The VC fund's operating model is like private equity and hedge funds. Mangers (General Partners or GPs) launch the fund and investors (Limited Partners or LPs) invest capital. LPs contribute most of the capital (99% in most cases) to any fund.
The VC funds invest in startups (early-stage, late-stage, sector-specific, etc.) depending upon their thesis. The fund gets back its initial investment with the return when either a bigger fund acquires its stake or through an IPO/acquisition.
LPs get all the proceeds minus an annual management fee and some profit share (known as carried interest – Carry for short, typically 20%). GPs make money through Carry. Most GPs also get a salary for managing the fund.
LPs care about the Net return (Gross return – Management fee – Carry) because that's the money they get. IRR is the most common way to measure both gross and net returns. You can think of IRR as compound interest.
The question is what are the investor returns from the Indian VC funds? And what is a good VC return considering the risks?
VC investments are super illiquid with 5 to 8 years lock-in depending upon the fund. Thus, it requires a higher return than most investments.
What should be the benchmark?
1. One way is to add a liquidity premium over the stock market index.
2. Another could be to add a currency premium over the US VC returns.
The lack of data is the biggest problem with Indian VC investments. Bain tracks the number of deals, sectors, exists, investments, etc for the Indian VC industry, but it doesn't estimate investor returns. CRISIL has created an AIF benchmark index from select Indian VC funds (known as Category I Alternate Investment Fund – AIF in India)
The USA has a more mature VC industry. Cambridge Associates tracks VC index returns for every period and every stage. Thus, investors can compare the track record of individual VCs with a benchmark index.
US VC returns* as of 31st Dec 2020:
3-years: 28.2%
5-years: 18.3%
10-years: 17.2%
15-years: 13.1%
There is a clear trend that US VC returns have been increasing over the years. We can add a 3% annual currency depreciation to create an India benchmark VC index.
Indian VC equivalent returns* adjusted for currency depreciation:
3-years: 31.2%
5-years: 21.3%
10-years: 20.2%
15-years: 16.1%
*These are gross fund returns not net returns to LPs. LP returns would be lower.
CRISIL VC Benchmark Index returns as of 30th Sep 2020:
Source: Crisil
DPI, RVPI, and TVPI are 3 other common metrics to measure the performance of a fund. But let's compare the IRR of Indian and the US benchmark indices. Despite hundreds of VC funds in India, this benchmark index tracks 84 funds. But it's better than nothing. Vintage is the year when the fund made its first big investment. All VC funds take at least 2,3 years to invest their capital. Thus measuring a fund performance before 4,5 years is meaningless because it takes at least 2,3 years for any startup investment to yield results.
So we should analyse the returns of funds launched in FY17 and before. The average IRR of the 13 funds from FY17 is 24.6%. While this return looks good in isolation, this return is 4% lower than the 3-year US VC return. And we are not even talking about INR depreciation against the USD.
Do Indian investors are better off investing in the US VCs? The scant evidence we have suggests so.
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