What are the returns on VC? On average, a diversified portfolio today makes about twice the funding provided to grow a business. And, surprisingly, first time funds’ performance is close to that of historical funds, which frees the field from that irrational fear that makes us lean towards baskets for which there is a track record. This data comes from a recent paper by the European Investment Fund (EIF), which provided about 10% of all funding to European VC companies between 2007 and 2014 – 1 every 18 euros that have been invested in start-ups. It’s a dense study attempting to shed light onto a market that has not been very transparent for investors, despite the sometimes intensive media coverage and exuberant storytelling around the industry. The analysis was conducted on a hand-collected dataset of about 3,600 EIF-backed VC investments made in the 1996-2015 period.
What are its conclusions? First of all, that European VC is a competitive asset class. This analysis was carried out on EIF investments after 2004, in order to have statistical value. Results show that over a year, the IRR of the VC funds in which EIF invested is 11.43%, against 14.87% of MSCI and 17.7% of S&P 500. But, in the long run, which is the horizon of a start-up investment, VC beats them all: its IRR is 8.52%, against 5.97% of MSCI and 7.51% of S&P 500.
In short, while being aware that VC is a high risk investment, it can be worth. Moreover, at fund or fund-of-funds level, the diversity and the granularity of start-up investment opportunities leave room for investors’ diversification strategies that can effectively lower the correlation with other asset classes.
Also, recent years, i.e. after 2010, display a clear upward trend in both average and median returns that, today, are quoted around 2x. The weighted average of the multiples on cost (MoCs) at exit for realised VC investments stands at 1.16x for the entire period, the median being 0.12x.
The exit scenario is influenced by macro performance: major recession events such as the dot-com bubble (2001–2002) and the European sovereign debt crisis (2009–2010) were linked to peaks in investment write-offs. On the upside, profitable trade sales continue the increasing path started in 2010, following the modest economic recovery, low interest rates and a rekindled confidence in the tech industry, which is also highlighted in the rise of the Nasdaq, whose performance, according to FEI analysts, can be considered a good predictor of start-ups median evaluations.
Also, empirical analysis confirms some recurring features about VC, for instance, the distribution of exit MoCs is extremely distorted because of risk: 70% of exited investments are either written-off or sold for an amount below cost. Deals in which venture capitalists (VCs) sell at cost account for 8%, whereas the remaining 20% are profitable liquidity events.
Noteworthy, 4% of the exits have returned more than 5 times the investment. This 4% generates almost 50% of the total aggregated proceeds. In other words, returns in the VC industry are power-law distributed: the rule by which in a basket of companies there must be one – or some – whose expected return is higher than that of all the others. A unicorn doing the work of the whole team, alone. EIF-backed VC returns comply with the power-law distribution for multiples over 2.35x.
How do exits work exactly? About 50% of the performing EIF-backed European investees are acquired by non-European corporations, particularly from the US. US-based buyers are typically larger in terms of assets and revenues, more innovative and mostly active in the ITC sector. Which raises the issue of whether the missing scale-up phenomenon in Europe could be linked to the lack of serial tech buyers, that is, incumbents in highly innovative and competitive sectors. The other path is going public: EIF has mapped 152 IPOs in 20 years, on 20 different stock exchanges around the world.
What affects the performance of VC investments? The empirical analysis identifies four elements:
Investors. More recent vintage years are associated with less likely write-offs and IPOs. Moreover, the first investment amount, i.e. the size of the initial investor’s bet on a start-up, is negatively associated with the probability of unprofitable trade sales and positively associated with IPO likelihood. Hence, investors appear able to recognize and cherry-pick successful companies at the time of the first check: the more money he bets, the higher is the probability that his returns will be positive. On the contrary, venture capitalist’s experience is strongly correlated with a lower probability of write- off and higher probability of profitable sale: the more investments a VC team makes, the higher the probability of a profitable sale and the lower that of a devaluation. The inverse relationship is not valid (the lack of experience is not correlated with any statistical rule).