Should Venture Funds Consider J-Curve Mitigation Strategies?

Most everyone involved with the venture industry is familiar with the J-curve. It is used to describe the nature of returns in a venture fund (based on the internal rate of return or IRR). Returns are typically negative in the early years and then turn positive in the range of three to five years after the fund starts investing. This happens as a result of a number of factors, including: management fees (which make up a larger portion of called capital early in a fund’s life), under-performing investments that are identified early and written down, and also the simple fact that investments take time to mature and grow. 

All in all, for investors with a long-term focus such as those investing in venture capital, the J-curve is is not a major concern since all good funds eventually emerge from it. Unfortunately though, in evaluating venture funds some investors irrationally eschew what are quality venture funds and firms based solely on IRR since it’s the most prominently used return measure and also the most commonly benchmarked. Funds with deeper J-curves or even funds whose early returns are viewed by investors without full understanding of the J-curve are often unfairly judged. This begs the question of whether or not venture funds would well served by taking actions that mitigate the J-curve. As the industry has come under scrutiny over returns and the competition over limited partner commitments intensifies, the idea of a venture funds using j-curve mitigation tactics isn’t so farfetched.

J-curve mitigation already happens at the portfolio level of institutional investors by mixing in funds with strategies that produce more immediate cash flows. Examples include secondary funds, direct secondary funds, venture debt funds and co-investments. Let’s say a venture firm wanted to mitigate the J-curve in a fund, what tactics could they use?

• Defer management fees to later years of the fund – management fees early in the life of a fund are a major drag on the IRR. Firms that can afford to defer them to later years of the fund could mitigate the J-curve and boost IRR.

• Be less conservative with valuations – by not writing companies off early or holding companies close to cost when they can be written up, a fund could boost NAV and IRR as a result.

• Alter the fund’s early investment strategy. Examples include:
  • PIPE deals – investing in publicly traded companies.  The liquidity associated with the public markets means an investment could be made and turned around in a short period of time.
  • Venture debt – providing debt financing to already venture-backed companies. Debt payments mean early cash flow while warrants can provide the option for future equity.
  • Early late-stage deals – If a fund has a balanced strategy in terms of investment stage, concentrating late state deals early in a fund’s life would provide early liquidity to mitigate the J-curve.
  • Direct secondaries – purchasing an investor’s (founders, employees or even venture funds) interest in a venture-backed company that is close to a liquidity event.

Below is an example of how early liquidity can not only help mitigate the J-curve but also impact a fund’s overall IRR. I’ve assumed that a fund is able to produce the same level of distributions regardless of strategy (the only difference being timing): 

As you can see, in addition to mitigating the J-curve, IRR can be boosted significantly by providing a moderate level of early distributions. Of course the difference in return is almost purely optical since the return multiple remains the same. Furthermore, by implementing these strategies, a venture fund is almost surely forcing a strategy that might not be optimal for the team, market and long-term benefit of the fund and limited partners.

Are investors concerned enough with the J-curve that they would accept lower risk-adjusted returns to mitigate it? The right answer to this question has always been no, since most sophisticated investors realize the long-term nature of the asset class (and use a broader measures of performance including return multiples). Still, the possibility of funds implementing such strategies is more real now than ever before, as managers try to keep ahead of peers and gain any edge they can in appearing better to less informed investors.

The Real Impact Of Overlooked Fund Return Considerations

The Private Equiteer recently brought up an aspect to private equity and venture capital returns that is often overlooked and unaccounted for: The fact that investors (limited partners) in funds have to set aside or plan around the capital they have committed to a fund. For those less familiar with private equity, investors in funds do not pay in the full amount they decide to invest in a fund right away. Instead, capital is called by the general partner as the fund makes new investments. Rarely do limited partners set aside their full commitment to a fund and hold cash to meet capital calls as they come. Most model around expectations provided by fund managers and hold only the amount of cash necessary to meet capital calls.

The Private Equiteer argues that opportunity cost of holding cash, or the risk of default associated with reserving inadequately should be factored into private equity returns. I would agree that there is some opportunity cost involved, but the simple fact is that virtually no limited partner holds the full amount of a commitment to a fund it has decided to invest in as cash – only for short periods to meet imminent capital calls, which in the grand scheme probably has a negligible effect on returns. There’s also a very limited chance that a limited partner defaults on a capital call. It’s extremely rare, and even if it does happen, there are remedies that would allow the limited partner to continue investing in the fund – rarely would all value be lost.

The reason these two issues aren’t talked about too much is probably because they’re not really major  issues to begin with. Putting aside the risk of default (which is incredibly small), let’s take a look at the effect holding committed capital as cash would have on a fund’s return. If you remember, in my model for a crowdsourced venture capital fund, I suggested that all committed capital would have to be called at the onset of the fund to make things logistically simpler – perhaps as the private equity and venture capital industries evolve, we’ll see more of this. Below I’ve modeled out a hypothetical private equity or venture capital fund’s cash flows under a normal model (which assumes that cash comes in right at the time of a capital call) and also for a model where cash is held/called at the onset of a fund (same impact on returns). I’m using 5% as an interest rate for the cash and the rest of the cash flows for both models are the same. Here’s what we get:

As you can see, there is clearly an impact on the fund’s IRR - a difference of around 1.3% in this case, but with a return multiple of 1.6x under both scenarios. Is this a significant difference?  I would say it’s definitely material, but it depends on the investor. The difference is probably significant enough to impact investment decisions and overall portfolio performance, and its why funds do not call capital upfront (negative impact on IRR, even though all other performance is the same) and why limited partners don’t hold cash. They assume they can earn even more than the 5% I modeled in on their cash. The only benefit derived from calling capital upfront or holding a commitment as cash is eliminating the risk of default, but as I mentioned before, it’s such a small risk in the first place that it does not make sense to protect against in such a way.  That said, I do stand by the idea that for different models such as a crowdsourced fund, you would still want to call all capital upfront, even if you sacrifice a bit of your IRR. 

VC’s: How To Benchmark Yourselves Properly

Plenty of VCs are guilty of deceitfully presenting fund performance – especially when it comes to benchmarking themselves against their peers in marketing materials. There’s a reason why so many LPs complain about almost every VC claiming to be “top quartile.” When raising new funds or providing updates, you too frequently find venture capitalists benchmark their performance improperly, often in an attempt to make themselves look better. Instead of these attempts, existing and prospective LPs would probably find it much more amicable if VCs candidly presented their relative performance - in fact, being candid in presenting performance and benchmarking goes a lot further than you would think with most LPs.  Here’s a guide on how to go about benchmarking properly and in a way that LPs will surely appreciate:

Selecting a Benchmark:

Use the Cambridge Associates Benchmark Statistics - don’t even consider any alternatives. Their benchmarks are far and away the most comprehensive. A common alternative you see is the ThomsonReuters (Venture Economics) benchmarks but they fall so short of Cambridge in terms of sample size that their statistical validity is questionable - sophisticated LPs are aware of this issue. The Cambridge benchmarks exhibit slightly higher returns because of their selection bias (all funds that Cambridge clients are in get pulled in so some consider it more of an “institutional quality benchmark”), but they are the industry standard and using anything else immediately raises doubts for LPs.

Don’t have access to their quarterly benchmark statistics? Simply contact them and participate in their quarterly survey and you’re receive the benchmark statistics free of charge. You’ll have to provide your quarterly financials to them but don’t worry, all data is kept confidential and your performance remains anonymous. They’ll even sign an NDA if you ask them to.

What to Present:

Determining the Proper Vintage Year: Cambridge Associates determines a fund’s vintage year based on the partnership’s date of legal formation - not by when a fund holds its final close and not by when a fund started investing. This means that under most circumstances you should do the same, unless there’s a special case where a fund took over a year to raise or if the fund was legally formed so late in a year and didn’t start investing until late in the next year that its most logical to use the next vintage year. If either case applies, make sure you footnote the situation properly.

 Determining the Proper Asset Class: Usually it’s not difficult deciding whether the venture capital or private equity benchmark is most appropriate. But in some cases where a fund has a later stage or growth equity strategy, LPs like to see it benchmarked using private equity benchmarks. If you have a strategy that straddles venture and private equity, consider using both benchmarks.

 Performance: You must of course show IRR, but make sure it is the IRR NET TO LPs (net of fees and carry) not the gross fund IRR. Nothing is worse than a VC that either purposely or inadvertently shows just gross IRR and then even worse, benchmarks it against the net to LP benchmark. It’s ok to show a fund’s gross IRR but if you decide to do so, you must also show the net IRR as the next line item. Generally, when benchmarking you want to show just the Net IRR because if there’s a large discrepancy between the net and gross, it draws attention to the effect management fees and carry is having on the return to LPs.

 In addition to the IRR also show and benchmark the distributed/paid-in and total value/paid-in multiples. Showing fund level cash flows is a plus too. The reason for showing the multiple is to help iron out some of the effects timing has on the IRR and give a truer sense of the fund’s performance. This goes back to being candid – you don’t want to omit multiples if IRR has been boosted by a quick exit, and conversely, for older funds you might actually be doing yourself a disservice by not including the multiples if IRR has been dragged down because of timing.

 Not Meaningful Performance: A general rule you can follow is that a fund’s performance is not meaningful and thus okay not reporting on and benchmarking if there has been less than three years of activity. Just make sure you footnote why you have decided that a fund’s performance is not meaningful and why it hasn’t been benchmarked. But also be sure to have the performance handy and expect to provide it if an LP asks for it.

Here’s an example of how fund benchmarking should look (note: figures are fictional):

 

Note that these guidelines apply to sharing fund level performance only and that the guidelines for sharing company level returns are much different – something I’ll eventually post about later. In the meantime, feel free to provide feedback or ask questions about these guidelines.

The 10-Year Venture Capital Return Doesn’t Mean Anything

Over the past year there’s been a lot of talk about how venture capital returns over a ten-year time horizon will no longer look so hot once this year is out. This is because after this year the ten-year timeframe will no longer include returns from 1999 – a year featuring huge exits through quick IPOs in what was the last year before the bursting of the tech bubble.  The 10-year venture capital return currently stands at 14.3% (as of 6/30/09 – VC returns are always on a quarter or quarter and a half lag), but has been in a steady decline. There’s been some speculation that the decline in this return will have a negative impact on the venture industry’s attractiveness to investors, but I don't think that is necessarily the case.

Over the last four quarters, the 10-year return has tumbled from over 40% to 14%. For a visual, here’s what the recent drop in the 10-year return looks like:

Before going further, here’s some background on how the return is calculated:

The 10-year return is an end-to-end venture capital fund-level return, meaning it looks at the fund-level (read: not company level) cash flows – to LPs only, meaning it is net of fees and carried interest ( a good thing because this is the true level of return an investor in venture capital funds would have received). The return is a standard IRR calculation except that it in the period in which it starts, in this case the second quarter of 1999, the cash flow pulls in the negative starting net asset value of all the funds comprising the index. Going forward, all contributions and distributions are netted to get the cash flows for each quarter (for timing purposes, the figure is assumed at the midpoint of each quarter). For the final quarter of the calculation the current net asset value of all the funds in the index is added in as a positive cash flow.

What’s the recipe for this drop in the 10-year return? For one, huge IPOs started tapering off after 1999 while at the same time, inflated valuations made the beginning negative cash flow much larger and tougher to overcome, dragging down returns.  Then add in the fact that there hasn’t been another period of fantastic exits since, and that the past year has been absolutely dismal for venture-backed exits and you get a free-falling 10-year venture capital return.

But how important is the 10-year return really? The whole notion that the 10-year return’s fall will have a negative impact on the venture industry is actually hugely flawed. The pure numerical drop in the 10-year return should not be what deters investors. Why? Because sophisticated investors (limited partners) are smart enough to not have been looking at the 10-year return anyway. If anyone looked at the 10-year return as their reason to invest in venture, they clearly do not understand the asset class enough to be making decisions on investing in it. 10-years, despite being a round number, is just as arbitrary as any other number. Nothing makes it different than looking at 9 or 11 years. Even if you are comparing to public markets. The only thing that makes this current case unique is that we are on the brink of excluding a great period for venture. But by now, most investors have come to accept the tech bubble as an aberration, and new expectations for venture returns are much more tempered, albeit still relatively high because of the illiquidity and risk.

Plus., if you want to get technical, the 10-year return isn’t realistic for investors because to have gotten those 10-year returns they would have had to have gotten into funds in the prior one to four vintage years – the ones which were actively investing prior to the bubble and able to exit during the bubble.

Finally, no legit VC I can think of is selling their fund based on 10-year industry returns. In fact they probably look to avoid having to talk about the bubble years because the business is so different now. What happened 10 years ago is pretty much irrelevant. VCs are judged on their performance over the last five years, how their strategies can take advantage of the current environment, and their ability to exit deals over the past year and going forward.

What the drop in 10-year return does more than anything is highlight a major shift in the venture industry - a shift that investors and VCs were aware of years ago and probably ever since the bubble burst. This drop in the 10-year return is not new information and could have esily been predicited a few years ago. We’ve gone from some 250 venture-backed IPOs in 1999 to just 10 so far this year. We know there will be attrition in the industry, but investors that stick with venture capital should be better off because of it. Innovation continues unabated and top mangers continue to provide quality returns through building and growing companies - the way it should be.

The Venture Capital Industry in 2009: Over/Under

With this week marking the start of the NFL season, and the calendar marching toward the fourth quarter, there’s no better time to do a bit of speculation around how this year may end up for the venture industry. Especially when you can have it take the form of the over/under wagers commonly associated with the sport (which are only made for fun of course). Half the fun was in deciding what the over/under should be the rest is in the takes. Here we go:

Category: Venture capital index return for 2009 (one year/end-to-end)

Over/Under: 6.5%

The Take: UNDER

This was a tough line to formulate without the second quarter venture capital index return which is not yet available. The Cambridge Associates US Venture Capital Index return for the first quarter was at -2.9% and the preliminary second quarter end-to-end return currently stands at 0.16%. With the NASDAQ up well over 10% in the third quarter so far, it’s fair to say the venture index will track further upward in Q3 and probably Q4. The venture index has been less volatile than the public markets despite FAS 157 mark-to-market rules, but the trend down the line should still be upward. There should be some bump in valuations before the year is out, but since exit activity will remain weak, the index should have a tough time breaking 6% for the year.

Category: Venture capital fundraising totals for 2009

Over/Under: Funds: 125, Dollar Amount: $12 Billion

The Take: UNDER – both number of funds and dollar amount

At the end of the second quarter, 70 venture capital funds had raised a total of $6.3 billion. Fundraising activity declined significantly in the second quarter, when only $1.7 billion was raised by 25 funds. As we find ourselves amidst the toughest fundraising environment in some time, limited partners have shown no signs of increasing their rate/level of commitment in the near future. Allocations within private equity for most institutional investors have either remained unchanged or dropped for venture, while increasing for more opportunistic strategies. Well established firms and proven general partners should be able to raise funds, but newer firms and those with less than stellar track records will have trouble.

Category: Venture capital deal-making totals for 2009

Over/Under: Deals: 2,750, Dollar Amount: $15.5 Billion

The Take: OVER – both number of deals and dollar amount

At the end of the second quarter, venture capitalists had invested in 1,215 deals totaling $6.9 billion. Investment activity was quite consistent between the first and second quarters. There’s the sense that investment activity has dropped a bit in the third quarter but that deal sizes seem to be larger, perhaps reflective of a shift to investment in the healthcare and cleantech sectors. Look for venture capitalists to continue to invest in innovative new companies, particularly as they should still have the upper hand on deal terms and valuations. Follow-on investments in later-stage companies will continue as well since the exit market will not open up significantly at least till next year.

Category: Total number of venture-backed IPOs in 2009

Over/Under: 9

The Take: PUSH

 At the end of the second quarter there were just 5 venture-backed IPOs for the year, I’m counting just the LogMeIn and Cumberland Pharmaceuticals IPOs since, and projecting just two more. You have to have faith that two more venture-backed companies can hold an IPO in the next four months buoyed by the solid performance of those that have managed to go public so far this year. The good news is that 2010 looks to be a much better year.

Category: Total number of venture-backed M&A exits in 2009

Over/Under: 230

The Take: OVER

Through the end of the second quarter there were 121 M&A deals in which venture-backed companies were acquired. At the start of September we were at around 165. While the third quarter will probably end in line with first and second quarter totals, I’m expecting the fourth quarter to be relatively more active. The over/under is adjusted for this expectation, but I’m still taking the over. Strategic buyers, particularly those with abundant cash reserves will probably look to take advantage of depressed valuations while they last. 2010 could see a rise in valuations, especially if the IPO market opens up a bit more. It’s still worth it to note though that even if we manage to reach 300, the year will go into the books with the lowest venture-backed M&A tally since 2003.

Note: NVCA data was used for all the statistics in this post

The 1999-2000 Problem

The fact that venture capital has not produced quality returns for 10 years has been getting a lot of attention lately, particularly as LPs start having to make tough decisions about whether or not to continue to commit to the asset class. When a typical LP looks at their portfolio, what do they see?

Let’s assume that it’s a fairly well established institutional investor who has been in the asset class since the early 1990s. My best guess is that it looks something like this: reasonable commitments and excellent distribution activity from (vintage year) funds up to 1997-1998. Then things hit a wall. The good times ballooned out of control into the “irrational exuberance” (I hate that term) of 1999 and 2000 when LPs went gangbusters committing to VC funds. Needless to say these did not perform well. So next, the tech bubble bursts and you have a massive pullback - there are probably relatively much fewer vintage year 2001-2003 funds in most venture portfolios. Too bad, because these funds, on average, have performed pretty decently. Then investing activity picks up again, you see more 2004 and 2005 funds, which have had acceptable performance and some distribution activity but are still young enough to hold further promise. Commitments probably increase significantly (though not as much as with buyouts) in 2006 and 2007 as the economy was firing on all cylinders. These funds are too young to have produced meaningful returns, as are 2008 funds which most LPs pulled back on investing in due to liquidity issues.

So with this picture of what LPs are looking at let’s go back to the 1999 and 2000 funds: The returns, everyone can find a way to live with. If you’re a 1999 or 2000 venture fund, an IRR of 0% would be above average, and most funds would be happy simply returning commitments at this point. VCs can live with this because most have already moved on: “hey we think we can return all of your capital in what were two really crappy years for everyone, and we’ve learned our lessons and promise not to mess up again.”LPs are probably willing to accept the returns as well. But there’s one problem- so many of these funds have so much capital still unreturned. It’s one thing to have these returns down on paper; it’s another thing to actually achieve them. We’re talking about funds that have to wind down operations in the next year (ok, throw in a couple years of fund extensions, but it’s still going to be a challenge). At year end, the net asset values of 1999 and 2000 funds was some $33 billion – a huge chunk of all venture capital, even after huge write-downs in Q4 of 2008.

What’s going to happen to all these investments and funds? Venture firms are going to have to either get really creative, really lucky, or liquidate at massive discounts. This is a major issue that isn’t talked about enough, but will be over the next couple years, I think. And it raises further questions which don’t have clear-cut answers, like: Will 2005-2007 funds be faced with similar issues if the exit markets don’t improve? And is this more of a fundamental issue with venture capital now? Take, for example cleantech deals and funds – there are already questions around being able to build, develop and exit solar or biofuel companies in five to seven years. I’m not saying venture is dead, there’s definitely a need and place for it, but it’s going to be different. For one, we may be looking at longer fund terms which means more illiquidity and higher return expectations. It may also mean a rise in liquidity options, such as special markets for illiquid assets, and secondary funds specializing in companies or LP interests in venture funds that need to conclude operations.