Measuring VC Fund Performance

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‍TL;DR: Measuring VC fund performance can be difficult, especially when it comes to an unproven manager with no track record. In those cases, you should look closely at the reputation and proposed strategy of the manager. For proven managers, there are a few metrics that investors can use to compare fund performance—namely, return Multiples and IRR. 

Over the last decade, venture capital funds have outperformed the S&P 500 by 5-15% annually. But if you're considering investing, it can be hard to gauge an individual fund. Fortunately, there are a few ways investors can track the performance of a particular fund, using that knowledge to inform their investment decisions for the future.

It can be hard to gauge how well a VC fund has performed in the past and whether it would make a good investment in the future. But there are a few ways investors can track the performance of a particular fund.

How should you measure VC fund performance?

Often, the first question investors ask of a fund manager is, “What is your track record?” 

While past performance is never a guarantee of future results, it is often a key starting point for setting return expectations and making investment/allocation decisions.

Note: What about new or “emerging” managers without an official track record? Answer: If a fund manager has never operated his or her “own” fund before, you can often still look at a track record of their attributed deals at a prior fund, or a series of non-fund investments they might have made as a scout or angel investor. If they have never invested before, you’ll have to place more weight on the forward-looking thesis or the quality of their network/record as an operator to decide whether or not they would be a good fund manager.

There are a handful of return metrics that you can use to compare funds in different asset classes and over different timeframes. For VC funds, investors typically prioritize two of these metrics: (1) Return Multiples and (2) Internal Rates of Return (IRRs). 

1. Return Multiples

Multiples are the most direct measure of how much money an investment has made. For example, if your fund returns “2x” that means that it has doubled your investment. Multiples are generally calculated as a ratio of two quantities, and convey slightly different information depending on the exact quantities in the numerator and denominator. 

The key differences include whether the numerator refers to realized, unrealized, or total proceeds, and whether the denominator contains the amount of capital invested (which sometimes includes amounts funded by the manager’s debt), committed, or called (“paid-in”). 

The most common forms of Multiples are as follows:

• Total Value to Paid-in Capital (TVPI): This measures the entire value of your investment — both realized (sold) and unrealized (not yet sold) — relative to the amount of money you gave to the fund
• Distributions to Paid-in Capital (DPI): This is a similar calculation, but only includes realized dollars in the numerator. DPI is asking “How much money has literally made it back to my bank account vs. the amount of money I sent to the fund?”
• Residual Value to Paid-in Capital (RVPI): This includes the unrealized dollars in the numerator. This quantity represents the “mark-up” of remaining unrealized investments relative to dollars paid into the fund. (Here we recognize that DPI + RVPI = TVPI)

In the world of venture capital, target returns are typically measured by Multiples, since it is numerically more convenient to compare a “3x” with a “5x” than “400%” with “600%.” Key questions when looking at a manager’s TVPI, DPI, and RVPI typically include:

• Has this manager generated a high absolute return with my money? A manager with a higher TVPI would be outperforming one with a lower TVPI.
• Has this manager successfully realized a high portion of their investments? A manager with a higher DPI would be seen as having de-risked the portfolio by returning cash instead of having significant remaining exposure to fluctuations in remaining value.

The graph below illustrates TVPI/DPI evolution over time, where bar height represents TVPI:

The key limitation of Multiples is that they are “time agnostic”. Knowing that a manager A has generated “2x” while manager B has generated “3x” is not very useful if we don’t know how long it has taken each manager to get there. This is where measures of return that incorporate time come into play. For private funds, the usual metric is the Internal Rate of Return.

2. Internal Rate of Return (IRR)

IRR is the industry standard metric for private funds. It measures cash flows produced by the fund project compared to the amounts paid in, while incorporating the amount of time required to generate those returns.

IRR also shows investors their returns over time, where each time period is weighted according to how much money was at work. This makes it the ideal metric to evaluate fund managers, who have discretion not just over what investments to make, but how much capital to allocate towards each of them.

Note: This is the key difference between evaluating performance for a VC fund and, say, a liquid mutual fund where the manager does not control how much money the investor has in the fund at any given time. Investments where the manager does not control how much capital is at work at a given time are typically measured by a different metric known as time-weighted return (TWR). 

Critically, IRR is an annualized metric that can be used to compare returns (in terms of their capital efficiency) across funds with varying hold periods.

Because a given year’s annual result is weighted in the IRR calculation by the number of dollars in the fund that year, and thus counts for more when the fund is larger and less when it’s smaller, internal rate of return is referred to as a “dollar-weighted” return.

The importance of IRR is that it weights different periods of time differently based on the amount of money at work. So imagine a fund manager raised a $1M fund. They don't call all $1M in capital in the first year; they only call $1. They invest that $1, and over the course of the following year, they double its value to $2. Their return on that money in percentage terms is 100%. Let's say the investor then calls the remaining $999,999 from clients the next year and invests it, but that the investment fails to grow in the year. The total value of the portfolio after 2 years is $2 + $999,999 = $1,000,001.

An IRR calculation would tell you that the return on the money over those 2 years was basically 0%, because the weighted impact of the 100% growth of $1 is so low compared to the impact of 0% growth on $999,999. 

In contrast, a time weighted return would tell you that the return for the fund was 50% annually (the average of a 100% return in year 1 + a 0% return in year 2). So the benefit of IRR is that it takes into account the amount of money at work.

There are a few limitations to IRR:

• If a fund manager doesn’t call the capital you committed, their IRR may still be high but they may still fail to meet expectations. If they raised a $1B fund, called $100, and doubled that to $200, they may have a sky-high IRR but make no money for investors. For this reason, it’s also important to track the amount of capital a fund is calling. It’s a generally good rule of thumb that managers should call almost as much capital as LPs commit. 
• IRRs do not tell you how much money an investment generated in absolute terms–for this reason they are best used in conjunction with investment Multiples.

• Two investments that generate 20% IRRs are not necessarily going to give the same Multiple (hence the same absolute $ profit). If investment A generates its 20% IRR over an effective hold period of 4 years, this would give a multiple on invested capital (MOIC) of approximately 2x; investment B has a 20% IRR but a 10 year hold period, which means the returns compound over time and generate a MOIC of over 6x!

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Example 

Here’s an example of how these metrics might be used in the context of a fund:

Manager ABC raises Fund XYZ.

Day 1: Investor commits $100M to the fund

Day 3: Fund holds its final closing with $1B of total commitments

Day 15: Issues its first capital call for 50% of commitments

• Investor wires $50M to the fund
• Fund makes its first investment at a cost of $500M

6 months later:

• Investment is valued at $600M. There have not been any distributions
• Our metrics (measurable at either the investor level or the fund level) are now: 

• DPI: 0.0x ($0 distributions divided by $500M paid-in capital)
• RVPI: 1.2x ($600M residual value divided by $500M paid- in capital)
• TVPI: 1.2x ($600M total value divided by $500M paid- in capital)

3 months after that:

• Another capital call, this time for $200M (paid-in capital = $700M)
• Existing investment is still valued at $600; new investment is initially valued at cost ($200M) so our residual value is $800M
• Fund makes a distribution for $100M, so total value is $900M
• After the dust settles our metrics (measurable at either the investor level or the fund level) now look like this:

• DPI: 0.14x ($100M distributions divided by $700M paid- in  capital)
• RVPI: 1.14x ($800M residual value divided by $700M paid- in capital)
• TVPI: 1.28x ($900M total value divided by $700M paid- in capital)

Bottom Line

In short, if you're measuring performance of a VC fund, think about it this way: