Why is assessing VC performance more difficult? (J-Curve)
“Lemons ripen early, pearls take longer” — Venture Capital proverb
An investor can invest in the public capital markets or in the private markets. In public markets, investments can be made in different types:
- Equity: Through ETFs, index funds, mutual funds or live stocks
- Debt: Through government bonds and corporate debt
- Real assets: Through REITs and commodity funds
Private markets are less liquid compared to public markets and investment occurs directly or through funds managed by third parties. The main investment classes are:
- Equity: Venture Capital, Private Equity
- Debt: Mezzanine debt, distressed debt
- Real assets: Private real state, private energy
Measuring asset performance in public markets is easier since there is a public market price observable by all investors. On the other side, private markets do not have public information, which generates information asymmetries and benefits for some investors. A clear example is VC, where it is impossible to obtain public information on the performance of startups or the other funds’ portfolios. Therefore, every investor should keep in mind how the performance of a VC vehicle is built.
A VC fund normally has a life period of 10 years, which is made up of 5 years of investment and 5 years of divestment. Throughout the investment period, the fund manager calls investors’ capital (capital calls) to invest and create a portfolio. Part of these capital calls is intended to cover administrative expenses (20–25% of the fund size) through a management fee, and the remainder is then used for the investment activity.
The capital invested in any startup enters within a specific investment round at a certain valuation (priced round). The round will be a proxy for the investors to better understand the fundraising traction of the company, since startups are expected to continue raising capital over time at higher valuations. As the startups raise significantly higher investment rounds, this often results in a capital appreciation by the investor which upon exit could make the investment profitable. This process usually takes several years due to the complexity of the startup’s growth.
From an investor’s point of view, it can be strange and even worrying for a fund to report negative returns for the first few years. However, it is something natural about VC funds’ investments as it is exemplified in the J curve. The “European Venture Capital and Private Equity Association” (EVCA) defines the J curve as the curve generated by graphing the returns generated by the PE fund over time (from birth to end). The fact of paying management fees and organizational expenses of capital contributions does not result in an equivalent book value. Thus, VC funds will initially show a negative return. When the fund receives its first returns it will show an accelerated return. During the divestment period after year 3, the estimated return could provide a reasonable explanation for the defined returns.
Investors may consider factors other than IRR in evaluating a fund manager’s performance. The performance of a fund may or may not be realized. If the portfolio companies have already had liquidity events, then the IRR and other metrics will show a real value. Otherwise, if there have been no exits, estimates can be calculated to determine the value to be realized.
Throughout the life of the fund the managers can display the value of the investment as either the actual cost or the estimated value.
- The real cost is simply the amount invested at the valuation of said round. This methodology is generally used when the startup has not had subsequent investment rounds and there is no information on comparable transactions in the market.
- The estimated value can be a mark to market at the value of the most recent round of capitalization or based on estimates of a potential value through comparables valuation methodology.
- Sometimes there are partial outflows that generate distributions to investors, this produces a composite return of actual and estimated amounts. NAV is the methodology most used by fund managers to show positive returns to their investors.
All VC investors must understand the meaning of the J curve and the factors that produce positive returns. The VC is an asset class that takes time to mature. Investors should think long-term and be patient to visualize the real return on their investment.
“The bad deals reveal themselves to you early and you have to deal with the fact you made a bad investment and figure out how best to get it out of your portfolio, by either selling it, merging it into something else, or shutting it down . The good deals take years to develop. If you have the patience, you are almost always rewarded. “ Fred Wilson — Union Square Ventures
Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.
Ricardo Latournerie. VC Investor at ACV.
ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.
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