Text copied from [2]. ## Internal Rate of Return (IRR) This metric is a good benchmark for how efficiently a firm put their capital to work. Without loss of generality, this can be understood as a function of how quickly cash on hand increases in perceived in value. However, IRR can be gamed too easily: multi hundred percent gross IRRs are easily attainable for established firms: they can simply call a line of credit to fulfill an investment without having made a capital call to investors. Then, when knowing that their original deal is to be marked up by a later investment, they make the capital call and show incredibly speedy valuation spikes that can rough out slow quarters. More importantly, IRRs are a transient snapshot of a fund’s health, which may fluctuate by macroeconomic conditions out of the control of the founder – none of which accurately predict real cash-on-cash returns. Though IRR is valuable to understand the time-value performance of the fund, it is a shortsighted game to maximize this number every quarter. ## Total Value to Paid-In Capital (TVPI) In lieu of gaming the capital call-timing component as IRR does, TVPI presents an indicator that correlates well to portfolio companies being successful. Whether the venture firm played an active in value creation past capital deployment is out of scope, but this metric indeed controls for how big a bet of LP capital the firm chose to take on a given portfolio company, a valuable proxy for understanding a GP’s risk management skills. Yet, looking at TVPI alone can also be gamed – in fact, it is frequently gamed. A study of 135 private companies that reached unicorn status (greater than a $ 1B valuation) found that their post money valuations are 48% greater than their fair market value [1], meaning that TVPIs calculated off of the unicorn valuations can exhibit comparable inflation. Additionally, leading research attributes lesser blame to the macroeconomic conditions at the time of valuation measurement, and more towards informal favors one venture firm may give to another in marking up deals. This phenomena is well-studied at the intersection of venture capital via the gift exchange theory [9]. **The impact is that TVPI points to paper valuations and can be severely discounted when bringing equities to liquidate.** ## Distributions to Paid-In Capital (DPI) This metric is the most fundamentally sound metric: DPI measures **how much capital a fund returns (distributions) against how much capital was invested (paid-in capital)**. Furthermore, gross DPI is net of all fees and carry – it measures the performance of the fund as it relates to its primary economic buyer, the limited partner/fund investors. This metric is difficult to obfuscate as both distributions and paid-in capital values can be discretely measured and reflects the very beginning and end of a fund’s life. However, this metric cannot be obtained until positions are liquidated many years into a fund, which makes it difficult for LPs to understand performance in the short term. **We elect to evaluate a venture firm by their TVPI to DPI ratio**. This configuration encourages fund managers to maximize a standard metric for value created in the short term, and, knowing that valuation is a lossy measure of value creation, the **penultimate burden for the fund is to see how much a fund can maintain and convert their TVPI to DPI.** ![[Pasted image 20240709133845.png]] Source: Cambridge Associates benchmarks as of 9/30/22. This represents the top quartile venture funds of each relevant vintage. Rates of returns are net of fees, expenses, and carried interest. Cambridge Associates shows that most funds take at least six years to settle into their quartile ranking. --- Source of text: https://arxiv.org/pdf/2304.03525 [1] Will Gornall and Ilya A. Strebulaev. Squaring venture capital valuations with reality. Journal of financial economics, 135(1):120–143, 2020. [2] Mohib Jafri, Andy Wu. Distributed VC Firms: The Next Iteration of Venture Capital. https://arxiv.org/pdf/2304.03525, April 2023.