Decision Dilemma’s

Calpers is a huge $358 billion dollar fund.  They need to return 7% on their assets each year.  They have huge liabilities.  Right now, they have invested $28 billion in venture and private equity.  They are thinking about allocating another $20 billion to the space.

Traditionally, venture capital returns are better than the stock market returns.  It’s about 9% although there are plenty of studies that show returns being higher.

If you think there was a lot of money in venture before, wait until Calpers allocates. Would Calpers just be better off putting it a no load mutual fund like Vanguard and forgetting about it?

The problem for them if they decide to allocate to PE/VC will be where to put it.

Wesley Gray founder of Alpha Architect evaluates investments using criteria he calls FACTS: fees, access, complexity, taxes and search.  Search is the due diligence of finding and monitoring managers. In private equity, he says bluntly, “Fees suck, access is hard, the complexity’s insane, taxes are actually okay, but the search costs are crazy.”  He leaves out that there is a liquidity premium as well.  PE/VC isn’t exactly liquid.

That’s why there is incredible competition to get into the top performing funds.  It is why top performing fund managers can basically snap their fingers and raise money.  It is also why it is very tough for new funds to raise money on their first couple of go rounds.  No track record and fund size are huge issues for the pools of capital.

Calpers and funds like Calpers have another problem.  They need to write bigger checks.  Writing a $5MM check might make sense in theory but because of what Gray outlined, the customer acquisition costs would outstrip the lifetime value of the customer.

It’s an interesting dilemma and it flows downhill.  How do VCs allocate capital?

Chicago Booth Professor Stephen Kaplan did a study in 2016 with a group of other distinguished academics on how venture capitalists make decisions.  Who do they invest in?  Here is the headline paragraph of the paper.

We surveyed 889 institutional venture capitalists (VCs) at 681 firms to learn how they make decisions across eight areas: deal sourcing; investment selection; valuation; deal structure; post-investment value-added; exits; internal firm organization; and relationships with limited partners. In selecting investments, VCs see the management team as more important than business related characteristics such as product or technology. They also attribute more of the likelihood of ultimate investment success or failure to the team than to the business. While deal sourcing, deal selection, and post-investment value-added all contribute to value creation, the VCs rate deal selection as the most important of the three.

The paper is pretty recent, 2016.  So, I think we can assume that the information would be the same three years later.

Here are some gems from the paper which is well worth reading in full.  These are larger VC funds averaging around $286MM in fund size with the median being $120MM.

• VCs don’t use discounted cash flow analysis to make decisions.  If you took a finance course in college or in your MBA, you certainly had DCF drummed into your brain.  Instead, VCs look at the potential internal rate of return (IRR). Of course, you can’t eat IRR you can only eat cash on cash returns! 9% of the overall respondents and 17% of the early-stage investors do not use any quantitative deal evaluation metric. Consistent with this, 20% of all VCs and 31% of early-stage VCs reported that they do not forecast cash flows when they make an investment.
• Only 33% of all firms that IPO have the founder as CEO.  This means that of companies that IPO, 67% of the original CEO’s are replaced at some point and it is usually by the VC.

• In their sample, 62% of funds specialized in a particular stage, 61% in a particular industry, and 50% in a particular geography.

• 75% of deals that exit are via an acquisition, not an IPO.  25% of investments lose money.  10% of investments earn 10x.  There is the power law of venture in the data right there.  The average VC firm reports that 15% of its exits are through IPOs, 53% are through M&A, and 32% are failures

• Just under 40% of our sample VCs claim to have invested in a unicorn.  91% of their sample believe that unicorns are overvalued—either slightly or significantly.

• California VC firms are more likely to say passion is important and less likely to say experience is important.

• Team was by far the most important factor identified, both for successes (96% of respondents) and failures (92%). For successes, each of timing, luck, technology, business model, and industry were of roughly equal importance (56% to 67%). For failures, each of industry, business model, technology and timing were of roughly equal importance (45% to 58%). Perhaps surprisingly, VCs did not cite their own contributions as a source of success or failure.

• VCs indicated that they were relatively inflexible on pro-rata investment rights, liquidation preferences, anti-dilution protection, vesting, valuation and board control. They were more flexible on the option pool, participation rights, investment amount, redemption rights, and particularly dividends.

• Over 30% of deals are generated through professional networks. Another 20% are referred by other investors while 8% are referred by existing portfolio companies. Almost 30% are proactively self-generated. Only 10% come inbound from company management.  Of course, deal flow is the lifeblood of a VC firm.  Without it, you are out of business.

For VCs the goals are slightly different than an LP like Calpers.  They need to generate a 3x return on their fund.  If you have a $120MM fund, you need to return $360MM to be in the top quartile and raise another fund.  VC math is unforgiving.  It is amount of equity owned times exit value divided by amount invested.  If you are a $120MM fund, writing a seed check of less than a million gets pretty hard to do.  Especially because 65% of VCs want a syndicate at an early stage to diversify risk and bring in another network to the deal.

Knowing data like this should help entrepreneurs pitch.  When you layer it in with the information in a book like Venture Deals, entrepreneurs should know what questions to ask fund managers to ascertain if they are likely to get investment or not.