Carta has changed the game with their first-ever VC Fund Performance report.
I’ve spent a lot of time looking for holistic reports on the VC space, especially when it comes to emerging managers. Many great resources (although mostly behind high paywalls) detail Growth and Buyout funds, but very few look at VC, and even fewer look at emerging managers.
Carta provides fund admin services to thousands of emerging venture funds which gives them full transparency into the performance of those funds. This report gives incredible insight into how emerging managers perform en masse which is incredibly helpful data when diligencing funds.
Let’s dive into this report.
Pace of Capital Deployment is Slowing. This is Good.
The 2022 vintage has the slowest pace of capital deployment on Carta’s records, deploying on average only 43% of capital at the 24-month mark.
We consider this a positive reset towards normalcy. In the bull market of the last 10 years, VCs got too comfortable deploying cash quickly, often into bad companies, and saw returns buffetted simply by the rising markets. The market reset of the past two years is forcing VCs to be more judicious about where they deploy capital. Ultimately, this should benefit LPs who will see their capital deployed more carefully.
There is a massive spread in the returns of VC funds.
It’s no surprise that there is such a spread in the performance of early-stage VC managers. These are typically managers in their first few years of running a fund and some are naturally going to hit it out of the park and some are going to stumble. However, I was shocked by how wide the dispersion is.
Now, it actually isn’t shocking to me that the IRRs are lower in more recent years. This is heavily impacted by 1) the J-curve (you can read a bit about that on our blog here) and 2) the slowing pace of capital deployment (which is, again, a good thing), but what does surprise me is the spread of returns in more mature vintages such as 2017 and 2018 funds.
The fact that a bottom-quartile fund from 2017 has a 2.8% IRR but a top-quartile fund has a 21.6% IRR highlights how important due diligence is when selecting the VC fund in which to become an LP.
To put these numbers into perspective, since 2017, the S&P 500 has returned roughly 11% per year. This means that the median VC fund from 2017 outperformed the S&P 500 by roughly 2 percentage points and a top-quartile VC fund nearly doubled the S&P’s performance. However, a bottom quartile fund severely underperformed compared to the S&P.
My takeaways from this are two-fold. First, VC funds are a useful part of one’s portfolio, however, due diligence is extremely important when looking at potential VC funds. For example, at OneFund we rarely invest in first-time funds as we want to see what each fund’s track record looks like and understand their ability to raise money from institutions. Second, diversification is extremely important to sure you have exposure to multiple, high-quality VC funds to smooth out variance and improve risk-adjusted returns.
VC investing is getting more discerning.
Fewer startups are graduating from Seed to Series A rounds as VCs deploy capital more slowly and judiciously. This may not be good for start-up founders, but it is excellent news for LPs.
For 2018 Seed start-ups, about 25% of them graduated to Series A rounds after 7 quarters. However, for the two quarters of 2022 that we have data on, only about 13% of Seed-stage companies graduated to Series A. Roughly a halving of the 2018 numbers
So what is happening to these start-ups that are not raising? They’re doing bridge rounds, deciding not to raise again, or failing. This is indicative of less money flowing through the VC ecosystem and VCs deploying their capital more carefully. While this lack of activity may be depressing near-term returns, the higher caliber of companies that VCs are investing in now compared to a few years ago should mean higher returns for LPs in the long run.
So what does this mean for investors?
In light of this data, many of the same axioms still hold true.
- Venture is a helpful component of one’s portfolio for improving risk-adjusted returns according to data from Fidelity (see below, this is one of my favorite charts).
- Venture is illiquid and money should only be deployed here that won’t be needed for 5+ years.
- Venture should compose a minority of most portfolios. Institutional managers typically allocate about 10% to 20% of their capital to alternatives.
So what does change from this data? In our view, it increases the urgency of investing in funds that have a real track record. There are many emerging managers that I’ve run into who collapsed after their first fund. I suspect if Carta split this data by first-time funds and second or third vintages, there would be a huge spread.
The key is to find emerging managers with a history of returns and, more importantly, distributions. This is like finding a diamond in the rough but excellent emerging managers are rarely easy to find but usually worth the effort.