Why are Exits a Perennial Problem for VCs?

Published in
April 6, 2024
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“Flee not, cowards and base creatures, for it is a single knight who attacks you.”

—Don Quixote

Venture capital firms (VCs) suffer with exits more than private equity (PE). Traditional wisdom suggests that they invest earlier in the life cycle and have to wait longer for the exit. Is this the real reason?

The past two years have been challenging for distributions for both VCs and PEs, especially the former hitting a 14-year low of 5% in distributions as a percentage of net asset value. Average distributions to paid-in capital (DPI) for VC funds launched in 2018 stand at a meager 0.3 times for both EU and U.S. managers, while DPI for funds launched in 2013 is at 1.1 times and 1.8 times, respectively.

The Basics: Measurement

The objective of any investment business is to generate returns. Hedge funds have liquid investments, so they simply mark their portfolio to market. Private investment managers attempt to do the same, but since the valuation of private companies is an imprecise exercise, only the cash-on-cash return achieved at exit is a true measure of returns for them. Key metrics used:

• Gross multiple of investment cost (MoIC) shows the pure efficiency of the investment operation of the manager, as it excludes the effect of management fees and other operating costs.

• Gross DPI measures the overall efficiency of the manager’s business post all fees and costs, but excluding the effect of carried interest (CI). While CI is usually 20%, it depends strictly on the deal between the investors and the manager, so its impact distorts the evaluation of a manager’s investment skills.

• Net DPI shows the clean cash-on-cash return for limited partners (LPs) post-CI.

The problem with DPI is that it is only fully determined at the end of a fund’s lifetime. During the life of the fund, managers use total value to paid-in capital (TVPI) as the main return metric, which also accounts for the investments held by the fund at any point in time.

The problem with TVPI is that it’s only an approximation based on the valuation policies of the manager. As such, it is prone to overstatement since many managers are fundraising for future funds and need to promote their current performance.

Internal rate of return (IRR) is a representation of TVPI and DPI in the form of annual compounded returns so that the efficiency of VC managers can be compared to other asset classes. However, it does not capture the duration of the investment, nor does it capture which portion of the return has been realized. Given the individual limitations of each of the metrics, follow all of them to get a full picture of the quality of the VC returns.

Why Are Exits Hard For VCs?

VC managers have a number of drawbacks in their ability to exit compared to PE. Three factors stand out:

• VCs predominantly own minority stakes—often less than 10%. Even if they have a board seat, their ability to impact the liquidity path of the business or control the exit is limited at best.

• Companies are financed through a series of investment rounds as they grow. In each round, new VCs enter the cap table as lead investors. They carve out rights and protections for themselves often to the detriment of existing investors. Most importantly they create a temporal misalignment between the shareholders of the business. At this point, the early investors may be significantly in the money on their investment, but there is no incentive to cash them out, so they become hostage to the investment horizon of the freshly incoming investors.

• Many VCs rightly believe that they should only focus on the winners in their portfolio since they will generate the bulk of the DPI. They also falsely believe that for successful businesses, the exit will take care of itself. Partly this is predicated on a conflict of interest with their LPs since (a) management fees are charged on investment cost, so the longer investments are held, the more fees will be earned, and (b) the manager is chasing the highest DPI, and an increase in the holding period generally improves the odds.

Exits As A Function Of Portfolio Management

Many VC managers do not have corporate finance experience. It’s not surprising that some of them do not view exit as a function of portfolio management—it’s just not their strength. However, exits are part of our job description as VCs. Furthermore, they are part of our fiduciary duty because we signed up to return funds to our investors within a given time frame. Here are some things to consider when approaching exits:

• Regularly evaluate your existing investments as buy, hold or sell. Create clear criteria for when an investment should receive a “sell” rating.

• Every sell decision should trigger an action plan, including conferring with all key stakeholders of the portfolio company.

• If a sale of the whole business is impossible, there are still ways to explore liquidity on a secondary basis—even with a discount.

• In some cases, a more combative approach is required, generating strategic offers for the business, even if there is no consensus among the shareholders to sell the business.

• Solutions at the fund level also exist. Funds can be rolled into new structures at the end of their lifetime, giving a liquidity option to existing LPs.

Evolve Or Die?

LPs need to focus on understanding the business processes that their chosen VC managers employ with regard to exits. In the current environment, potential fund investors shifted their focus from TVPI to DPI as the most important metric to evaluate managers.

Refusing to balk under pressure, I implore VC managers to steal a leaf from the playbook of their elder cousins in the PE business, who have no qualms over driving exits hard. Even though the task may seem quixotic, and every exit may feel like a giant windmill, they need to embark on this journey without fear—just like our favorite knight-errant.

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