Evaluating venture capital funds and fund managers is a complex process. When assessing the opportunity to invest in a venture fund, diligent investors seek to understand numerous factors, including the fund manager's investment strategy, its historical track record, the experience of investment team members, fund size, terms, valuation policies, compensation and incentives, and fundraising history. They consider the insights before deciding whether a given fund is worthy of their investment. The most astute investors, though, know that consistently high DPI (Distributed to Paid-In Capital) production by a fund manager in the past is the best predictor of future venture capital performance.
Nevertheless, despite its low correlation with long-term cash-on-cash returns, many investors have gravitated towards using TVPI as the overriding metric to evaluate the quality of funds and fund managers. On the surface, that does not make sense.
At BIP Capital, we refer to the failure of advertised TVPI to materialize as "The TVPI Moonwalk." In other words, while TVPI may appear high in the short term, that early positive indicator does not always translate to actual cash-on-cash returns. We evaluate hundreds of funds annually, and many seem to specialize in hyping unrealized fund performance early in a fund's life only to deliver much lower actual cash-on-cash returns. Interestingly, funds that are good at quickly generating TVPI in the current period also tend to produce quicker TVPI performance in future funds (FVPI—Future Value to Paid-In Capital). Still, there seems to be little correlation with longer-term DPI. This disparity raises questions about the relevance of using TVPI in evaluating venture funds.
Experts warn that the process of valuing illiquid, unrealized assets—a significant component of TVPI—is prone to significant manipulation. Yet, many "sophisticated" investors persist in using TVPI as a key metric for evaluating funds and fund manager quality.
That begs the question... why?
The reasons for prioritizing the TVPI metric over DPI are curious at best, especially given the mounting evidence that TVPI in the average fund tends to decline after the third year of a fund's life. The tendency of TVPI performance to decline after three years is even more suspicious when you learn that many institutional investors are compensated based on three-year TVPI performance.
If you believe that incentives drive behavior, that trend suggests that institutional investors tend to invest in fund managers who play the TVPI hype game. This decision creates a situation where funds may focus on generating high but fictitious TVPI in the short term without necessarily producing significant DPI returns in the long run. Lamentably, the empirical evidence shows that is exactly what often happens.
"If cash is king in business, DPI is king in venture capital." (Bill Gurley, famed venture investor and GP of Benchmark Capital)
It's worth noting that past DPI production is the best predictor of VC's future DPI performance. It's an important metric because it indicates the actual, realized cash returns investors have received from their investments, rather than projected unrealized returns.
The question becomes: When large institutional investors who are supposed to be acting as fiduciaries are compensated by short-term TVPI, why would they not focus on venture funds that generate short-term TVPI? In any other industry, we would call that what it is—fraud! What should we call it? Fraud? A legalized Ponzi Scheme? Or something else?"
We will leave those questions for you to answer. The point is this— investors should consider a range of factors when evaluating venture funds. But the most predictive factor is consistent DPI. There is no question that TVPI can be useful in certain situations, but investors should know its shortcomings as a metric.
TVPI stands for Total Value to Paid-In Capital. This performance metric is used in venture capital to measure a fund's total ROI (Return on Investment). It compares the total value of the fund's investments to the amount of capital that investors have contributed to the fund. TVPI considers the current value of the fund's investments, including realized and unrealized gains.
DPI stands for Distributed to Paid-In Capital. This performance metric is used in venture capital to measure how much of the money invested in a fund has been returned to investors.
FVPI stands for Future Value to Paid-In Capital. This performance metric is used in venture capital to measure the value of a fund's holdings relative to the capital invested by limited partners, reflecting the unrealized gains of the investments.
The moonwalk is a gliding dance motion in which the dancer appears to be moving forward but, in fact, is moving backward.
You can learn more about core VC metrics TVPI, DPI, and IRR in the BIP Ventures article, Understanding TVPI, DPI, and IRR: Key Metrics for Informed Private Capital Investors.
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