If you’re reading this blog post, you’re likely a high-level leader of a venture capital firm that is trying to efficiently navigate this dynamic and competitive landscape. Managing venture capital funds is a complex challenge, but fortunately, as much as the markets around the world do change, the fundamentals behind seeking high returns remain the same. In this blog post, we’ll share everything you need to know about venture capital returns.
The Life Cycle of a Fund
First, let’s review the life cycle of a fund so you can better understand how to measure fund performance. Since venture capital funds are typically illiquid, they usually do not have redemption rights and are structured to have a limited life cycle, typically around 8 – 10 years. Over the course of these phases—fundraising, investment, management, and exit—fund managers raise capital for the fund, invest that capital, hold the investments, and then sell and return the capital to the fund’s investors, ideally for a significant gain.
During the investment period, the fund’s operations officially start once the initial closing is complete. This phase lasts around 4 years and during so, the limited partners committed capital is gradually reached through a series of capital calls initiated by the general partner. During this period, it’s normal to see a negative Internal Rate of Return (IRR)—a metric we will discuss later in this article.
Measuring Fund Performances
Venture capital is unique among asset classes, making it quite difficult to accurately measure the performance of the fund early on. This particular asset class is characterized by long stretches of illiquidity (and volatility), which is why estimates of returns to VC investments can be misleading—how can you accurately determine the value when the assets are not priced on an open market or haven’t been acquired by another company?
As a result, evaluating venture funds is best done within the framework of two categories: realized returns and unrealized returns.
This is an important bucket to capture and many refer to realized returns as cash on cash returns (CoC). After an exit and the management fees and carried interest are taken out by the fund, the realized return is the ratio between the amount of money an investor receives to the initial investment amount. For this reason, realized returns are referred to CoC because it should be actual cash in a bank account. This metric is also commonly expressed as a multiple, such as a 2.5x or 5x return.
An unrealized return is the theoretical value of a fund’s position in privately held companies that haven’t been acquired or gone public. Rather than being actual cash in a bank account, as with realized returns, unrealized returns exist only on paper.
Key Metrics to Measure
Between the two categories of realized and unrealized returns, there are a few key metrics that are critical to measure. In this blog, we’ll focus on one, the Internal rate of return, which is an industry-standard metric that can mystify even the most experienced of limited partners and venture capitalists.
Internal Rate of Return (IRR)
The idea behind the internal rate of return is that it evaluates the amount of money a fund returns across its entire lifetime by calculating the annual return rates for each year of the fund. The lifetime for calculating the IRR starts when a fund has its initial capital call and ends when it makes its last distribution to the LPs. That’s why calculating IRR can help VCs gauge performance even if a fund’s payouts occur in inconsistent increments. Ideally, however, a fund only calls capital when necessary and distributes returns as soon as possible.
It is significant to differentiate between realized IRR and unrealized IRR. As you might have deduced or already know, realized IRR is when there has been a liquidity event such as an acquisition or an IPO, whereas unrealized IRR is a more objective private market methodology. As such, realized IRR, or net IRR (less management fees and carried interest), is what most LPs and VCs are interested in.
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