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How investors evaluate VCs

LPs, the investors in VC funds, have a difficult job to do, largely because they have to work with poor quality data and only a small fraction of VCs deliver the returns that make them worth investing in. The problem is made worse by the fact that LP demand to invest in the handful of serially successful VCs well outstrips supply and most LPs have to invest most or all of their venture allocation in other VC funds.

The CB Insights Investor Mosaic sets this out very well. They also describe the factors that they think LPs should use to make those tough decisions:

  • Past performance – unlike most other asset classes in venture capital past performance is a good predictor of future performance. CBInsights calls this ‘Performance Persistence’.
  • Network centrality – “how connected a VC firm is with other VC firms in the industry, as networks have been proven to be a critical driver of VC performance”
  • Brand – “brand is important in venture capital as firms with great brands and reputations see higher quality dealflow, gain entry into emerging industries and can also achieve better economics because they are a preferred source of capital for company founders.”
  • Investment discipline – “VC returns have been shown repeatedly to be tied to discipline. Discipline spans fund size as well as sector, geographic and stage preferences. Disciplined stage and sector investing fosters learning opportunities and the development of stage and sector specific knowledge and skills. Discipline also helps to keeps a venture fund’s loss ratio low which is important as they are ultimately stewards of LP investment funding.”
  • Selection aptitude – “a measure of dealflow quality and selection prowess for each investor. It highlights each investor’s ability to source and ultimately select high quality investments and then shepherd them to favorable outcomes. While the platitude that 1 of 10 VC investments is a homerun is often thrown around, the reality is that some venture capital firms are significantly better at hitting homeruns then the rate of 1 in 10. Conversely, several VCs are much worse.”
  • Illiquid portfolio strength – “this score measures the quality of current, non-exited companies in an investor’s portfolio and also looks at the investor’s entry point into the company.”

This is a really good list and at Forward Partners we aspire to be great on all these dimensions, but for me selection aptitude stands out above all the others as a driver of success. It is the least measurable (aside from looking at past performance) and as a result LPs often focus more on the other drivers. To my mind that’s a mistake. The analogue with VC investing is being comfortable assessing entrepreneurs without a track record of success, and getting that right is one of the best ways to get big wins.

  • http://blog.raywu.co/ @RayWu

    Hi Nic, great list. I’m curious to see what you think about http://www.avc.com/a_vc/2013/11/loss-ratios-in-early-stage-vc.html

  • http://www.theequitykicker.com brisbourne

    Fred is right that low failure rates are an indication that more risk could be taken. There are a couple of differences between USV and Forward Partners though. Firstly there are more billion dollar exits in the US for then to aim at, and secondly we have a larger team of people helping our portfolio.

    In combination these differences mean that we should have lower failure rates because we are targeting a different risk profile (a bit less upside, a bit less downside – that’s necessary until we have more large exits here, something we are working hard to change, believe me) and because our support should reduce failure rates.

  • http://www.cbinsights.com/ Anand Sanwal

    Nic,

    Thanks for highlighting what we are doing at CB Insights with Investor Mosaic and for the kind words on our approach. We’ve been really glad to see LPs who wish to build or continue having exposure to the VC asset class use what is a very non-traditional, purely algorithmic way to evaluate venture firms.

    Your comments do a nice job of highlighting something we don’t explicitly call out on our website which is that not all of the dimensions you list above are weighted equally. And Selection Aptitude is definitely a more important measure/predictor of VC firm quality in our algorithms which assess VC firm quality.

    One of the important factors that influences Selection Aptitude is a firm’s “point of entry” into companies, especially the winners. This is particularly important given the “momentum investing” (aka logo chasing) that we’re seeing in VC today. By that what I mean is that we see lots of firms jumping in at the later stages when a company already looks like a winner. There is nothing wrong with that strategy per se, but it’s a very different beast than VCs who truly have that sixth sense and who take prescient bets early.

    Also, a recent analysis by our team shows that firms who are able to get in early to the big winners are exceedingly rare. If you think of billion dollar exits as a goal for VCs (I know your fund’s goals are different), very few truly have the ability to identify these Black Swans, i.e, the Selection Aptitude of most firms is not very good. In fact, only 17 VCs have participated in more than 1 billion dollar exit within tech since 2004. And of those, only 24% got in at the Series A or earlier.[1]

    In any case, we’ll be peeling back the curtain more on Investor Mosaic over time. If you’re amenable to it, would love to share some of our findings with you.

    Thanks,
    Anand

    [1] http://www.cbinsights.com/blog/trends/billion-dollar-exit-venture-capital

  • http://www.cbinsights.com/ Anand Sanwal

    Ray – Fred’s view on this metric takes a glass half full view of the metric, i.e., “you’re not taking enough risk”. The glass half empty view on this loss rate is “you don’t know what you are doing”. It’s also easier for Fred to make this claim to an LP if they ever had to since he and USV are a top decile firm with a track record that any VC would envy (in early to major exits like Indeed, Twitter, Tumblr, etc)

    The main problem is that there is not a single metric like this which you can use to evaluate the quality of an investor and whether they are taking on appropriate levels of risk. One of the commenters, Terrence Yang, on the AVC blog bluntly spoke the truth in my estimation. His quote is below.

    “Higher loss ratios are only good if they actually lead to superior risk adjusted returns net of fees. This seems like another b.s metrics that barely correlate with actual performance.”

  • http://blog.raywu.co/ @RayWu

    Thanks for sharing this quote!

  • http://blog.raywu.co/ @RayWu

    In Singapore (where I am now), seed investors do have Series A and B to hand off the investment to; exits are also starting to come through. It’s hard to imagine a high loss ratio simply because the exits don’t support the same economics.

    The quote that @cbinsights:disqus mentioned is great.

  • http://www.theequitykicker.com brisbourne

    Hi Anand – thanks for the comments. It would be interesting for your research to look at the significance of billion dollar exits as a predictor of fund returns. That would uncover whether logo chasing drives returns and also whether many funds without billion dollar exits make great investments for their LPs.

    This is a difficult topic for GPs to talk about, I think for a few reasons: – entrepreneurs want to be associated with VCs who have had billion dollar exits, and failing that who aspire to
    - rightly or wrongly LPs are looking for funds like Sequoia, Greylock, and Kleiner to invest in and billion dollar exits are one of their defining characteristics
    - billion dollar exits are a good thing for any fund, and the subtlety of wanting to get some, but not betting the farm on getting any, is difficult to get across without sounding unambitious

    I’m very much up for talking more about this whenever makes sense for you.

  • http://www.cbinsights.com/ Anand Sanwal

    Hi Nic,

    Great questions/points.

    With regards to billion dollar exits as a driver of fund returns, fund size is an important determinant that we considered as it needs to be figured into the equation. If you are NEA or Andreessen Horowitz with billion dollar plus funds, the billion dollar exits are required if you have any hopes of providing a return to LPs. On the other hand, someone like a Union Square Ventures which has kept a smaller fund size consciously and which has an uncanny ability to spot and hunt elephants early and often will be able to potentially return an entire fund with just one of these Black Swan exits.

    Of course, getting accurate fund performance data is basically impossible as Ashby Monk of Stanford did a good job describing here – http://www.institutionalinvestor.com/blogarticle/3199024/Blog/Beware-of-Private-Equity-Performance-Data.html

    Yes – everyone is top quartile :)

    Your point on GPs is spot on. This is a lot about marketing to the important constituencies that GPs need to keep happy and engaged – LPs and entrepreneurs.

    For entrepreneurs, I think there is a lot of education that needs to happen and a lot of mis-education going on today. The survivorship bias in the media is significant which may be one driver, i.e., the billion dollar exits generate a ton of noise but there is very little out there that shows how much of a lottery those billion dollar exits actually are. And since other entrepreneurs on the journey are always proverbially “crushing it”, there is no discussion of the exceedingly minuscule chance you have of actually being part of one of those exits. Of course, entrepreneurs suffer from the same challenge — either you are building a billion dollar business or you are unambitious and building the dreaded “lifestyle business”.

    Of course, it seems that VCs themselves are to blame for promoting this narrative as well. With the calls to “change the world”, go big or go home, and the need to see hockey-stick growth, the VC discussions has becoming entirely focused on size and growth and so it seems entrepreneurs are responding to that call and telling VCs what they believe they want to hear. Would you agree?

    For LPs who need to put serious money to work (the large institutions), a VC fund has to talk about billion dollar exits as the reality is that the VC just won’t be large enough to warrant the LPs time. So part of it is about sounding ambitious and part of it is just that the most deep pocketed LPs are only interested when they can invest lots of capital. Basically, LPs have to determine if they should be doing the mental gymnastics of investing in a $50 million fund versus a hedge fund that can handle a $1 billion commitment esp when that $50 million fund has close to no shot of moving the needle for the fund. This gets to another problem that faces the VC asset class which is its lack of scalability. Of course, there are smaller LPs who are investing in micro-VCs which is a burgeoning and increasingly crowded area right now as well.

    Ultimately, one of the biggest challenges in this entire tech/high-growth company ecosystem is the amount of marketing that goes on which makes separating fact from fiction quite difficult. We’re hoping with Investor Mosaic that we can cut through the noise with an unbiased, algorithmic view of VC fund quality. We are seeing LPs who remain bullish on the VC asset class but who are sick of the asset class’ poor returns take to the approach so far. Of course, like Google PageRank, we’re constantly tinkering with and adding new predictive variables to the Mosaic models.

    We’re going to be revealing some Investor Mosaic ratings for Micro-VCs in the near future so will be sure to send those on.

    Thanks,
    Anand

  • http://www.theequitykicker.com brisbourne

    Thanks Anand. I think some entrepreneurs do change their pitch to match what they think investors want to hear, but not many of the best ones. There is something about being insanely ambitious which gives you a higher chance of success. That said all the talk of billion dollar exits makes them seem more achievable. All of this suits the billion dollar funds of course as they increase the number of entrepreneurs who cleave to a strategy that suits them.

    I’m going to start asking you question to entrepreneurs explicitly now. Will let you know if I hear anything interesting.

  • Lora Kolodny

    Would love it if they looked at social impact, diversity of staff and founders funded and more beyond the obvious… Maybe some of that fits under “brand” and “discipline.”

  • http://www.theequitykicker.com brisbourne

    Hi Lora – most investors in VC funds have a snore mandate from their investors to make money. It’s not really within their gift to start evaluating based on social impact.

  • Lora Kolodny

    Companies that do good things for people make more money than companies that don’t — that’s been proven time and again by financial professionals far more deeply than I will articulate here. Please see this as one reference: http://hipinvestor.com/ Many others. Will try to come back with more extensive reading list later.

  • http://www.theequitykicker.com brisbourne

    I agree, and think it’s a trend that will accelerate. If it does we may get LPs looking to VCs to play it. Not so far though, and I suspect most of then will remain motivated by money rather than impact.

  • CB Insights

    Hi Lora,

    Thanks for the comment. As Nic highlights below, this isn’t something most LPs are looking for. More importantly, however, we nor has any academic research found that the pursuit of social impact, diversity of staff & founders, etc been a driver of VC outperformance.

    Our goal with Investor Mosaic is to model the factors that have been demonstrated/shown to be drivers of fund performance and hence which LPs care about.

    Thanks,
    Anand

  • Lora Kolodny

    Anand, Please confirm: Did you ask LPs if a fund, “making a positive social impact” mattered to them? If not, how do you know it’s something that most are not looking for…? Also – what was your sample of LPs? Did it include LPs in funds that have a stated social interest, like some of the firms investing in a focused way in edtech or agriculture and food? Also – it’s pretty extreme to say there’s not “any academic research” supporting the notion that VCs who take social impact (The triple bottom line in some cases) into consideration do not outperform average investors. It is really disappointing to see you simply blow off the notion, seemingly to support your already completed research and the fact it did not address this question. I suggest you familiarize yourself with the Social Ventures Network, the research of HIP Investor Inc. and University Ventures Fund for starters.

  • Lora Kolodny

    pt. 2 – with outsized exits like Climate Corp. and a slew of organic baby food cos. in this realm in the last few years- it just seems like your research may be a touch incomplete @cbinsights:disqus — and I look forward to more of it, and hopefully CB Insights exploring this question more carefully.

  • CB Insights

    Hi Lora,

    Sorry if my response seemed dismissive of the notion that social impact matters. We’ve talked to and worked with numerous LPs (fund-of-funds, family offices, sovereign wealth funds) and there is no one-size-fits-all criteria that they employ.

    And so they use our data in ways that works with their strategy and that comports with their world view. But none of them has asked us for data on social impact. That, of course, doesn’t mean it is not important to any LPs but among LPs we work with, it has never come up. We assume that if it was an important driver of their decision process, they’d ask us.

    We’ve built our Mosaic models by studying existing academic research on what drives VC performance and have algorithmically assessed those drivers to remove some of the gut-driven aspects of VC fund selection. Social impact and its impact on VC returns has not been studied (as far as we know) and so it’s not something we’ve integrated in our models. But again, if our customers started asking for it as an important dimension, we’d see if there was a way to evaluate it.

    Hope that helps to clarify and again, apologies if the tone of my initial response suggested that social impact wasn’t important.

    Best,
    Anand

  • CB Insights

    Lora,

    I think if you look at Climate Corp’s investors that it’d be a tough argument to say that any of their VC investors consider themselves social impact investors. While I’m sure that the social impact is something they like, it seems unlikely given the history we’ve tracked on each of them that social impact drove their investment into the company (beyond the “change the world” mantra that all VCs ascribe to). And so distinguishing between a conscious investment thesis around social impact and talking about social impact after the fact is important.

    Re: our models, they’re the only ones that offer predictive insights into VC performance. Unfortunately, most VC performance data is backward-looking and suffers from some major selection bias issues. Good article on this here from Ashby Monk of Stanford – http://www.institutionalinvestor.com/blogarticle/3199024/Blog/Beware-of-Private-Equity-Performance-Data.html

    Nic does a nice job summarizing our dimensions in this post, but the full detailed breakdown on them can be seen here – http://www.cbinsights.com/investor-mosaic

    That said, if you see any research that ties social impact investing to VC returns, do let us know. Although LPs are not asking us for this data, I’m sure they’d be interested to know if a real tie to performance exists.

    Thx again for the comments. It’s on our radar now :)

    Anand

  • Lora Kolodny

    The LPs and VCs I interview consistently talk about how they want to make money while making a difference. So…just because social ventures may not be a focus or their only and driving priority does not mean the “triple bottom line” (or social impact) isn’t influencing their decisions. As we see in consumer research – consumers almost always prefer a green option if it’s on-par in terms of pricing and performance with a competitor’s non-green product. From laundry soap up to cars. If VC is somewhat commoditized? Being social-minded may make the difference in drawing big LPs. But you won’t know if you don’t dig deeper. . .