COVID-19 is impacting the world in many ways, and one of these is investment performance. Anecdotal discussions of VC performance in periods of economic dislocation are common. In an attempt to quantify this topic, we took a look at the relationship of average VC Vintage Year performance to two recent extreme market dislocations: the Dot-Com Crash, and the Subprime Debt Crises. Our conclusion is, to the extent COVID-19 mirrors previous market dislocations, VC Funds investing in deals with post-COVID features should produce meaningful premiums of 45% - 80% above normal VC return expectations.
The Study
The chart below studies the relationship of a constructed VC Relative Performance Index (VCRPI) to economic market dislocations during 1999 – 2017.
VCRPI in any given vintage year1 is defined as a combination of that vintage year’s VC funds 'pooled performance' relative to the five preceding years. On average, vintage years with VCRPI greater (less) than 100 performed better (worse) than the five previous vintage years. 'Pooled performance' for a given vintage year is the sum of net LP cash flow for all Funds in that vintage year, divided by the sum of paid in capital for all Funds in that vintage year, as reported by Cambridge Associates. This pooled TVPI or 'pooled total value to paid in capital' performance measure is designed to represent the experience of an average LP investing in VC funds in that vintage year.
Results and Interpretation
Two VC vintage years stick out in the chart. 2003 and 2010, the years directly following the Dot-Com Market Crash and the Subprime Debt Crisis, show up as the highest relative performance during the data period with VCRPI of 157% and 177% respectively. The implication is that an LP investing in VC Funds within those two vintage years would have enjoyed 57% (77%) higher TVPI on average. For example, if LPs would otherwise expect to return 2.5x net TVPI on average, for Funds formed immediately after the Dot-Com dislocation, they might expect 3.9x net instead.
Averaging annual calendar data makes it difficult to get a precise sense of timing by simply looking at the chart. However, the data clearly indicate VC vintage years after dislocations have better performance on average, and this backs up our intuition and anequedotal market evidence. One thing certain about post dislocation VC vintages is they contain an increasing number of post dislocation deals with attractive features reflecting the new business environment (e.g. price, deal terms, revenue, growth expectations, value prop, etc.). With regard to COVID-19, we expect VC deals this year and next to increasingly see these revised features and be optimally poised to benefit, assuming the patience and skill to source forward looking deals.
The VCRPI measure is necessarily somewhat arbitrary. In the chart we chose a five-year look back period to measure relative performance. However, we also looked at numerous other definitions using various look-back periods, and some that combined look-forward periods. All of these give similar results with performance premiums in the 45-80% range. Average VCRPI performance across all years in our dataset is 94.6. With more data, we would expect this average to tend toward the baseline index level of 100.
Also plotted in the chart is the number of VC Funds established in each vintage year. Annual VC ‘pooled’ performance is negatively correlated with the number of VCs raising Funds in any given year @ -0.51, and this is easily seen on the chart. A probable implication is that vintage years awash in investment demand for VC strategies have lower returns: implying too much money chasing the same deals in some vintage years, lowering returns in those vintages. Of course, the opposite is also true, and in the case of severe dislocations likely helps create the return premium we see here.
The average number of Funds raised per vintage year across our dataset is 62, but only 35 per year were raised, on average, in the periods following our two market dislocations. Fewer VCs raised Funds during these periods, and it was likely more difficult to raise due to LP liquidity and risk concerns across their extended portfolios. However, for those who can raise or participate in Funds during times of economic distress, the reward is expected to be handsome, aligning closely with our intuition that the marginal utility of dry powder during such times is high.
Finally, it’s worth noting that the problem we study here is important well beyond LP returns, as VC willingness and ability to deploy capital during times of severe market stress is a pure good from the viewpoint of entrepreneurs, who might otherwise be unable to raise money at all.
Conclusion
The dramatic impact COVID-19 is having on economic activity mirrors many aspects of the two previous market dislocations considered here. Broad economic market measures (e.g. S&P500, GDP) dropped precipitously, and serious sea changes occurred in technologies deployed by businesses and underlying economic buying power. These influences were seen to cause re-pricing and repositioning within the marketplace. At times like this, early stage VC investing is one of the few bright spots in the investment firmament. With regard to both re-pricing and repositioning, this part of the market is quick on its feet and should provide us a rich set of opportunities.
We undertook this study to be able to say something concrete about the unusual period in which we find ourselves, and about VC performance characteristics of the post COVID-19 period. We are encouraged by the results and will continue looking at performance characteristics of VC Funds as we guide NFC, our LPs and our entrepreneurs through tough times.
The underlying data for the study was gathered from readily available historical market and economic data sources, the VC data is from Cambridge Associates.
1 VC performance data is often organized by ‘vintage year’, combining data for all VC Funds established in that year. The performance numbers typically cover the life of the Fund. So, for the 2003 vintage year, the performance reflects initial portfolio company investments made from 2003 to 2005 or 2006, and the cash flows of such investments held from 2003 through (roughly) 2013 to 2015, for a typical 10 to 12 year Fund life.