VC firms being ‘disadvantaged’ by traditional 8% hurdle rate compared to PE

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Venture capital firms are being unjustly punished by the traditional 8 per cent hurdle rate used across alternative assets, new research suggests.

More than 60 per cent of leveraged buyout funds have managed to beat the 8 per cent hurdle since 1991, data from financial software provider eFront shows – well above the 38 per cent of VC funds which managed to reach or exceed that figure.

Despite the majority failing the achieve the hurdle rate, the performance of US venture capital funds has been steadily improving since the dotcom bust, eFront said, 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.

The top 5 per cent 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.

But the dominance of the 8 per cent hurdle, and LPs putting such a strong focus on the figure, is disadvantaging VC houses according to eFront.

It said that because the hurdle rate is normally calculated as an IRR, and is therefore sensitive to time, it is technically easier to reach the threshold if a fund holds assets for a shorter period of time – to the advantage of PE funds, which tend to hold assets for less time than VC firms.

Tarek Chouman, CEO of eFront, said, “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.”

Third, a one-size-fits-all hurdle rate calculated as an internal rate of return 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 hurdle rate is useful, it is long overdue for a revamp.”

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