Vintage Year Impact on VC Fund Performance

Does Vintage Year Impact Fund Performance?

The intuition behind a fund’s performance being related to its vintage year comes from the thought that a fund formed in (or immediately prior to) poor economic conditions should benefit from investing at lower average valuations. The lower average investment values should theoretically drive superior returns because these funds are able to ‘buy low’ compared to funds formed in good economic conditions. In order to prove this hypothesis, we need to be able to validate that the performance of funds formed in worse economic conditions is indeed superior to the returns of funds formed in better economic conditions. However, when we actually analyzed the data, we found that although fund performance was correlated with vintage year, the primary driver appears to be the investment stage rather than the lower valuations. In this case we will use a fund’s Pooled IRR as the measure of performance and the average GDP 18 months after fund formation as a mechanism to assess the economic situation of the vintage year (since the average investment is made roughly 18 months after fund formation).

            When we chart the Pooled IRR against average GDP growth 18 months after fund formation, we see a generally positive relationship (correlation of 0.39). While the observed relationship isn’t extremely strong, it is the opposite direction of what we would expect if the relationship between vintage year and fund performance were due to depressed valuations.

To support the argument that funds formed in (or more specifically, investing during) worse economic conditions outperform because they are able to invest at lower average valuations, we would expect a negative correlation between Pooled IRR and GDP growth. To better understand what is going on in our data, we need to deconstruct several of the underlying assumptions that were used to make our first hypothesis. In particular, we need to analyze whether lower venture valuations are actually associated with worse economic conditions as well as whether lower average valuations lead to superior returns.

Is average investment size negatively correlated with GDP growth?

            To begin, we’ll analyze whether we actually observe materially lower valuations during periods of worse economic performance. To validate our assumption, we would expect to observe a positive relationship between average investment size and GDP growth at time of investment. To help break out any sub-trends in the data, we analyzed not only the total average deal size by vintage year, but we also included the average deal size by investment stage. The following chart details the relationship between these variables.

The correlation between average GDP growth 18 months after fund formation (gray line) and average investment size (black dot) in the above chart is roughly -0.10. While the relationship is weak, this implies that when the economy improves, the average deal size actually declines and when the economy worsens, average deal size increases. This seems counter-intuitive until we consider the impact that the mix of investments has on the total.

When we analyze the relationship by investment stage, we see that the average seed investment size has a positive correlation with GDP growth (0.56) while early stage and expansion have roughly no correlation (at .08 and -.02 respectively) and later stage average investment size have a slightly negative correlation with GDP growth at -0.13. This implies that as the economy improves, seed investments tend to appreciate as investors become more risk tolerant. Conversely, later round average deal sizes appreciate as economic conditions deteriorate because investors become more cautious and there is a slight flight to safety. This relationship is reinforced by the correlation between mix and GDP growth. The correlation between total proportion of deals coming from the seed stage and GDP growth is 0.25, while the correlation between total proportion of deals coming from later stage and GDP growth is -0.59. From these we can see that as economic conditions improve, investors become more risk prone and shift investing dollars towards earlier stage deals – increasing average seed deal size and mix – while later stage deals see the same trend as economic conditions worsen. Early stage investments appear to be pro-cyclical, while later stage investments appear to be counter-cyclical.

Do lower valuations lead to higher fund returns?

            The effect of investment mix is also highly relevant in the analysis of our second assumption that lower average valuations lead to superior returns for the vintage year, but let’s first look at the broad trend. In aggregate, the relationship between average deal size and vintage year IRR is moderately negative at -0.31, which aligns with our assumption. As deal size declines, vintage year IRR increases. In the chart below, this trend is visible by comparing the movement of the Pooled IRR (gray line) to the average total investment size (black dots).  

The mix of investment also provides an interesting trend for fund returns. The relationships between fund IRR and average deal size for early stage, expansion and later stage investments are all negative (-0.25, -0.10 and -0.08 respectively) but the relationship for seed investments flips with a positive relationship of 0.60. This implies that for all investments other than seed investments, the fund IRR increases as average investment size declines. But for seed investments, the fund IRR actually tends to increase as the average seed investment size increases. This trend in seed investments is coupled with a positive relationship between vintage returns and the proportion of total deals made in the seed round (0.69). The observed relationship between seed investments and fund performance indicates that fund performance tends to increase as the average size and proportion of the seed investments increase.

           The chart below displays the relationship between proportion of total investment by stage and vintage year IRR.

Our second assumption that vintage year returns are negatively related to average investment size is actually a combination of two separate trends. Early stage through later stage investments seem to follow our expected assumption and there is a negative correlation between average deal size and fund returns. However, seed investments exhibit trends opposite from what we would expect – vintage year IRR’s tend to increase as the average seed investment size increases and as the proportion of total made as seed investments increase.

Conclusion:

            When we go back to our original question of whether vintage year impacts fund returns, the answer appears to be no for each of the different investment stages, but for different reasons:

• Seed: While seed investments tend to be pro-cyclical from an average investment size perspective (average investment size increases as economy improves), the relationship between vintage year performance and average seed investment size is the opposite of what we would expect. In fact, vintages that have the highest average seed investment size (and proportion of total deals as seed investments) tend to perform better.

•  Early Stage and Expansion: Early stage and expansion investments didn’t exhibit any material relationship between average investment size and GDP growth. The relationship between % of total investment and GDP growth was marginally negative for early stage (-.11), while it was fairly positive for expansion stage at 0.55. This implies that as the economy improves, the proportion of total investments made as expansion stage investments tends to increase. The relationship between average investment size and vintage performance is slightly negative for both investment stages (-.25 for early and -.10 for expansion), while the relationship between vintage IRR and % of total investment is moderately positive for both (0.32 for early and 0.28 for expansion). Both of these investment stages roughly follow the performance expected in our original hypothesis, but the strength of the relationship between the variables is too weak to be meaningful.
  
• Later Stage: Opposite to seed investments, later stage investments tend to be counter-cyclical from an average investment size perspective, as the average investment size tends to increase as the economy worsens (and vice versa when the economy improves). This trend is reinforced by the fact that the proportion of total deals made in later stage investments also declines as the economy improves (-0.59 relationship). The relationship between average investment size and vintage year IRR for later stage investments is close to zero (-.08), but the relationship between proportion of investments made in later stage and vintage year IRR is strongly negative at -0.71. This implies that vintage years that have a higher proportion of later stage investments tend to perform worse. This trend seems to validate our hypothesis that vintage year does matter for later stage investments, but for a reason different from what we initially expected.

Overall, vintage year does not seem to exhibit a significant effect on performance, at least not for the reasons initially expected. Our hypothesis that vintage performance would be higher for those formed during worse economic conditions did not seem to hold up at the aggregate level, or for any of the specific investment stages. However, there were two interesting trends that did emerge. Vintages with higher proportions of seed investments have tended to perform better, even though they are usually formed in the best economic conditions. Conversely, vintages with higher proportions of later stage investments have tended to perform worse although they are generally formed in poor economic conditions. While both of these trends prove to be interesting, without further analysis and more robust statistical methods, we cannot prove that they are anything more than interesting observations. 

About OCA Ventures

OCA Ventures is a venture capital firm focused on equity investments in companies with dramatic growth potential, primarily in technology and highly-scalable services businesses.  OCA invests in many industries, with a preference for financial services and for-profit education.  Over the last decade, OCA has invested three funds in over 45 companies.  In response to the increase of attractive seed-stage investment opportunities, OCA Ventures created a seed program called OCA EDGE.  OCA EDGE invests smaller amounts in seed or very early stage rounds of highly scalable technology businesses.  OCA Ventures partners with proven entrepreneurs to build market-leading companies. OCA Ventures complements management teams with a wide range of strategic, human and financial resources.  OCA Ventures was initially backed by the entrepreneurs who founded and built O'Connor & Associates, the derivatives trading firm that was acquired by Swiss Bank (subsequently UBS). OCA Ventures is based in Chicago and has investments throughout the United States.

Sources:

1. NVCA VC Performance Report, Q2 2013
2. World Bank Economic Data
3. MoneyTree™ Report, Data: Thomson Reuters - Investments by Stage of Development Q1 1995 - Q3 2013
4. Capital IQ Transactions report - 1/1/1995 - 12/31/2010 (n=71,715 transactions)

Notes:

• GDP +18 months was created by averaging the average annual GDP growth from year +1 and year +2 from the vintage year.
• Average transaction size was calculated over a similar time period as the GDP +18 months variable.
• Early stage roughly translates to series A investments, expansion roughly translates to series B investments and later stage refers to series C+.