eFront research: Hurdle rate remains exlusive for VC funds

eFront research: Hurdle rate remains exlusive for VC funds

Opkomende markten Obligaties Aandelen Fusies & Overnames (M&A)
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July 15, 2019 – The latest research from eFront, a financial software and solutions provider dedicated to Alternative Investments, shows that reaching the hurdle rate – traditionally set at 8% – 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% of LBO funds managed to beat the hurdle rate, while only 38% of VC funds exceeded the 8% 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%. Following a significant slump around the turn of the century during the dotcom boom and bust, when pooled average IRRs fell to -5.03% for 1999 funds, performance has since improved steadily, with all vintage years from 2007 onwards achieving the industry standard hurdle rate of 8%.

A closer look shows that the top 5% systematically managed to exceed the hurdle rate, even for the vintage year 1999, with an 8.98% IRR, while the bottom 5% effectively never reached the hurdle rate. As for the top 25%, only in four instances did it not reach the 8% 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% of funds from 2005-2012 perform extremely strongly, with IRRs of 20-40%, 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% until 2012, compared with 18% up to 1991. Four out of the 13 individual years tracked  miss the 8% mark. Here again, the top 5% 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.