Few VCs deliver the returns they promise

A little-known fact about VC funds is that few deliver the target returns they promise. Aligning with successful funds is highly desirable for founders; it provides positive signalling to the rest of the market and greases the skids for subsequent rounds. So what is a successful fund? A VC fund needs a 3x return to achieve a “venture rate of return” and be considered a good investment by its LPs. (i.e. $100 million fund => 3x => $300 million return). The 3x target is key. For a typical 10-year fund this requires a compounding, 12% annual return. This may not sound like much of a reach. As an industry, VC is the best performing investment of the past 25 years. Research from Cambridge Associates has shown that from 2010-2020, the CA US Venture Capital Index generated an average annual return (AAR) of 17.2%, compared to the S&P 500’s AAR of 13.9%. From mid 2020 through 1Q21 quarterly returns grew even more dramatically. Private market exuberance and an IPO frenzy elevated returns to all time highs. Since then however, returns have been slammed into reverse as Pitchbook's recent Global Fund Performance Report confirms. 4Q22 (the last period where we have complete fund data) registered a sixth consecutive quarter of decline in the rolling one-year horizon IRR, and a second successive quarter where the IRR figure landed in the negative territory. To understand how all this is now playing out for individual funds, we need to dig more deeply into the performance data.

The first big insight is that VC returns are heavily skewed. It is the top quartile funds that generate the really high returns. Cambridge Associates reveals that since 2010, the top quartile of VC funds generated AAR ranging from 15% to 27%, while the AAR of the bottom quartile VC funds generated AAR in the low single digits. Investors investing in the bottom quartile would have been better off putting their capital in the S&P. In fact the distribution of target returns is very highly concentrated. Further analysis shows that only 5% of funds return more than the magical 3x. Then 10% return 2-3x, 35% return 1-2x, and then a whopping 50% return less than 1x. In other words, half the funds actually lose money for their LPs. Contrary to generally accepted investment theory, the highest performing managers are aggressive risk takers and do not follow a classic diversification strategy seen in other investment classes. Their reasoning is that portfolios must remain concentrated in a select few companies so as not to dilute the potential winners. As VC Michael Megarit points out, the fund managers who reduce risk through diversification will ultimately generate substandard returns. In addition, diversification is hard to execute operationally. He says, "Many VC funds are comprised of just ten partners, with each partner managing 5-10 deals. Scaling partnerships to more than ten partners becomes increasingly complex because there are too many conflicting opinions and investment thesis to contemplate and allocate resources towards."

The second insight relates to fund size. As Pitchbook reveals, smaller venture funds have outperformed their larger counterparts during recent periods. A reason for this outperformance is that those funds have focused on the earlier stages of the venture lifecycle, where valuations have held up relatively well throughout the slowdown. In addition, GPs with smaller fund sizes might also have been unwilling to mark down their portfolio to match the fair market value - either in the hope of waiting for the market downturn to pass and valuations to rebound, or out of concern that they lack strong performance to present to LPs during fundraising conversations. Whatever the reason, VCs are currently out in force raising new funds as we highlighted last week. All the evidence suggests that LPs are moving away from the smallest, sub €50M funds given the time, effort and risk profile relative to the size of cheque they want to write. Consequently, only 23 first-time VC funds have closed in Europe through 3Q23, compared with 76 for the full year 2022, according to Pitchbook. The result is that the relative share of mid-size €100M to €250M vehicles, usually run by more established managers, is increasing. Where possible, founders that are raising early-stage rounds - especially at Seed - should try to align themselves with top performing managers closing new funds in this range.

The impact of stress on startup founders

A recent study shows that the startup grind is taking a major toll on founder mental health. Against the backdrop of the most uncertain markets faced for years, 54% of founders say they are very stressed about the future of their startup. This is just one of the key findings from the Startup Snapshot study, which assesses the current state of the startup mindset through global data collected from hundreds of founders in startups of all sizes, in all verticals. The analysis pulls no punches, claiming that the toll that founding and leading a startup takes is dangerously overlooked and rarely spoken about. The research highlights the founder paradox: On one hand, 72% of founders report an impact on their mental health. The financial pressures, time constraints, and risk of failure that come with starting a business can all contribute to strong feelings of uncertainty and loneliness. Yet founders also report they are enjoying the journey, raising many questions as to their perception of reality. Some claim that the high enjoyment is due to the fact that founders are inherently optimistic people, a trait that they need in order to push their visions ahead against all the odds. However, others claim that this datapoint just highlights the slightly distorted story that founders tell themselves in order to keep motivated despite the hardships.

A key insight is that founders learn to ignore their own wellbeing in order to achieve their long-term goal, accepting the mantra of ‘no pain, no gain’ often sold by today’s leading entrepreneurs. But the impact can be severe. 37% of founders say they suffer from anxiety, 36% suffer burnout, 13% have depression, and 10% say they have panic attacks. Loss of sleep is a major stress contributor and this gets worse as the startup grows. 51% report they sleep less in the early stages (<$5M raised), rising to 66% ($5-$15M), to 74% ($15-30M), to 83% ($30-70M). The main sources of stress are: Ability to fundraise (60%), work-life balance (38%), the global economic situation (35%), cofounder relationships (15%), existing investors (14%), and managing employees (13%). In sum, fear of failure takes centre stage, with 42% of founders saying they are affected. The fear is often more destructive than the failure itself. The good news is that this fear subsides with age and experience due to a variety of factors. These include increased confidence in their abilities, a deeper understanding of the industry, and a greater sense of resilience after experiencing setbacks and overcoming challenges. But fear remains a massive inhibitor to the success of the venture. It can paralyse founder decision-making and risk-taking, as they become hesitant to take on new challenges or try new approaches.

Many founders remain silent, fearful that if they express their anxieties it might be taken as a sign of weakness. Perfection is what they feel is expected of them; showcasing anything less, in their eyes, is deemed negative for investors, employees and the market. Ironically, trial and error are inherent in the startup journey, where mistakes are embraced and turned into key learning tools. Yet disclosing personal anxieties and struggles don’t fall under the same rubric. Being a startup founder is often a lonely and isolating experience. 81% of founders say they are not open about their stress, fears and challenges. Founders often rely on friends and family for support, but they don’t have the expertise to help with founder-specific challenges, so this is not an ideal remedy. Unsurprisingly, only 10% of founders turn to investors to talk about their stress. Founders are known for their innovative spirit, but in terms of therapy, the report claims they are stuck in the past. Only 23% of founders report going to a psychologist or coach. Why? Nearly half of entrepreneurs believe there is a stigma around seeking support. This is significantly greater in men (versus women), in younger founders (under 35), and in European founders (63%) versus US founders (43%) who are far more likely to build a coterie of formal and informal advisors in a support network. Those seeking further information on founder coaching can find more here about our own coaching programme related to the capital-raising journey, or here for more general executive coaching support.

Happy reading!