PE Tech Report

NEWSLETTER

Like this article?

Sign up to our free newsletter

Hurdle rate remains elusive for VC funds

The latest research from eFront shows that reaching the hurdle rate – traditionally set at 8 per cent – remains a significant challenge for venture capital funds and, to a lesser extent, LBO funds.

Looking at the distribution of historical internal rates of return (IRRs) delivered by LBO and VC funds of all vintage years, more than 60 per cent of LBO funds managed to beat the hurdle rate, while only 38 per cent of VC funds exceeded the 8 per cent threshold . This confirms that shorter holding periods characteristic of buyout investments work in favour of LBO fund managers.

Despite the majority failing the reach the hurdle rate, the performance of US venture capital funds has been steadily improving since the dotcom bust, with more recent vintages enjoying very strong IRRs. US VC funds created up to 2012 have recorded an overall pooled average IRR of 14.4 per cent. Following a significant slump around the turn of the century during the dotcom boom and bust, when pooled average IRRs fell to -5.03 per cent for 1999 funds, performance has since improved steadily, with all vintage years from 2007 onwards achieving the industry standard hurdle rate of 8 per cent. 

A closer look shows that the top 5 per cent systematically managed to exceed the hurdle rate, even for the vintage year 1999, with an 8.98 per cent IRR, while the bottom 5 per cent effectively never reached the hurdle rate. As for the top 25 per cent, only in four instances did it not reach the 8 per cent threshold. It can therefore be concluded that reaching the hurdle rate remains a significant challenge for venture capital funds. 

However, for more recent funds, the picture has improved. The top 5 per cent of funds from 2005-2012 perform extremely strongly, with IRRs of 20-40 per cent, and even bottom quartile funds stay in largely positive IRR territory, despite not reaching the hurdle rate.

Does LBO differ significantly from venture capital? The overall pooled average IRR is 12.11 per cent until 2012, compared with 18 per cent up to 1991. Four out of the 13 individual years tracked miss the 8 per cent mark. Here again, the top 5 per cent exceeded the hurdle rate comfortably in all instances, as did top quartile funds. Bottom quartile fund managers managed to hit the hurdle rate in six out of 13 years and came close in three more vintage years.

Macroeconomic and business factors, however, play a role: LBO performs less well when the economy is at the top of the economic cycle. But here, shorter time-to-liquidity plays in favour of LBO fund managers: on average, it is 4.22 years. The maximum time-to-liquidity was reached with funds of the 2006 vintage year (6.4 years), which was a comparatively poor performer. 

The hurdle rate is normally calculated as an IRR, and is therefore sensitive to time. Technically, it is easier to reach this threshold if a fund holds assets for a shorter period of time, implying that the use of credit lines can help the fund manager to reach this performance threshold, but also that VC funds are at a disadvantage, as they tend to hold assets for longer than private equity funds.

This is illustrated further by the fact that, on average, the time-to-liquidity was 3.6 years for VC funds of vintage years 1992 to 1998, while it was 5.7 years for funds of vintage years 1999 to 2012, making high IRRs and therefore hurdle rates harder to achieve. 

Tarek Chouman, CEO of eFront, says: “The first conclusion from these analyses is that the hurdle rate remains a challenging target to reach for venture capital fund managers. The second is that adverse macroeconomic and business conditions can deprive fund managers of the reward of their work. It is difficult to argue that LBO fund managers collectively suddenly did not create any value if they raised funds in 2006. 

“A one-size-fits-all hurdle rate calculated as an IRR appears as inadequate: it might unjustly punish venture fund managers, for example, as they require more time to develop their assets. The logical conclusion is that if the method of calculation of the hurdle rate is useful, it is long overdue a revamp. A possible solution could be to negotiate a variable rate, computed as a premium on a public market equivalents.”

Like this article? Sign up to our free newsletter

MOST POPULAR

FURTHER READING

Featured