Portfolio Design: A Modern Approach to Asset Allocation

RETURNS ON VENTURE CAPITAL

By the very nature of venture capital, returns occur over an extended period of time. Investors have to commit capital for a decade or more, and the first years of the partnerships bring few if any returns. The pattern of cash flows is highly uneven, so the calculation of returns is tricky.

The returns on venture capital are best calculated using the internal rate of return (IRR) rather than time-weighted returns. To see why this is the case, consider a simple example from Metrick (2007). Suppose that an investor has committed $11 million to a fund. At the beginning of the first year, $1 million is drawn down. At the end of this year, the investor receives $2 million on this investment. At the same time, the remaining $10 million is drawn down for a second investment which returns $6 million at the end of the second year. A time-weighted return would consist of compounding the 100 percent return on the first investment with the 40 percent loss on the second investment for a cumulative return of (1 + 1.0) (1 − 0.4) − 1 = 20%. The annual equivalent is (1 + 0.20)½ = 9.5%. Surely there is something misleading about this calculation since the investor hasn’t even recovered the $11 million initially invested.

The cash flows of this investment are very uneven. At the beginning of the first year, there is a $1 million outflow. Then there is a net $8 million outflow at the beginning of the second year ($10 − $2). Finally, there is a $6 million inflow at the end ...