When I say fund performance, the first metric that comes up is the Internal Rate of Return or IRR. Investors typically compare the fund performance with the aggregate returns generated by an entire VC asset class. For instance, let’s say that a specific fund of a certain vintage year generated 34.5% IRR then an investor would use this to compare with appropriate benchmarks.
However, in this process, there are some caveats-
- The Vintage Year Temptation- Sometimes fund managers are tempted to assign vintage year when he started raising the fund not when the final close happened.
- The Categorisation Issue- There is a gigantic gamut of universes to compare. It is a good practice to position your fund in an appropriate category to avoid comparing apples with oranges. Appropriate categories can be-
All Early stage VC funds
All Early stage Technology VC funds
All French early stage technology VC funds
- The Peril of Unrealized Returns- It is a good practice to not include unrealized returns in calculating fund performance as unrealized returns are risky since value of shares held in a private company can often exhibit large deviation.
- The Precision of data- VC industry has the self-reporting culture and often LPs have opinionated that mostly the mediocre managers report data.
DRAWBACKS OF IRR
According to an informal research done by McKinsey in 2004, only 20% of executives understood the critical drawbacks of IRR. In hindsight, if you compare two funds, one with an IRR of 24% with that of 11%, one would be inclined to regard the first fund as better performing. However, the devil here is again in the details. The IRR is not telling us the reinvestment risks and capital redeployment in other investment opportunities.
Next, the IRR is a percentage and so there is a case where a small investment can show a big double digit or a triple digit IRR while a large investment can show an IRR of single digit but be more lucrative once it is accounted for the net present value (NPV).
OTHER FUND PERFORMANCE METRICS
Some LPs measure the performance of funds using metrics such as COC, TVPI or DPI. Who are these suspects? I am going to explain them below-
Cash-On-Cash return (COC)– In VC and PE landscape, COC multiple shows how much return the fund received after exiting the investments. Investors will always prefer an investment with 40% IRR over a 5 year period with COC of 4x over an investment with 100% IRR over a 1 year period with 2.0x COC. The COC multiple of an entire fund helps the LPs know how much carried interest will be available to split.
To explain the next multiples, I will first introduce some terminology which are used to calculate the multiples listed below-
Paid in Capital- This refers to the capital contributed by the LPs to a fund. It is also known as “Contributed Capital”.
Distribution- This is the value of cash stocks that is given back or distributed by the fund to the LPs.
Residual Value– The remaining value of a fund at a given point in time. It is calculated by adding fair value of all remaining investments plus any cash equivalents minus any liabilities. Total Value (TV) – The total value of a fund is the sum of Residual Value and Distribution.
TV = Distribution + Residual Value
The figure below shows an illustration of the terminology discussed above-
Now let’s have a look at different multiples
Distributions to Paid-in Capital (DPI)– It is calculated by dividing distributions by paid-in capital.
A DPI of 5x means the fund provided a return to LPs that was 5 times the paid-in capital. Therefore, LPs desire a higher DPI multiple.
Residual Value to Paid-in Capital (RVPI)- It is calculated by dividing residual value by paid-in capital.
Total Value Paid-in Capital (TVPI)- It is calculated by dividing the Total Value by Paid-in Capital.
Since Total Value = Distribution + Residual Value
Hence, TVPI = DPI + RVPI
ENTER THE PUBLIC MARKET EQUIVALENT (PME)
Besides IRR, the other multiples discussed above serve as a good metric to measure the performance of a fund. However, there is another measure called Public Market Equivalent which basically measures the performance of a fund compared to a public market index such as S&P 500. A fund having a PME of more than 1 indicates that the LPs received better return by investing in the fund rather than investing in the market.
Let’s say an LP invested $100 million in a fund and received $500 million after 5 years. In the same time frame, had the investor invested in S&P 500, he would have earned $395 million. So the gross PME = 500/395 = 1.26. In this case, the investor didn’t lose money by investing in VC fund as the PME is greater than one.
What I have described above is a simple way to calculate PME, there are different forms of PME which have been developed over the years such as LN PME, KS PME, mPME, PME+ and Direct Alpha.
THE KUSHIM WAY OF MEASURING FUND PERFORMANCE
The Portfolio Management suite of Kushim offers customizable and user friendly interface to continually monitor the performance of a fund.
All Fund Performance Multiples
The fund performance section offers all the information about your fund’s performance and all the multiples mentioned above are calculated as well-
You want metrics? Here they are!
The Kushim Management suite offers 60 in built metrics to measure the performance of your portfolio companies. Keeping in mind the bespoke nature of our solutions, now you can add your custom metrics. You can even send an email directly from Kushim Management suite to your portfolio company and invite them to update the metrics.
The representative of your portfolio company will only be able to access the company page of his/her company and update the metrics.
The dynamic data about your portfolio’s performance can be exported to excel with a single click.
For the love of analytics
For those who love analytics and want to create custom reports. The Kushim Management suite features a report generation tool that is dynamic in nature. All you need to do is select the type of data you want to compare and create dynamic reports that can be downloaded any time.
These are some of the salient features of Kushim’s Management Suite. If you would like to know more then click on the button below to book a demo.
Lastly, thank you for taking out time to read my article. More intuitive articles about the VC industry will be published soon.
John C. Kelleher and Justin J. MacCormack, “Internal Rate of Return: A Cautionary Tale,” McKinsey Quarterly, October 20, 2004.
The Business of Venture Capital by Mahendra Ramsinghani