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Venture Capital Introduction: Risk & Returns

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| Benjamin Fong, Business Development |

In this series, I will cover short and simple thoughts on the Venture Capital (VC) industry from the perspective of someone new to it, to get you from 0 to 1.

I just read a research article published by Going VC, on common pitfalls in the industry and suggestions to improve them, titled – “Is the VC Juice Worth the Squeeze?”

My thoughts? An interesting and holistic analysis of the VC industry, definitely worth a read for interested entrants or current industry members! Before I begin, I must caveat that these are technical in nature, and may actually be different in practice. We will try to examine from a facts-based perspective due to some controversial statements that could be made. Here are some of my takeaways:

The VC industry remains highly attractive to investors relative to other asset classes, with the top 25% of VC fund managers’ returns outperforming other top performing asset alternatives including private equity, real estate and high-yield bonds. Yet with this attractive outlook comes the overlooked caveat of the remaining proportion of VC funds, the not-so trivial ‘many’.  

According to data from Horsley Bridge, a respected Limited Partner (LP) in multiple VCs, a small 6% of their investments, which represented only 4.5% of their total dollars invested, generated 60% of their total returns.

A study in 2016 showed that while only 2% of the total VC funds invested belonged to the top 20 VC funds, a massive 98% of VC funds invested belonged to the others, which might not stand the same chances of success. This means that while the returns on paper might be extremely high, there is an even higher chance of the returns not being generated at all in reality.

Thus, this reinforces the strong 80/20 pareto effect in the industry, and the highly volatile returns structure, where one singular bet could make up 90%-99% of the returns to the fund.

2. Lottery-like approach and low fiduciary nature of compensation results in a stronger emphasis on generating returns, rather than focus on risk management, leading to increased risk.

Lottery-like approach is simple to understand. VC is arguably more of an art, with managers forming their own science around the approach. At the seed and Series A level, it is tough to measure how a startup can succeed, except through more qualitative approaches such as looking at the team experience, and betting on the founder’s tenacity, connections and experience.

With regards to the low fiduciary nature of compensation. This is arguable depending on the fee structure. For some funds, with fees guaranteed regardless of performance (i.e. management fees), risk management may be inevitably de-emphasised, causing uneven fund allocations with a bias for higher risk investments. Add to this the illiquid nature of the capital invested. However, that said, different funds use a myriad of fee structures, with some having a 1%/25% instead of the usual 2%/20% (management fee/carried interest), which skews the fund to be incentivised to make sure that their investments yield returns, or they may not get paid.

Adding to that, we see a faster pace of deal-making. Whether or not this de-emphasises risk remains to be seen.

✦ The Founder of First Round Capital, Josh Kopelman spoke to the heightened pace of deal making at his own firm at a tech showcase in California, saying that the average time from first contact with a startup to drawing a term sheet has shrunk from 90 days in 2004 to 9 days today.

Combining these 3 factors together, perhaps returns could be argued to be prioritised over risk.

✦ For instance, well known ‘unicorn hunter’ Kleiner Perkins, has already invested much of the $600mil raised in 2019, and is already looking to raise a 19th fund, revealing the speed of deal-making and what some refer to as a lottery system of “spray and pray”.

That said, this is the nature of the VC industry with extremely high risk. One could always play safer in growth capital in the Series C stage onwards or allocate capital into other markets with low correlations and betas.

3. Higher expectations on General Partner (GP) accountability

For the uninitiated, the GP manages the money in the fund, which consists of moneys from LPs. Based on economics, LPs expect GPs to put some of their money where their mouth is, and invest also in the very startups that they will use other peoples’ money to invest in.

In order to increase accountability and prudence in investments, there could be higher expectations for GP’s accountability. Increasing skin in the game, regular performance updates and sharing investment direction with Limited Partners are all ways the VC GP can operate to ensure higher accountability to their clients.

✦ One such example would be Indie.vc, whose approach to funding removes the wait for an exit to cash out that most VCs adopt, and instead is compensated with cuts from the excess cash flows of the company, until Indie.vc makes its desired return on investment. Additionally, the startup can also opt to buyback their shares from Indie.vc within 12-36 months of the first check.

This model targets sustainable businesses instead of unicorns, holding the VC more accountable to performance, since the startups will have to prove strong revenues in order for the VC to get its return.

Conclusion

As we consider the risk-return metrics and considerations in the VC industry, it will be interesting for finance majors and those in asset management to note how do these risk-return metrics compare across asset classes, especially the public markets, or even Private Equity (PE) leveraged buy-outs (LBOs).

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