After record distributions during the past two years in both private equity and venture capital, 1Q 2016 returns were somewhat disappointing. Venture capital cash flows back to LPs went negative, while PE funds’ net cash flow hit just $27.9 billion globally, well off the pace of the past three years. While the 1Q exit market could be blamed, the massive sums each asset class invested is the real reason for the change in cash flow. Neither industry should worry.
Introduction
Over the long term, private equity horizon IRRS have outpaced most other asset classes, yet on a short-term basis, the venture market has done better. Limited partners continue to see positive inflows from PE vehicles, but fundraising figures remain impressive and net cash flows have declined, an interesting trend to note given the consistent quarterly drop we’ve seen in deal flow.
For venture, net cash flows to LPs were negative for the first time in three years. While that has historically been the case, recent years have seen a series of outsized exits support distributions. With liquidity remaining low as of late, the pace and level at which late-stage private companies exit in the coming future will be closely watched in terms of how they’ll affect the distribution of cash and
current fund IRRs—which today are certainly supported by hefty paper gains they have yet to realize.
Throughout this report, we take a deeper look into private market IRRs, fund cash flows and return multiples, across other metrics. We hope this report helps inform your decision making process, and as always, feel free to reach us at [email protected] with any comments or questions.
Nizar Tarhuni
Senior Analyst
KS-PME Benchmarks
When using a KS-PME, a value greater than 1.0 indicates outperformance of the public index (net of all fees). For example, the current 1.27 value for 2005 vintage PE funds means investors in a typical vehicle from that year are 27% better off having invested in PE than if they had invested in public equities over the same period.
When using a KS-PME, a value less than 1.0 indicates underperformance of the public index (net of all fees). For example, the 0.92 value for 2006 vintage VC funds means investors in a typical vehicle from that year would see only 92% of the value they would have in the public markets.
Horizon PE KS-PME versus Russell 3000
The current differences between PE and VC fund lifecycles are well illustrated by the charts to the left, although the timeline for PE has been slowly lengthening beyond historical norms.
KS-PME Case Study: IT
Over the past 10 years, the venture market has seen huge growth in almost every aspect. Valuations have gone so high in the private market that last year many believed, and maybe still believe, that a bubble had formed and would come crashing down in the near future; the number of unicorns has gone from just a couple to well into triple digits in number; and the amount of funding available to private companies from VCs shows no signs of slowing. The venture industry is made up by much more than tech companies and is present in near all markets, but tech is still a main focus of many VC investors. So it comes as no surprise in many cases when the private market outperforms the public markets at certain horizons, especially with regards to IT-focused venture funds
Across one to 10-year horizons, IT-focused venture funds have outpaced the Russell 2000 Index by no less than 20% on each horizon. The largest outperformance (almost 26%) can be seen at the three-year horizon, which has been driven by the recent growth in valuations and overall rise in financing totals during that time. In our recent VC Unicorn Report, we noted that Series D+ postvaluations for unicorns had outpaced the Russell 2000 Index by more than double since 2005, which more than helps illustrate this trend. That said, for the purpose of calculation we do incorporate unrealized values into VC IRRs with the understanding that those values could change upon a future exit.
IRR by Fund Type
As LPs make decisions about alternative asset allocations, it’s important to keep in mind that diversification and a long-term mindset remain paramount. That being said, horizon IRRs for venture capital investments are outperforming private equity returns on a one-, three-, and five-year basis. On a 10-year horizon, global PE produces an IRR of 10.4% compared to venture capital’s 8.9%, but if current trends hold, VC returns may outpace PE on every time horizon in the next few years. Keep in mind, however, that much of this venture capital performance is driven by inflated valuations in an overcrowded and ballooning latestage deal market.
As expected, differences in returns across asset classes are more pronounced in the short run, and more or less converge on a 10-year horizon basis. Debt funds do not show a return until after the first few years, as the restructuring processes and distressed debt strategies that many of these firms use take more time to show an initial change in NAV.
Turning to median IRR by vintage year, venture capital funds that first deployed capital in 2010 saw a 5.2 percentage point decrease in IRR since the last edition of this report (which did not include data from 1Q 2016). Venture returns across the board have been marked down as worry spreads that many of these late-stage companies may not ever see an exit at such frothy valuations. Meanwhile, 2011 and 2012 vintage PE funds saw IRR increases of 0.3% and 1.9% from last quarter, respectively, as managers continue to slowly refine operations at more mature portfolio companies.
Quartiles & Benchmarks
In the last edition of this report, we discussed the widening gap between top-quartile and bottom-quartile PE managers in the years since the recession. That trend, however, is not as pronounced when we include the most recent fund return data from 1Q 2016. The difference in IRR between top and bottom-quartile managers is 11.5% for both 2011 and 2012 vintages, less than the 12%-13% difference seen for vintages from 2008 to 2010. Meanwhile, 2009 is no longer the best year to have deployed capital—at least on an IRR basis—since the recession. 2012 vintages, with a median IRR of 12.0%, now hold that distinction.
Median IRR for funds that first deployed capital between 2005 and 2008 is still below 10%, as is expected with net asset values worldwide nosediving during the financial crisis. Certain managers were able to keep their businesses solvent through restructurings and refinancings, then exit years later after prices had recovered. Many other firms, however, were forced to exit their investments at lower EBITDA multiples or extend their holdings for so long that IRRs became diluted accordingly.
Venture Capital
Top-quartile benchmarks for venture capital funds have moved consistently lower for three consecutive vintages starting with 2011 funds. Vintage 2010 funds have posted a top quartile IRR of nearly 32%, riding high on the unique opportunity many of these funds had to invest in the likes of Facebook, Uber, Twitter and other current or previous unicorns while they were in the early stages. Globally, 2010 vintage venture capital vehicles have invested in more than 70 companies that have achieved a $1 billion-dollar valuation while in the private market, and were positioned to ride the growth of valuations coming out of the crisis.
While the subsequent vintages have fallen back from the 2010 top-quartile IRR, each vintage is still returning an IRR above 20%. The ability for each vintage to capitalize on the growth in valuations has been limited each succeeding year. Much of the IRR value within these later vintages may still be yet unrealized, which will bring more into focus whether or not these larger IRRs have been underpinned by true or artificial valuations.
Private Equity IRRs
When observing returns to any asset class over time, it’s important to remember the market conditions that these investments have weathered. For example, PE horizon IRRs are lower on a 10-year time frame than five, due to the stretched hold periods and asset write-offs that happened during the recession. Meanwhile, the three-year horizon IRR is the highest in our dataset, due to the fact that these investments were made before the recent run-up in valuations and have been subsequently marked as such—even though many of these returns have yet to be fully realized through an exit.
Interestingly, our data show that PE funds sized between $250 million and $500 million, and $1 billion+ largely track each other in performance. The horizon IRRs for these two buckets are within one percentage point of each other on a one, three, five, and 10-year basis. Funds under $250 million in size underperform the rest of the asset class on a one and threeyear horizon—perhaps due to a more pronounced J-curve effect in smaller, more operationally focused funds—but returns converge on a five and 10-year basis. Globally, all fund sizes report between a 10.3% and 10.9% 10-year horizon IRR, with the smallest funds producing the largest returns in that range.
Focusing now on returns by geographic region, US PE funds perform better than both Europe and the rest of the world on a three-, five-, and 10-year basis. As with differences in size of funds however, the disparity in returns is less pronounced over the longer-term. US PE funds have a 10.9% 10-year horizon IRR, compared to 8.7% in Europe and 10.1% in the rest of the world.
By PitchBook, read the full article here.
