Josh Kopelman take a look at VC math issues from a much different perspective and I this case I very much agree with his conclusions. Taking this even further the implications are even bolder in my view.

Facts first:

1) Average performance of Venture Capital as an asset class (in Europe AND US) has lately been disappointing. On some vintages recently coming to maturity the average fund have delivered negative returns.

2) US funds have hugely grown in size (75% of US VC funds have more than 100 Mio under management whereas only 25% were larger than that 10 Years ago)

3) Managers’ % remuneration in the private equity industry (and therefore in VC too) remains disconnected from the amount of assets under management. Consequently a manager with 1,0 Billion fund receives 10 times the fees of a 100 Mio fund.

4) Remuneration % being tied to capital commitment rather than on a reasonable budget of the management company, forces the manager to “allocate” prorata such costs to investments in portfolio. As small investment often require the same (and sometimes more) amount of time and energy from the manager than large investments, obviously such allocation tend to penalize the smallest investments.

5) VC funds returns are determined by essentially two main factor:

a) the ability to invest in “fund returners” (deals which alone allows to payback on exit all or a substantial part of the fund) and

b) the ability to timely put stop losses on poorly performing deals particularly if highly capital intensive.

Given that aggregate stats in the industry are generally not too reliable I drew some data from our last realized fund (raised in 2000, with 130 Mio Euro committed capital) and more precisely the math is:

a) Out of 20 Investments made 2 of them represented > than 50% of the total amount returned and allowed returning alone all paid in capital.

b) Losses have been incurred on 6 investments absorbing in total 15% of all paid in capital, other 12 investments were sold at a multiple between 1,2 and 4 X allowing cumulatively to return another 90% of paid in capital

c) Percentage owned in the 2 star investments at exit was 40 and 25% respectively and their entity value at exit was between Euro 220 and 300 mio.

Other previous funds (from the bubble years) had in aggregate a similar concentration of value realization on 2 or 3 holdings. In that case however we were able to deliver even higher multiple on shorter times and with smaller percentage holdings …. But as said we were in the bubble days when you could flip unprofitable holdings 6- 12 months after investing and make 20X multiple. I’d not bet on those conditions to return again soon.

Of course (heard that already) all entrepreneurs reading this will immediately think that they are the “Stars” and that its not their fault if we are dumb investors in many “dogs” and that we and not them shall be paying for those mistake. But this clearly doesn’t apply in this business: a VC so cautious to avoid bad investments is most certainly also too cautious to take the risk to find the “stars” (every entrepreneur, particularly the most successful, should try to remember what their company was like when they first pitched investors).

All of the above lead in my opinion to the following conclusions:

1) In order to payback a 100 Mio fund with an average holding companies at exit of less than 10% one should only target star companies with potential Mkt caps of over 1,0 Billion Euro. If the VC’s goal is to deliver a 20% return in 6 years one needs to triple the fund and if accounting for fees and carried one needs to realize 350 Million from proceeds. That means “finding” in your portfolio 2 stars valued more than 1,5 Billion each at exit. How many venture backed companies reaches that threshold annually ? Obviously very few (none last year across all Europe for example)

2) The larger the fund the more the above is true… with a 400 Mio fund and 10% ownerships a VC has to create 15 Billion of Market value… (Google, probably the deal of the century, went public with a market cap of Euro 17 billion at today’s exchange rate)… Can any VC with a sound state of mind design his investment strategy on finding the next Google ?

Hence that a VC needs to own a sizable chunk (20 to 40) percent of a company depending on stage of investment in order to hope to generate strong returns, is indeed a sound rule of thumb and more of a necessity to survive than a sign of greediness.

Particularly in light of the latest aggregate asset class performance averages, if anybody can claim some VCs are too greedy those shall be the LPs of too large VC funds rather than entrepreneurs. But there again were those LPs forced to invest in funds trebling in size to milk more fees ? No they weren’t… they were just sheepishly following.

Comments

[kunal]

RoR does not depend on 'size of the pie', it is simply a function of how much you grow the pie in the given time. You give historic data to prove that bigger chunk of investment in companies returns a strong rate. There is no logic behind this statement.

for example, you own companies A, B and C with 5% in each.
The companies grow by these amounts:
RoR(A) is 20%
RoR(B) is 50%
RoR(C) is 0%

your net RoR is thus 23%

now you increase your stake to 20% in each of these 3 companies
if the companies grow by the same amounts, the net RoR will still be 23%