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.