Duet Partners
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Weekly Briefing Note for Founders

13th January 2022

This week on the startup to scaleup journey:
  • VC 'Power Law' means most funds will underperform
  • How VCs make money
  • US Venture investment smashes all records

1. Insights of the week

VC 'Power Law' means most funds will underperform

We often hear VCs talking about the importance of 'picking the winners' or 'finding the outliers'. How each investment they make has to have the potential to 'return the fund'. What does this all mean and why is it important to a VC fund manager? Veteran investor Fred Wilson said a few years ago: "I’ve said many times on this blog that our target batting average is “1/3, 1/3, 1/3” which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments." History has shown that for a small number of the very best funds such a distribution is possible, but for the average fund, life is a lot more scary. Such funds are not particularly good bets for their investors. In fact, many funds fail to return any capital at all.

A recent analysis of Venture outcomes over the past decade by Seth Levine of Foundry Group is illuminating. Using data from Correlation Ventures, a VC that takes a heavily data-driven approach to investing, it is clear that venture returns are significantly more skewed than most would expect. The analysis of almost 28,000 financings into companies exiting or going out of business between 2009 and 2018 showed that 65% of investments failed to return 1x capital and only 4% returned greater than 10x capital. Applying this to a fund of $100M, which makes say 30 investments (just over $3M per investment - typical for Seed), then just 1 company out of this portfolio of 30 would return 10-20x and 1 would return 20x or greater. In fact in both cases it is slightly less than 1. Note that a 20x return doesn't even 'return the fund' on its own. The top performing funds will of course have several of these and will make great returns for investors.

Overall, venture funds look to return at least 3x the invested capital after fees, so more like 3.5x on a gross basis. This either requires a true outlier return (50x+) and/or consistency of 10x+ returns. The very best funds do have multiple companies that return in that range - or even higher. Hence the so-called 'power law' return profile rather than a 'standard distribution'. But that means the average fund doesn’t have any of these high-end returns. 'Picking the winners' at the very beginning is hard, so to improve overall fund performance less capital may be deployed in the first round. Then the fund manager will double down on those that are showing real promise in subsequent rounds and essentially forget the rest. In addition, those experienced VCs that have greater confidence in 'finding the outliers' will likely invest in fewer companies, say 20, and have more allocation for each, hoping to return well in excess of 3x. But those that can only manage average returns will fall well below the typical 3x cash on cash target and may struggle to raise a subsequent fund. Finding the outliers is essential.

How VCs make money

Understanding how VCs make money provides insight into how VCs think. Compensation drives behaviour. A VC fund generates income from two sources: 'Management Fees' and 'Carry'. Most VCs employ a '2 and 20' model: 2% management fees plus 20% carry. Management fees provide the fund manager, known as the General Partner or GP, with income to cover operating expenses: salaries, rent, resources and other overheads associated with operating the business day to day. The 2% management fee is calculated on AUM (assets under management). For a typical $100M fund that's $2M in management fees per year and for a big $500M fund it's $10M per year. No surprise why VCs look to raise bigger and bigger funds. The more money they have under management, the heftier the salaries. But the rub is that these fees are subtracted from the total amount of deployable capital, so this is money that isn't directly invested in the portfolio. As VC funds are typically 10-year funds, a $100M fund could provide $20M in fees over its lifetime, with only $80M then available for investments.

But the real upside for VCs is in the 20% 'carry', short for 'carried interest'. This is a share in the profits that the fund makes. For example, if a $100M fund generates 3x the original capital net of fees (a common target for many funds), i.e. $300M, then the first $100M of returns go back to the investors, the Limited Partners (LPs) and then the $200M profit is shared between the LPs (80%) and the VC partnership (20%). The 3x return approximately translates into a 12% per annum return for the investors. LPs need this high rate - if it were much lower they would simply invest in less riskier asset classes. Plus, their money will likely be tied up for the 10-year life of the fund, so there is the opportunity cost to also consider. The methodology for ultimately sharing profits can also vary but in all cases requires investments to become liquid through some form of exit. (As the fund ages, exit pressures therefore increase). Generally, VCs start to take carry once the original capital raised has been returned to investors. This can take many years - perhaps 6 to 8 years or even longer, unless there are some big early exits.

As we remarked above, success is far from evenly distributed across the VC community. Top early stage funds will regularly return much more than 3x but the majority will return less than 1x. As a result, LPs clamour after the most successful fund managers, fighting for allocation. It's difficult for emerging managers to carve out a position, especially in an uncertain market. In 2021, LPs left the anxieties of 2020 behind by pushing $128B into US VC funds. Emerging managers took $41B compared with only $27.5B in 2020. Yet despite the fact that fund sizes have risen globally, and the amount of capital being deployed has rocketed, the number of investments made has essentially been flat over the past 4 years. And if the number of deals is not increasing, you don't need to increase the size of your team. This has meant that VCs have been able to keep operating costs more or less level. If these bigger investments pay off, there will be more profits to share across the same number of partners. We'll find out in about 8 years!

US Venture investment smashes all records

US venture capital (VC) investment in 2021 topped $329.8 billion according to Pitchbook's fourth quarter Venture Monitor. This was nearly double 2020’s total of $166.6 billion - the previous record. A big proportion was "mega-deals", those >$100M, which produced $190.8 billion in deal value - almost 58% of the total. The overall surge in investment was driven by bigger deals, not more of them. The number of completed rounds in 2021 was roughly flat with those of 2020. The party looks like continuing as VC also generated record-breaking fundraising levels, closing over $128 billion of new funds in 2021, with a further $13B in the first week of 2022! The enthusiasm for deal-making continues unabated driven by record VC returns over the past few years. Nontraditional investor participation - as we have been regularly highlighting - has been booming: Deals involving Hedge Funds, Private Equity funds and Mutual Funds were up a remarkable 64% YoY. 

The combination of companies staying private longer and then contributing enormous returns at IPO has proved to be a huge magnet for these so-called crossover investors. IPOs generated an "astounding" $774 billion in exit value in 2021, fuelled by special purpose acquisition (SPAC) activity. That may not last. In 2022, PitchBook analysts foresee increased volatility in the public markets, which could disrupt IPOs. Kyle Stanford, CAIA senior analyst, speaking to Institutional Investor magazine this week said, “With increased volatility and maybe skepticism of the losses that VC-backed companies are coming to market with, we could see a more difficult time for companies looking to go public with…metrics that would cause concern for some risk-averse public market investors.” Time will tell.

Keeping half an eye on the US market is vitally important for founders in Europe as it provides a leading indicator of investment sentiment here. US investors - including several of these new crossover investors - now participate in 1 in 5 European deals and are a vital source of late stage funding. As valuations in the US market have shot up in 2021, US investors have looked to Europe for value. The median pre-money valuation of a funding round in the US reached $115M in 2021, up 64% from $70M in 2020. In Europe, the median pre-money valuation across all rounds increased 71% from $14M in 2020 to $24M in 2021. Given the number of US VCs setting up new offices around Europe, this pursuit of value looks set to continue for some time yet.

2. Other pieces really worth reading this week: 

Required reading for marketplace startups: The 20 best essays
Andrew Chen is a general partner at Andreessen Horowitz, a Silicon Valley venture capital firm, where he invests in consumer startups. Following a broad survey of the best writing on this topic, he has shared the 20 best links he has seen. A great resource.

The Internet is Rotting
Jonathan Zittrain is a law professor and computer-science professor at Harvard, and a co-founder of its Berkman Klein Center for Internet & Society. This thought-provoking essay in The Atlantic reveals some of the internet's gravest shortcomings: "Too much has been lost already. The glue that holds humanity’s knowledge together is coming undone."

Dan Wang: 2021 Letter from China
Highly respected analyst, Ben Thompson (who we featured last week), rates Dan as “one of the deepest thinkers and most careful observers of the world.” His year-end reflections on China’s development and ambitions prove why. For any founder looking to more deeply understand the dynamics of the Chinese market, this is an essay worth consuming (75 min read).

Happy reading!

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