Once a venture capital investor invests in a new venture, he will evaluate the performance of his investment at the time of liquidation, and also during the life of the investment.
The performance is generally measured by calculating the internal rate of return (IRR) on:
- Cash flows since the beginning of the investment
- Unliquidated remaining holdings
Many associations such as European Private Equity and Venture Capital Association (www.evca.com) have published detailed guidelines for performance evaluation. Another such organization is the British Private Equity and Venture Capital Association (www.bvca.co.uk). The guidelines can be downloaded from their websites.
EVCA’s IRR Measure of Performance
The EVCA advocates that the performance be measured at three levels:
1. The Gross Return on Realized Investments
This return takes account of the cash outflows (investments) and inflows (divestments, including realization values, dividend and interest payments, repayments of the principal of loans, etc.), which take place between the Fund and its realized investments.
2. The Gross Return on all Investments
This return takes account of all of the following:
- The cash outflows (investments) and inflows which take place between the Fund and:
- Its wholly realized investments
- Its partially realized investments
- Its wholly unrealized investments
- The valuation of the unrealized portfolio (consisting of wholly unrealized investments and the unrealized portions of partially realized investments but excluding cash and other assets held in the portfolio).
3. The Net Return to the Funder
This measures the return earned by the Funders in the Fund, and takes account of:
- The cash flows which take place between the Fund and the Funders, net, by definition, of all of the following:
- The Venture Capital Company’s carried interest;
- The management fees paid to the Private Equity/Venture Capital Company by the Funders;
- All other applicable professional and ancillary charges which are paid out by the Venture Capital Company in the course of investing, managing and divesting from its investment portfolio.
- The valuation of the unrealized portfolio (consisting of the unrealized portions of partially realized investments, wholly unrealized investments and also including cash and other assets), after deducting the implied carried interest.
When the portfolio is fully realized/fully distributed, the Net Return is the ‘cash-on-cash’ return to the Funders.
There are several challenges in measuring the performance of venture capital projects:
- It is difficult to arrive at detailed valuations, as they have very limited information.
- There is no meaningful benchmark against which the performance can be measured.
- Any reliable performance feedback is of long-term nature.