The Outlier Problem: Understanding the Real Distribution of Venture Returns

Notoriously, venture capital is at the mercy of “Power Law” distribution. Correlation Ventures, a firm taking a data driven approach to investing, analyzed over 21,000 funds in the US venture market from 2004 to 2013, determining the returns each generated as a multiple of the value of the fund. What they found is a sobering reality.  A majority, ~65%, failed to generate even 1x return(the value of the fund), and only 4% generated a return of 10x or more, the classic benchmark for a company “hitting it big”. 

Venture capital’s distribution “Power Law” continues to affect the industry today, 13 years later. Given this market reality, VC firms construct their portfolios to maximize companies in the 4% “home run” returns, while minimizing investments failing to return even 1x the fund. Firms try to accomplish this by investing in 20 to 30 companies, with a focus on balancing risk with diversification. Diversification is a key part of portfolio construction because it can minimize losses. Fund portfolios can be diversified across industry sectors, funding stage, company geographic locations, and investing timing, all protecting the fund against unique negative market forces.

Investing across industry sectors enables the firm to capitalize on an industry taking off due to a new invention, while minimizing losing funds to an industry that suddenly enters an unexpected recession. Diversifying across funding stages means a VC firm doesn’t only invest in early stage start-ups, but also later funding round companies, balancing risky investments with more proven companies. Investing in varying geographic locations minimizes facing regional market issues, and increases chances of capitalizing on a global opportunity. Finally, diversification in the timing of investments, known as “initial” and “follow-on” investments, enables the VC firm to put ownership stake in a company with an "initial" investment, and then using 50%-70% of its remaining capital, to put in a “follow-on” investment in later funding rounds towards companies that have shown high revenue potential or in the General Partners(GPs) opinion just need more time and money. 

The above ways of diversifying a portfolio benefit both the fund manager and limited partners by limiting losses and maximizing success. However, there is an advantage to diversification which does not benefit limited partners, and it has played out most notably in significantly longer holding periods before GPs attempt an IPO.

Diversification helps ward off “psychological ruin”. Steve Kim, a managing partner at Verdis Investment Management, states "psychological ruin” is when a VC firm quits a fund due to poor returns. Diversification combats this by allowing fund managers to see moderate wins from some companies in the fund, providing positive reinforcement of their investing strategy and giving them confidence to not throw in the towel. As Mr. Kim states, “Power Laws take years to materialize. The critical question isn’t ‘What’s my expected value?’ It’s ‘Will I survive long enough to realize it?’” Diversification benefits skew in favor of the fund managers, because they are comfortable waiting over a decade for a company to generate 10x returns, while limited partners see few returns in that time. 

If a limited partners(LPs) investment does generate 10x returns on an IPO or acquisition, the reality of the returns the LP actually sees isn’t great in traditional venture capital business models. VC firms typically promise investors 2.5x returns on their investment after management fees and the VC firms share of profits. In comparison, the stock market usually generates a 1.6x return over a 5 year period. This makes a 2.5x return a good deal to the limited partner, because they get higher return in exchange for being locked in to a longer time frame, and making a riskier investment in a start-up. However, data reveals LPs rarely see the 2.5x returns promised. Cambridge Associates and the National Bureau of Economic Research(NBER) tracked VC returns from over 1,500 and over 1,300 firms respectively, from a period 1984 to 2020. The results of that study are in the chart below:

As you can see, since 1984 a significant majority of the time LPs did not receive 2.5x return on their investments. Returns usually averaged much lower, with many years barely reaching 2x. It should be noted that the top 25% performing funds averaged 5.34x returns from 1984 to 2000 and 3.84x from 2001 to 2020. However, the remaining 75% of funds over this 36 year period did not reach a 2.5x return. This reveals the reality of a LPs experience in traditional venture capital, a lack of even exchange of value between the LP and VC firm.

It’s clear from the data that investors need to take charge of their investing strategy, and actively avoid traditional VC firm business models. Tiger Venture Capital Management built a completely different model, one that actually aligns with investors and is meant to provide sustainable, long-term returns - independent of exits. To learn more, visit our website at tigervcfunds.com.