#209 Why Invest in Venture Capital? Making A Simple Case for FAs / RIAs

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• #203 VC Fund Model: DPI Forecast Template

• #202 VC Fund Math Revisited

• #201 VC News, YC, & The Future of Venture Capital

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Picture of the Day: UNC Basketball Great Michael Jordan & Coach Dean Smith

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Why Invest in Venture Capital? 20% Net. Making The Case for FAs / RIAs

Earlier this week, I was catching up with a UNC basketball legend (not the ones pictured, but close!) turned investment advisor / strategist. He asked a very simple question:

Why invest in venture capital or any private alternatives funds for that matter?

It’s a good question. For all of the folks reading, today you have options:

• Invest in US Treasuries for a risk-free return of 5%

• Buy a low cost S&P 500 ETF for a 10% target return (not guaranteed)

Simply put, to invest in venture capital, you should believe there is a path to 15%-20% annual returns, or a >5% premium to public markets.

Good news: studies show that this can be done if you pick your investments well!

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Back to Fund Models - What is the Math Behind >20%?

How do you do generate >15-20% returns in venture capital? You need a fund model (more below)! Here’s a simple example for the back of the napkin:

• $50m fund invests in 25 companies at $2m each (assumes recycling of fees)

• Each $2m investment is at a $20m valuation

• Own 10% of each company at investment (you own 5% at exit after dilution)

• $5 billion of exit outcomes (IPO or sale); your 5% is worth $250m

• Returns: MOIC of 5x gross ($250m/$50m), 4.2x net ($210m/$50m)

• IRR of 22% gross, 20% net (assumes 8 years to exit)

Key question: do you believe your venture capital fund can generate $5 billion of exit outcomes? Does your fund model support the claim that you can generate the 15-20% net return required by investors?

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How VC Really Works: Returns Are Driven by Power Law

For years, we’ve been saying that every VC fund manager needs a fund model (portfolio construction and reserves). Why? A fund model provides a plan for investing, is often required by investors, and can drive outsized returns (and help avoid value-destroying mistakes)!

While our fund models typically get super-detailed with various scenarios in play, we always find it helpful to simplify VC fund math (credit Fred Wilson in 2008) to something like the following:

• 1/3 of your investments lose money

• 1/3 of your investments breakeven

• 1/3 of your investments make money, with “~6% of investments generating ~60% of total returns” (credit Chris Dixon on the power law, citing Horsley Bridge industry data)

This point can’t be overstated! In a VC fund portfolio with 30 investments, this means that ~2 companies will drive ~60% of the total returns.

You need to hit home runs to deliver superior performance to your investors!

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VC Losses Are Real, But Dwarfed by Outperformance

James Health (VC Principal at Multi-Family Office in London) share insights (linked here) from the SuperVenture conference:

• 🤯 The VC power law, backed up by 15+ years of data

• 📖 The power law suggests a small number of investments will have an outsized impact on the total returns. It is very real

• 🚀 VC is an outlier asset class. Forget loss ratios. If a vintage (or fund) doesn't have its outliers, it's not going to outperform

A couple of takeaways:

• 💰 The only group outperforming cost is investments returning 5.0x or more. Anything less technically isn't worth doing

• ❌ Nearly 50% of investments made won't return the capital initially invested

• 🚀 80% of the returns are made in just 18% of the investments. If the average VC portfolio is 25 companies, you are looking at your returns on one hand

• 🔎 Realised returns of LP investments in Europe between 2006 - 2022, presented by Adams Street Partners this week at SuperVenture.

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How Can This Deal RTF? The Investing Math (Yes or No)

Every venture fund manager I know wants to deliver superior performance. Before investing in any deal, a VC fund investor should ask: “How can this deal RTF? Or 2x, 3x RTF? What do I need to believe about the future for that to happen?”