Milestone Group Quarterly: July 2007

Articles

• Face to Face: Dinesh Wadhawan, CEO IndiaTimes
• Investment Viewpoint: Naren Gupta, NexusIndia
• By Invitation: Satish Nambisan and Mohan Sawhney: An Advance Look at Harnessing the Global Brain for Innovation and Growth: The Execution Challenge
• Milestone POV: Venture Math by Anurag Chandra of Milestone Group’s Advisory Board

Milestone PoV:

Venture Math by Anurag Chandra of Milestone Group's Advisory Board

Making money in early stage information technology (IT) venture capital has always required hard work (and some luck), but these days it seems as if it's really hard work for even top-tier early stage venture capital firms. The math just doesn’t seem to be adding up for this rarified and historically most successful subset of the VC industry.

Here is some back of the envelope analysis:

There are numerous early stage venture firms devoted to IT investing, but let’s just take the “Top 25” (a conventional designation for the venture capital industry's elite or “top-tier”) to see how the math stacks up for them as a class. Since the 2000 NASDAQ correction, these firms have raised about $400M in funds devoted exclusively to early stage IT investing (some of the firms have larger funds out of which they invest in other sectors and stages). They typically collect 2.5 percent of this $400 million in management fees each year (more in some cases) for 10 years from their investors (i.e., Limited Partners or LPs). These fees cover operating expenses (e.g., salaries, rent, travel and due diligence).

Although the 2.5 percent usually starts to decrease by one tenth of a percent each year after an initial deployment of capital period (4-6 years), I want to keep the math simple so let’s go with 2.5 percent of $400 million per year for 10 years, which equals $100 million. This means that investors will commit $500 million in total over the life of the fund.

The next important assumption is that an early stage IT venture fund typically attempts to maintain about 20-25 percent ownership in each of the companies it invests in. Said another way, the fund will own one-quarter to one-fifth of all of the companies it invests in.

Now let’s answer the following question: “What is the aggregate amount of total exits a $400 million early stage IT venture fund must generate across its entire portfolio of investments to return the $500 million provided by its investors?”

This is simple math. Take the $500 million received from LPs and divide it by the portion they own in all of the companies they’ve invested in, either 20 percent or 25 percent. (I’ll use 20 percent ownership instead of 25, because I think it’s more accurate under current conditions, but the magnitude of the analysis is not significantly reduced if you choose 25 percent.) The equation is $500M/.20 equaling $2.5 billion.

So, an early stage IT venture fund's entire basket of investments must total $2.5 billion for that firm to simply return capital to its investors. If a fund hopes to double the $500 million it raised (i.e., generate $1 billion in gains from investments), its portfolio’s aggregate exits need to equal $5 billion.

For all of the Top 25 early stage IT venture funds to be in the range of just returning capital raised (1x return) to doubling capital (2x), they need to generate returns between $62.5 billion to $125 billion (25 multiplied by [$2.5B-$5B]). It is true that these venture firms often syndicate with one another, thus making the calculated range prone to “double counting” errors. However, there are many more than 25 venture capital funds of all sizes in the early stage space who are in the mix for syndication. This, I think, is a more than reasonable offset for the times when two top tier firms each grab 20-25 percent of the same company (i.e., there will be plenty of winners in which there's only one Top 25 firm or no Top 25 firms participating).

Keep in mind that while $1 billion in exits would be a doubling of capital for a $400 million early stage venture fund, it's not a 2x return to the LPs because after the first $500M is returned, the next $500 million is split 80/20 between the LP and the venture fund's managers (or sometimes 70/30 for the premier firms who can dictate a higher percentage split for themselves), so it’s really a 1.8x or 1.7x cash on cash return to the LPs, but to keep themath simple let’s assume the LPs are getting it all.

This 2x return has to be justified in a reasonable time period - LPs probably won’t be happy with a 2x return if it takes 20 years to achieve. The IRR on that time horizon likely makes fixed income investments, like T-bills, far more attractive for the pension funds and endowments that invest in the best venture firms because of the greater risk of the venture capital asset class.

So what is an acceptable time horizon?

I’m going to say that 5 years is acceptable for an institutional LP. Why? Well, doubling your money in 5 years equals about a 14.7 percent return. It's not quite the 20-25 percent IRR, which is the goal set by many firms in their pitch books to LPs (and it's certainly not 80+ percent, which the top-tier venture firms returned in the 1996-1998 vintage funds), but I think 14.7 percent is plausibly acceptable to LPs. A conventional benchmark used by LPs to justify riskier investments in illiquid asset classes is to aim for 500 basis points (5 percent) above the historical S&P 500 return (the S&P being a yardstick for the most liquid and stable equity investments in the U.S.).

The S&P has been just above 9 percent historically, so 5 percent above that is 14+ percent (close enough to 14.7 percent for this exercise). So, double your LP's money every five years and they’ll be happy (or at least content) with their early stage IT venture capital investment. For all of the Top 25 early stage IT venture firms to perform accordingly they need, as a group, to generate $12 -$25 billion in exits annually ([$62.5B-$125B] divided by 5 years).

Can the Top 25 early stage IT venture firms, as a group, generate these types of exits annually? It hasn’t happened since the NASDAQ market correction of nearly 7 years ago. The exits just haven’t been there, not even close. It appears that cutting back from billion dollar fund sizes of the late 1990s to even $400 million hasn’t “right sized” the industry enough. Granted, we’re talking about a set of firms that are the smartest and most experienced at early stage IT venture capital investing and it's difficult to bet against any one firm when you look at their roster of talent; but too many competitors, no matter how smart, in an insufficiently large enough market means these firms have their work cut out for them.

Perhaps another Internet boom is around the corner in the form of clean tech, nanotechnology, or some other class of disruptive innovations soon to arrive at the doorstep of commercialization and will then create the magnitude of outcomes implied by my set of assumptions. So far information technology investments haven’t done so and it's tough to see how they will, especially since the larger exits are taking at least five years to grow and mature (there just aren’t that many relatively quick winners like YouTube to go around).

The top venture firms have done some form of this math and are evolving to meet the challenges. Thus far, there are three new discernible approaches: (1) go international (India, China, Israel, etc.); (2) invest across stages (early, mid, mezzanine, growth capital for cash flowing companies, and even PIPES); or (3) go after the new markets, like clean tech, that may grow the way IT investing did in the second half of the 20th Century. Some firms are adopting more than one approach. Many are raising separate funds for the different geographies and/or approaches. It will be interesting to see if the top-tier early stage venture capital firms can scale along these paths.

Many of the senior partners at the top venture firms have faced the challenges of previous low points in venture capital over the last 30 years and faced questions about the ongoing health of the industry. They have emerged successfully from those nadirs and it will be interesting to see if the top-tier early stage firms can evolve their business model once again.

Anurag Chandra has sat on Milestone Group's advisory board since the firm's inception. Currently, he is a Managing Director in Lighthouse Capital Partners, V and he recently co-founded Telemoto, Ltd., a mobile wireless startup. At Lighthouse, Anurag led the firm's investments in Airespace (acquired by Cisco), Ironport (acquired by Cisco), and Modulus Video (acquired by Motorola). Prior to Lighthouse, Anurag was the Vice President of Corporate and Business Development at Instraspect Software (acquired by Vignette).

Anurag also served as the Vice President of Finance and Operations at netDialog, where he played an instrumental role in its acquisition by Kana Communications. He is currently an advisor to or board member of four early stage startups. Anurag holds a B.A. from Stanford University in economics and political science and a J.D. from Loyola Law School.