Lecture 6: VC Risk & Returns Flashcards
What is Asset Pricing 101?
For a well diversifed portfolio, Sharpe ratio summarizes risk return trade off
For individual securities held by a well diversifed investor, risk is measured by co-movement with risk factors.
Why can Asset Pricing be applied to VC?
Because of the particular institutional setting of Venture Capital
What is the VC institutional setting?
A VC fund is a portfolio of different investments
A limited partnership has a predetermined life (usually y 10 years)
LPs commit capital at inception, but funds are called only at investment
Return to LPs is realized only upon exit LPs have to pay fees to the GP
What is the return of a VC?
LPs prospective return:
R = [(NAVt+1 + Ct)/NAVt-1] -1
Ct = net LPs cash flow over the quarter, the difference between distributions and capita calls
NAV = calculated as the (market) value of the fund’s assets minus its liabilities
==> Every quarter the GP must ca cu ate and communicate to LPs the Net Asset Value (NAVt) of the fund
What are the issues with NAV?
Staleness: even with accounting rules, book values rare y reflect market values
Manipulation: GPs tend to be conservative, they are slow to mark up valuations and aggressive in marking them down
Fees: cash flows are net of
fees, but NAVs are pre-fees. Returns become a mix of pre and post fee numbers
Valuation: post-money valuation of an investment (value of the firm after the VC invested) is very different from the
start-up market value (particularly severe for VCs)
What are solution to NAVs?
1) Use onger-horizon returns
==> If NAVs are autocorrelated at quarterly frequency use data at yearly frequency
==> Doesn’t solve manipulation and fees problems
2) Imputation
3) Secondary market prices
4) Don’t use NAVs!
What is Imputation?
The idea is to impute the value of each portfolio company in each quarter
Update the company’s most recently observed value using the return to publicly traded firms in the same 3 digit SIC industry
What are some of the problems with imputation?
1) Need portfolio company data for all VC funds (expensive)
2) Does solve manipulation and staleness problems
3) Does not solve problems with valuation of portfolio companies and after/before fees numbers
What is the Secondary Market Prices solution to NAVs?
Use sale prices of LPs’ stakes instead of NAV
LPs’ stakes must be traded at market value of the fund:
- No manipulation
- No staleness
- It represents the value of the stake net of fees and at “market” value of the portfolio companies
What are some of the problems with Secondary Market Prices solution to NAVs?
Problem: the market for LPs’ stakes is iliquid as transactions are rare.
1) What about funds in which LPs do not sale their stakes?
2) High transaction costs and bargaining power between the parties
What are other solutions to NAVs?
Use cash flow based measures
Total Value to Paid-in Capital (TVPI)
- Sum of distributions to LPs divided by the sum of capital calls
- For active funds, include final reported NAV as a pseudo-distribution
- It represents a cash-on-cash multiple
Internal Rate of Return (IRR)
- IRR is the discount rate that makes the fund NPV equal to zero
- For active funds, include final reported NAV as a pseudo-distribution
- Discount all net cash flows to fund inception
For a liquidated fund TVPI and IRR are based solely on cash flows
Which solutions to NAVs do LPs prefer?
1) Cash-on-cash multiple
2) Net IRR
What are some of the issues with TVPI and IRR?
TVPI ignores the timing of cash flows
IRR drawbacks:
- IRR does not always exist
- A fund can have multiple IRRs (as many as the number of times the net cash flows switch sign)
- Very sensitive to the timing of the cash flows
- Reinvestment assumption: IRR does not assumes that distributions can be reinvested at rates different from the IRR (e.g. the public market)
Both TVPI and IRR ignore risk!
What is the Public Market Equivalent (PME)?
PME is essentially a discounted TVPI
PME = sum of distributions (and if active final NAV) discounted by public market return, divided by the sum of capital calls discounted by the same public market return
PME benchmarks venture capita against public equity market
PME = 1: VC returns performed as well as the market
PME > 1: VC outperformed the market
PME < 1: VC underperformed the market
The Benchmark: for private equity the S&P500 is used, but for VC Nasdaq or Russe 2000 are better proxies
What is a problem with PME?
Discount rate
Since VC investments are highly iliquid, should we include a liquidity premium?
- The duration of the investment is shorter than the fund life: not all capital is called at inception and most distributions come before the end of fund life
- Self-selection of investors who can bear illiquidity well
What about diversifcation?
- LPs are well diversiied investors
- GPs are not; GPs could care more about idiosyncratic risk exposure
