Continuing our recent series on The Catharsis in Understanding How VC Really Works, it was only recently, spurred by Quora, I really thought through just how many VC partners can really be considered a success.
Turns out math says it can’t be that many. No matter how it may look from the outside.
1. The top ‘quartile’ of funds since Web 1.0 have returned about 20% IRR and 2x returns net of fees. On paper, that’s probably gone up a lot recently with the Rise of Unicorns and growth of Nasdaq, but 20% IRR is still a good basic yardstick for Top Quartile results. You can argue the exact numbers, but they’re close enough for the analysis.
2. Now, 20% IRR and 2x cash returns net of fees — the Top Quartile of VC firms — turns out is sort of barely good enough. Because venture capital is sooo illiquid. If an LP (the folks that invest in VCs) can get 20% IRR from Private Equity (which has a 2-5 year path to liquidity) … why do VC? No point. Even worse, if that LP made 20% in instantly-liquid Nasdaq the past few years… VC can seem pointless as an asset class.
So let’s say really only the top 15-20% of VC funds have ‘good enough’ returns to merit another fund. Let’s be generous and call it 20%.
And if you don’t generate these sorts of returns — your VC firm dies. Because your investors (the LPs) won’t write you another check for the next fund.
3. But the math for ‘success’ is worse, because it turns out, returns are very bimodal at almost all VC firms across their partnerships. In other words, most VC firms have just 1 or 2 partners that drive the vast majority of the returns. The rest often have negative returns, or barely return 1x. It’s hard to tell from the outside, but that guy that did WhatsApp… the guy that did Facebook… etc. etc. It’s that guy. Not a firm. See what other deals he or she did… you’ll usually see a lot of hits. Only a small subset of VC partners manage to successfully invest in Unicorns early, let alone repeatably.
Let’s be generous and say 1/3 of VC partners have ‘good’ returns at the 20% of VC firms that deliver ‘good enough’ results … > 20% IRR and > 2x net of fees.
4. So let’s just take 20% (% of VC firms with good enough results) and multiply by .333 (% of partners at these firms that actually drive returns) = 6.6%.
Now, this isn’t totally fair. There can be, and are of course, partners at VC firms where the other partners just weigh them down so much, that on average, the VC firm doesn’t hit this hurdle for “good” returns.
So maybe let’s almost double that 6.6% to 10%, maybe 12% if we are generous, to account for great partners stuck in sub-par firms. I.e., they have strong individual results over many years, but the VC firms themselves don’t.
So 6-12% of VCs are actually ‘successful’. The rest are failing. No matter it how may look at breakfast at Madera.
>> It’s a high bar. If it makes you feel any better.
And maybe, you can understand the psychology of VC just a tiny little bit better. What risks and why they take them, when and where.
[And to be clear — I’ve proven nothing at all myself, but paper mark-ups. So Face East for me, when you have a moment. I don’t want to get stuck in the Bottom 88% 🙂 ]