week 6 Flashcards
Sharpe ratio
The Sharpe ratio shows how much excess return you are getting per unit of risk. Higher Sharpe ratio indicates that the portfolio is providing better return for the same amount of risk
Why doesn not Sharpe ratio, CAPM, and FAMA French apply to venture capital
- illiquid and highly idiosyncratic investment
- its institutional setting
- risk factors are not quantifiable etc.
Venture capital institutional setting
A venture capital fund is a portfolio of private startup companies. These companies are highly concentrated and individually riskier, meaning there is little diversification within a typical VC portfolio
Venture capital funds are structured as limited partnerships (LPs), typically with a predetermined life of 10 years. Capital is committed upfront by the LPs (investors), but the funds are called as needed over time, and the actual return to LPs is realized only upon the exit of the investments (typically via an IPO or acquisition). This structure introduces a long-term, illiquid horizon.
LPs in VC funds must pay management fees (typically 1-2% per year of the committed capital) to the general partner (GP), as well as a portion of the profits, called carried interest (usually 20-25%). These fees reduce the overall return to the LPs and create an additional layer of complexity in measuring risk-adjusted returns.
Issues with NAV
- Staleness: often considered backwards looking because they rely on historical data and valuations, which might not accurately reflect the current market value of assets
- Manipulation: The General Partners (GPs) of the fund often have discretion over how assets are valued, which can lead to bias (conservative or aggressive) in the NAV calculation.
- Fees: NAV calculations can overstate the true returns for LPs because they do not take fees into account, leading to discrepancies comparing the reported NAV with the LP’s actual return.
- Valuation: post-money valuation of an investment (value of the firm after the VC invested) is very different from the start-up market value. This problem is particular severe for VC compared to the rest of PE
Staleness
Autocorrelation introduces downward bias volatility, upward bias sharpe ratio
Downward biased beta, and upward bias alpha
How to deal with NAVs
Use longer-horizon returns: use long term to smooth out the impact of staleness. However, it does not solve the manipulation and fees
Imputation: involves estimating missing or stale NAVs by using external sources of information or statistical techniques
Secondary Market Price: prices give an indication of the true value of the asset, as these prices reflect the market’s willingness to pay for an interest in the fund or asset.
Imputation
The imputation method involves estimating the value of a portfolio company (or investment) based on available market data
The use of a CAPM beta (in this case, 1.4) from a firm’s past data is a typical method of determining a portfolio company’s systematic risk relative to the market.
Problems regarding imputation methods:
- Need portfolio company data for all VC funds (expensive)
- Does solve manipulation and staleness problems
- Does not solve problems with valuation of portfolio companies and after fees numbers
Secondary Market Price
The Secondary Market Prices approach suggests using the sale prices of LPs’ (Limited Partners’) stakes in the fund as a way to determine the true market value of the fund, rather than relying on NAVs (Net Asset Values).
Problems/Challenges with Secondary Market Prices Approach:
1) Illiquidity of the Secondary Market
2) High Transaction Costs and Bargaining Power
TVPI
TVPI is a ratio that reflects the total value (both distributions and remaining NAV) relative to the total capital that LPs have committed (or paid-in).
IRR
IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows from the fund equal to zero.
TVPI issues
- It does not account for the timing of when capital is called or when distributions are made.
IRR issues
1) IRR does not always exist: In some cases, IRR cannot be calculated if there are no cash inflows (distributions) or no sign changes in the cash flows.
2) Multiple IRRs: If cash flows are irregular and switch signs multiple times (e.g., there are several rounds of capital calls followed by distributions), the fund can have multiple IRRs.
3) Sensitivity to Timing of Cash Flows: The IRR can overstate or understate the actual performance of the fund if cash flows are not evenly distributed
4) Reinvestment assumption: IRR assumes that interim distributions (such as capital returned to LPs) are reinvested at the same rate as the calculated IRR.
Public Market Equivalent (PME)
The idea of the PME is essentially a discounted TVPI, the idea behind PME is to assess whether the private fund has outperformed or underperformed a public equity market index over the same period, after adjusting for the timing of cash flows.
Problems with PME
Skewness
Discount rate - using the same discount rate as the market rate may not accurately reflect the opportunity cost for LPs
PME might be sensitive to time of cash flows because there is mismatch in duration (duration for VC and fund itself is not the same)
Investment Level Data
When evaluating the performance of venture capital (VC) or private equity (PE) investments, one alternative to using fund-level data (such as NAVs) is to use investment-level data.
- Preqin, CB Insights, and MarkIt are some platforms that provide access to detailed investment-level data.
- These sources include financing round valuations, which give insight into the value of individual investments at various stages.
