Two years ago, India’s largest English-language newspaper, the Times of India, instituted a startup awards list for India. One of the top award categories was “Investor of the year” and it was won by Nikesh Arora. Arora was then SoftBank’s head honcho and had in the preceding few months set the Indian startup ecosystem atwitter with a bunch of mega-bets backing companies like Snapdeal, Housing and OYO. The cheques that Arora signed were huge enough to catapult many of these chosen ones to an exalted unicorn status overnight.
But as Arora himself was gracious enough to admit, anointing an investor as the best Venture Capitalist (VC) in the country simply because he placed large bets on a bunch of companies is not only premature but also completely missing the wood for the trees. It is akin to lauding a painter for buying an easel and a box of crayons from the store.
Just as a painter cannot be gauged by the quality of the easel she paints on or by the price of the paint she uses, the true measure of a VC cannot be gauged by the size of the cheque she signs or the purported quality of the companies she backs. But unlike evaluating a painting where subjective matters such as aesthetics and taste come into play, a VC firm can be evaluated by a far more objective metrics—in the quality of the exits made from the companies in the portfolio.
But before getting into that, a short primer on the VC model might be required. Much like the startups they back, VC firms themselves raise money from other parties (referred to as Limited Partners or LPs) and commit to offering a minimum return (usually in the range of 8% per annum) over a fixed period of time (usually 10-12 years). This minimum rate of return is referred to as the ‘hurdle rate’ and any return over and above this is shared between the LPs and the VC firms in a preset manner (usually a 20-80 split between the VC and the LPs). Given that some part of the funds raised is reserved by the firm for running the operational aspects of the fund (referred to as a management fee and usually 2% per annum), for a VC firm to provide a meaningful return to its LPs, it has to return a minimum of 2X of the capital raised. A 2X return though would be equivalent to a VC getting passing marks in an exam—for a VC to be counted as a top performer, she would be expected to return 3X of the capital raised.
If you were tempted to believe that providing a 3X over 10 years seems simple enough, history would tell you that achieving this milestone is far from easy. Even in mature economies like the US, fewer than one in five VC firms manage to touch this number.