The best investors know that they have to measure the ongoing performance of an investment to make the biggest returns. Monitoring an investment’s performance is critical to a successful exit and choosing the right metrics to monitor that is key. The performance of an investment can be evaluated by looking at two groups of metrics:
Ratios or multiples of capital invested
Accounting for the time value of money
These metrics can then be compared to benchmarks like the performance of comparable funds (to measure quartile performance) or their public market equivalent (such as the S&P 500 or the Nasdaq). However, ratios and IRR should just be one of many criteria driving investment decisions.
The below discussion looks at metrics from the perspective of an investor in a VC fund, but the same metrics can be applied by an Angel investor to evaluate the performance of their investment.
Prior to jumping in, some key concepts need to be defined:
DPI — Distributions Per Investment
Also known as a realization multiple, it measures how much money has been distributed by the fund to the LPs. The ratio starts off low and increases as the fund matures and investments are exited. A DPI of 1 means that the LP has received the same amount as the paid-in-capital; whereas a 2 means that the LP has received twice the amount of paid-in-capital.
RVPI — Residual Value to Paid In capital
It is the ratio of the current value of all remaining investments in a fund plus any cash equivalents to the paid-in-capital. It is a measure of how much capital is yet to reach an exit. While DPI is a measure of performance to date, RVPI could show how good a fund may be in the future.
TVPI — Total Value to Paid in Capital / MOIC - Multiple on Invested Capital
Also known as Investment Multiple or Multiple of Invested Capital (MOIC). It provides an estimated return per dollar invested. It is the sum of DPI and RVPI. Once the fund closes, this ratio equals the DPI as there are no on-ongoing investments, and the residual value equals 0.
Interim vs. final performance
Funds have maturity dates between 7 to 13 years and sometimes going to 16+. Distributions that are made early in the fund’s life are highly variable. That is, the early interim performance should not be taken as a predictor of the final performance. The final performance is when all investments have been realized, distributions have been made to LPs, and the fund has been liquidated. Interim performance becomes a more reliable indicator of final performance after 5 to 7+ years as the distributions become more stable.
Residual value relies on estimates
These are estimates of the remaining value of portfolio investments that haven’t been sold. The challenge here is that company valuations change as the company matures. The estimates that go into building the valuation can be subject to a lot of variability.
Time value of money
The time value of money is a concept that attributes a higher value to money currently at hand and discounts any future cash flows (i.e., money in hand now is worth more than the same amount in the future). Ratios or multiples don’t consider this as they indicate a fund’s performance at a snapshot in time. That is, a TVPI multiple of 2x at year 14 of a fund’s life may not be a good result whereas the same multiple at year 7 will be a lot better. This limit is overcome by considering the Internal Rate of Return (IRR) of an investment.
IRR is the return from a series of cash flows over time and importantly accounts for the time value of money. IRR identifies the rate of discount that makes the present value of all future cash inflows equal to the net cash outflow for the investment. The higher the discount rate (i.e. higher the IRR), the greater the expected returns on net outflows. Essentially, it is the rate of growth an investment is expected to generate annually.
The timing of capital inflows and outflows significantly influences the IRR. Early capital inflows and late capital outflows (from the perspective of an LP) are required to maintain a high IRR. That is, early distributions from investments and late calls for capital provide the perfect recipe for a high IRR. Due to the nature of the formula, IRR is best calculated using programs like Excel.
While the timing of capital flows impacts the IRR, this will not influence the ratios discussed earlier. In the below examples, we see that TVPI remains constant while the IRR varies based on the timing of capital flows. However, we go on to see that even the IRR metric is quite risky and for most LPs, it is important to have a high MOIC.
As a starting point, we have $40m in calls as an outflow and a single, final distribution coming in at year 5 of $50m. The IRR for this fund is 5%, with a TVPI of 1.25. In the below examples, we will see that the TVPI remains constant, but the IRR continues to increase based on the relative inflows and outflows.
Here, the same $50 is split into a yearly distribution of $10m each year for 5 years. While the TVPI is constant, the yearly distributions have improved the IRR to 8% - a 60% improvement compared to the baseline!
The same $40m in calls are split over two periods while the distribution remains the same as above. By taking in cash a bit later, the IRR has improved to 10%.
In the final example, the same $40m calls are split over the life of the fund and taken as required while the distributions remain the same as the above example, resulting in a 16% IRR!
Lagging indicator
IRR is an accurate representation once all investments in the portfolio are realized and the fund is closed. It cannot reliably be used to measure the fund’s performance during its 10+ year life. That is, an evaluation of the firms’ bets can only be made 6–10+ years after the bets have been made. Accordingly, it is tough to benchmark a fund’s early performance on IRR against other comparable funds and other asset classes.
Interim IRR calculations
They are unreliable as they depend on:
Estimates on the valuation of start-ups in the investment portfolio can vary drastically as they are not generating predictable cash flows. Further, in reality, the LP doesn’t actually get any distributions back until the holdings are sold and so it is a critical assumption the estimated valuations are a cashflow back to the LP.
Reinvestment rate of distributions
IRR is a true indication of a fund’s annual return on investment only when there are no interim cash flows or when those cash flows can be invested at the actual IRR. That is, the distributions that are made to LPs by the fund as it exits its investments must be reinvested at the same rate as the IRR, or the true IRR can be lower.
It is more reasonable to value the distributions at the cost of capital (i.e. the return available elsewhere on a similarly risky investment) to ensure that the IRR is less distorted by the reinvestment rate assumption. Using a Modified Internal Rate of Return (MIRR) value that attributes more realistic reinvestment rates (such as the cost of capital) can provide a more accurate equivalent annual yield.
The last bull market saw an unprecedented number of VC firms join the web3 space. While there are quite a few reputable firms that seek to co-develop and grow the industry, many were created to fund short vesting projects with a goal to quickly flip and extract value. These firms backed early-stage companies that did not necessarily have a strong use case and then sold as soon as they opened to retail investors or listed on major exchanges, using the retail investors’ liquidity to exit their position for a significant profit. IRR calculations and investment ratios on these firms look incredible and are most likely far higher than those VCs that are in it for the long term. However, such behaviors damage the web3 industry and do little to grow it.
Accordingly, performance metrics should not be the only factor driving investment decisions. Weighting should also be given to some qualitative elements such as the funds’ theses, contributions to the industries they participate in, and feedback from the start-ups they invest in.
Ratios such as DPI, RVPI and TVPI are a great way to understand an investment’s performance at a particular point in time. However, they have their limits - namely, they are not a reliable indicator of an investment’s performance at an early stage,
rely on estimates to calculate the residual value, and are unable to account for the time value of money. On the other hand, IRR can account for the time value of money. However, as a lagging indicator that relies on critical assumptions on reinvestment rates and estimated valuations being treated as cash flows back to LPs, it too has its limits.
Nevertheless, IRR, when measured correctly, is a powerful metric that can be used to benchmark performance across asset classes. Further, when combined with ratios, they provide a holistic understanding of an investment’s performance. However, ratios and IRR should just be one of many criteria driving investment decisions.