|
Justify My Love
|
|||||
|
My buddy Peter - a very smart cat - was a pure math major in college. Once, I asked him what the difference between pure and applied math was and he told me with an impish grin: “the applied math guys know how to add . . .” Of course, Peter went to Brown University, a very funky place, so I’m sure that he could’ve done an interpretive dance about the Lebesgue Outer Measure and still gotten a passing grade on his senior thesis (just kidding — feel the love, Providence!) I, on the other hand, studied history in college which means that I’m good with trivia at cocktail parties, but that’s about it. Every now and again, though, I get to thinking about arithmetic; specifically, the arithmetic of the venture business and I wonder if we’re all closer to the pure math end of the spectrum than the applied end. VC math should be pretty straightforward: send a dollar out to a portfolio company and hope it comes back with a few of its friends. Do that often enough and you’ve got a good fund-level return. Unfortunately, the LPs who throw down a Dollar and a Dream have prevented the shakeout that we were all talking about in 2002 from happening and there continue to be too many iffy $500 million “early stage” funds out there. Now I’ve got nothing against $500 million funds in particular. Despite my seed-stage and smaller-fund bias (I like being long idiosyncrasy and short momentum), we’ve got a few investments in that size stratum and think those specific guys have some distinctive advantages. Here’s where it gets dicey for most, though (and I’ll make some gross simplifying assumptions): if you’re an LP and investing in an run-of-the-mill $500 million fund hoping to get a 3x net return, that fund has to generate $1.75 billion in returns ($1.25B in profit less 20% carry equals two turns of profit). Of course, that’s just the capital that accrues to the firm’s ownership stake. Since a lot of firms end up owning only 10-15% of their companies at exit, you’ve typically got to gross the $1.75 billion up by a factor of between 6.67 and 10. That suggests that those firms need to create between $12 and $17 billion of market cap just to get a 3x fund-level net return to their LPs. Caliente! Let’s unpack that box a bit more: at the $15 billion midpoint of the exit range above, a firm that invests in 25 early-stage companies will have to get, on average, $600 million exit valuations for each and every one of them. That’s a pretty daunting number when you consider that the typical M&A valuation has hovered in the high double-digit millions for quite some time. Of course, such a batting average would be unprecedented (this is a slugging percentage business, after all), so if you assume that a quarter of the companies generate all the returns while the other three quarters collectively return the cost basis, each of those 6 home run companies has to enjoy an exit valuation of $1.67 billion (roughly what Google paid for YouTube). That’s livin’ la vida loca! The situation above is exacerbated by the fact that not all firms invest 100% of their capital because they reserve up to 15% of capital for fees. Also, you could make the argument that the firms most likely to earn the above returns will charge premium carries, making the hurdle higher for compelling net returns. To be fair, firms have a few levers to pull - maintaining higher ownership percentages in companies and recycling capital are great examples - that can make the challenge less daunting. They could also deploy less capital per company, but that’s tough to do with a larger fund. Like I said, though, I do still believe that some firms will be the exceptions that prove the rule; some will be good while some others will be lucky. In the meanwhile, a lot of LPs will be serenading their GPs with the line from that old Madonna song (cue the sensuous and moody bass line): “I’m just wanting, needing, waiting for you to justify my love. Hoping, praying for you to justify my love . . .” Chris Douvos co-heads the private equity division at The Investment Fund for Foundations (TIFF). Prior to TIFF, Chris was at Princeton niversity Investment Company where he helped select and monitor managers in illiquid asset classes.
Most Popular Posts |
 |
 |
May 14th, 2008 at 11:24 am
Once again, Chris hits the nail on the head and makes me laugh in the process.
May 15th, 2008 at 6:09 am
This is a useful take on venture investing. The math adds up. However, a key point is missing: Why is the return expectation 3x? Using a reasonable cash flow forecast for investment and distribution timing, a 3x money multiple implies a (gross) IRR in the mid-20s range. Those are exceptionally high returns.
May 15th, 2008 at 7:51 am
Chris wants to get compensated for his risk-taking. The opportunity cost of that capital is a wonderful small or lower-middle market buyout fund that can generate a 2.5x or better.
p.s. I don’t buy the correlation arguments either.
May 15th, 2008 at 8:11 am
Exactly how large is the universe of wonderful small or lower middle market buyout funds that consistently generate 25% annual returns? Those levels of return, in my view, are generally well above the risk in the underlying assets in these funds, so managers who are consistently able to general such returns would be adding exceptional value. My point was to understand in more fundamental detail how Chris established his return requirement. That question is as relevant for buyout firms (small, medium, large, mega) as it is for venture firms. Without understanding that starting requirement - i.e. how Chris determines the appropriate level of compensation for the risk he takes - his post isn’t as useful as it might otherwise be.
May 15th, 2008 at 9:19 am
Let’s not confuse ‘want’ with ‘need’. Chris ‘wants’ to have his cake and eat it - hence the ridiculous 3x requirement. (He also - in common with most LPs - wants to always invest with ‘top quartile’ funds, and never to have to take the risk of investing in something that he might need to nurture along to become one in the future).
In reality, he ‘needs’ to beat the market - a significantly lower hurdle today, and one that invalidates the argument to a large extent (although I agree the concept of a $500m early stage fund is a joke).
May 15th, 2008 at 9:54 am
Maybe a 3x prospective return is aggressive, although I wouldn’t call it “ridiculous.” Remember that Yale is pretty public about having high-30s IRRs since inception. That pencils out to a well north of 3x return.
Looks like Chris was at Princeton. Don’t know specifically about their portfolio’s performance, but I’d guess that he’s seen a pretty good number of funds that can hit that bogey.
May 15th, 2008 at 11:14 am
I am sympathetic with “Ramdom GP”. As an LP who invests reguarly in venture funds, I hear lots of emerging venture fund managers cry “Just give me a chance…I’m as good as (insert brand name here).”
The question is: where’s my additional compensation for the risk of investing in emerging managers? It certainly isn’t lower management fees. Is it lower carried interest…which is to say 20% instead of 25% or 30%? Bah hum bug. I’ll pay the higher carry for the significantly greater odds of outperformance. Where’s my incentive?!
I’ve said it before and will repeat it here: there are only 15 or 20 VCs worth investing in. Everybody else is just hoping and praying to win the lottery.
May 15th, 2008 at 3:39 pm
All good points. I’m particularly sympathetic to “Another LPs” question on compensation for risk. My next post will try to get to the question of how people think about risk adjusted return (and my short answer is that I’m not sure anyone pays attention to the “risk adjusted” part of it. (
I’ll probably put the post up on my blog (www.LP2dot0.com) next week - I don’t want to wear out my PEHub welcome, although I’ll probably cross-post it if Dan lets me.)
May 15th, 2008 at 3:47 pm
Just to pile on Random GP - I’m not sympathetic at all. It’s too bad that Random GP’s “hide is feeling chapped”…but it’s really a sad statement that RGP doesn’t believe that the capital invested in these kinds of enterprises should expect a substantial premium (eg. at least 1000 bps) over public market returns in exchange for accepting the plethora of risks involved. Let’s not forget these are investments that can go to zero, and that can often take more time to be nurtured and realized than was intended - so, is 3x net over a 6 year period ridiculous? Even an art major can figure out that math.
May 16th, 2008 at 2:12 pm
I’m just going to say…
A lot of VCs currently in the business should find new jobs. I’m tired of the moaning and groaning. This is tough work. If you can’t stand to be held to very high standards go back to investment banking.
May 21st, 2008 at 8:52 am
These calculations seem nice, but they tend to forget that:
1. there is something which is called preferred shares and they usually tend to guarantee a liquidity preference for investors
2. A VC which is investing steadily until liquidity is preserving its stake (hence the USD500 million), so the maths don’t work if you are doing your work (hence negotiating a 30% stake for a substantial capital injected).
3. Coming to quartiles, top performance, etc. Your incentive to back up emerging team is… actually to do your work! Otherwise don’t complain that you don’t access to the future top teams (oversubscribed). The performance of endowment is coming from their ability to take risks. There’s no free lunch.
Studies (Harvard and others show the following):
1. emerging VC have higher marginal return than established ones (more hungry)
2. terms with emerging VC firms are better for LPs
3. Top VCs remain in the top league over time (persistence of returns)
As for multiples and IRRs… If you regularly read the PE Week Wire, and do the maths, you can realize that actually, quite a few investors are making 3x and above (which is gross multiple). An LP should not expect a 3x net on its portfolio of VC funds. Risk diversification, return enhancement, ok. But don’t expect to achieve the same performance than direct investments at a fund of fund level.
May 21st, 2008 at 4:29 pm
Cranky LP: I agree there should be a premium, I just don’t think it should be as high as you do. Market conditions are very different today, and even LPs need to adjust to that. After all, it is the same market that will dictate VC exits. Of course, there are a lot more Art Majors in the LP base than there are in the GP base…
Random LP: If there are many VCs that ought to leave the market (and you’re right, there are) who funded them and then kept on supporting them, even though their returns are so bad? Enquiring minds want to know. And it is laughable to hear an LP opine on the tough work that needs to be done when you can’t get your attention for five months of every year. Stop dreaming that KPCB is going to call you and beg you to invest in their next fund, and think about developing relationships with the KPCBs of the future. Of course, that would force you to do some original thinking…
Hats4Bats: You’re right, I shouldn’t have said ridiculous - misplaced in today’s environment is more accurate.
It is instructive how a piece of analysis many years ago by McKinsey on returns in the PE market has come to dominate LPs’ thinking. I liken it to the MCI claims of growing Internet penetration/usage that so fatally over-stated the need for bandwidth. What will it take for the investor community to start thinking afresh on where value can be found? I applaud Chris for at least trying to.
May 21st, 2008 at 5:11 pm
Cyril asks a good question: who is funding all of these very average VCs: obviously, it’s LPs. Of course, I hasten to add, of course not us. We only invest with the best.
Ok, so that’s a load of crap. The reality is every half awake LP repeats the mantra about the need for top quartile returns and the persistence of returns. And then, they say (or their consultant or FoF manager), but we can pick a winner.
In such situations I try and remember that even the Harvard Endowment, with its amazing network and one of the very smartest LPs anywhere running the PE, for years attempted to run an emerging manager program. As I understand it, even they’ve given up!
That’s the point. Bet on proven winners or don’t bet at all. Recalling one of Chris’ earlier columns comparing venture to lotteries, I don’t think you have to buy a ticket. And I’ve stopped.
And if I start to think I’m smart enough to pick the next KP (wouldn’t invest with them today — different story for a different post), I hope my friends in the LP community will give me a good smack. In the meantime, I’ll keep smacking them (nicely) for thinking they can beat the odds.
May 22nd, 2008 at 12:12 pm
@Cyril:
Fair point about preference shares, although it wasn’t too long ago that VCs were getting 7x prefs and it turned out that 7 times nothing was still nothing . . .
January 14th, 2009 at 5:47 pm
[...] a comment » I usually try to blog on my own ideas and run my own numbers, but I just read a great write up on PEHub from early in 2008 on large venture capital funds. It was written by Chris Douvos, from SuperLP, [...]