Dispersion and Persistence of Returns - Understanding the Dynamics of the Israeli Venture Capital…
By: Amit Kurz
Tags: Performance, Return On Investment, Venture Capital, Israel

Dispersion and Persistence of Returns - Understanding the Dynamics of the Israeli Venture Capital Ecosystem

Over the past 20 years, the Israeli venture capital ecosystem has continued to expand and grow in complexity. With more fund managers than ever before (over 120), successfully investing in the local market has become increasingly challenging and mandates a strong understanding of the local dynamics.

At Sweetwood, we ran an analysis on the returns of hundreds of Israeli venture capital funds over the past three decades (thanks Michael and Kirsten). The results are clear — much like the global venture capital asset class — dispersion and persistency of returns among managers are the key fundamentals of Israeli venture capital (VC).

Let’s dive into what this actually means.

Dispersion of returns

Unlike most asset classes, VC has historically shown enhanced dispersion of returns, as compared to other asset classes. This means that there is a vast gap in returns between top quartile and bottom quartile performers. To give more of a perspective, over the past 30 years the average differentiation of returns (standard deviation, if you will) in the asset class has been 73%, while general private equity only accounted for 58% during the same period (see figure I).

For those versed in the asset class, this dispersion comes as no surprise. The performance of venture capital funds mostly mimics the distribution of returns from their underlying portfolio companies, which tends to exhibit a power law type of distribution. Under such distribution (and excuse the baseball lingo), the probability of hitting a home-run is low, but when one is hit it tends to travel far enough to impact the entire performance of a given fund. As only a small number of home-runs are hit per game (vintage), the probability that a given fund will hit a home-run (along with a few doubles and triples) and achieve top quartile performance, remains limited. Furthermore, only top quartile managers (or even the top decile managers, at times) return the type of risk-adjusted returns that their investors are expecting in return for locking up capital for a long time (i.e. 3x net multiple/25% net IRR and above).

The clear conclusion is quite simple, a smart investor in VC must ensure an allocation to top quartile funds. In layman’s terms — if you do not invest in top quartile VC funds, your money is better off in a different asset class.

This rule rings true in Israel as well. Between 2000 and 2015, top quartile Israeli VC funds have generated a net IRR of 26.27% and above, while the bottom quartile only generated a net IRR of 5.5% and below. This represents a staggering difference of over 23 percentage points, with the top quartile producing outsized returns, while the bottom quartile hovering close to losing capital.

Persistency of returns

The second fundamental, and perhaps the lesser known one, is the persistency of returns in VC. In simple words, this fundamental revolves around the notion that top managers tend to stay top managers and that moving up between performance quartiles is achievable, but highly unlikely. This is especially true when it comes to 3rd and 4th quartile managers becoming top quartile managers. Simply put, this is an outlier scenario.

While this notion has been evident for several decades in the U.S. VC market, our data on the Israeli VC ecosystem suggests vastly similar dynamics, despite it being a younger ecosystem. As seen in figure III, the concentration of high probability for subsequent same quartile performance around the diagonal is quite clear.

Specifically, Israeli venture capital funds that have been ranked as top quartile have a 62.7% chance to repeat their performance in their subsequent fund. The same applies for a bottom quartile fund which has 48.9% chance of repeating its poor performance in its subsequent fund. The edges of this paradigm do not bud well for lower quartile managers, as such have a mere 11.1% chance of turning their performance around and becoming a top quartile fund. While some of this data may be intuitively inferred by many members of the ecosystem (the brand value in venture as one key reason behind this for example, which allows firms to generate superior access to deal flow), we think that the numbers presented set forth an extremely strong case for only investing in top quartile managers, or not investing at all. And perhaps more importantly, following these managers across vintages.

As noted above, the conclusion of the data points has been quite clear for us. However, we wouldn’t be able to call ourselves true venture investors if we didn’t look for the outliers within our data, those special investments that change the return of a venture portfolio. So, after compiling this data, we asked ourselves — what if there are hidden gems in the stack? What if there are outliers to our guidelines? And what if we could successfully identify them?

To start, we tried to understand where outliers could emerge from and what may be the weak spots of our analysis. We identified two key categories: emerging managers and those special managers in the 9.4% probability quadrant that defeated all odds and still became top quartile managers despite poor initial vintages.

The Emerging Manager

The first group of emerging managers is an interesting group — in fact it’s so interesting that we will dedicate a full post to the topic. But in order to avoid the tension of waiting to our next post, we will say that the most interesting part about this group is that they tend to clearly outperform established managers by a significant margin (see data below on local ecosystem). This is done mostly on the back of a personal track record and without brand association and therefore the ability to identify these managers is quite challenging. Our dedicated post will cover this, in depth.

The Renaissance Manager

The outlier manager bracket is a bit more challenging to derive concrete conclusions about, as the performance of venture funds is impacted by hundreds if not thousands of parameters (some controlled, while many are not) and the ability to isolate a single parameter is an ambitious, perhaps presumptuous task. However, when we looked at the outlier manager scenario, there was one reoccurring theme that we couldn’t ignore — all outlier managers went through generational change in the composition of the leadership of their firm between the vintage years which were studied. While we acknowledge that this may not be the only reason for the change, a generational shift is such a profound event, that we find it hard to believe that it isn’t a significant catalyst in the change.

As there were other firms in our data set that have gone through a generational change, but did not become an outlier manager, we wanted to dive into the topic a bit more and decided to try to identify a short list of key items that worked in the generational shift of those outlier managers, which perhaps provoked them to see such a drastic shift in performance.

First and foremost, a multi-generational transition revolves around individuals who will experience a step-up and a step-down in their roles and economics, a delicate change which mandates an empathetic point of view of the process. When observing such process, there are two clear questions that ought to be answered — when and how?

With regards to timing, we arrive to the conclusion that successful changes were planned proactively at least one fund cycle prior to the generational transition taking place. For instance, if senior partners are scaling back their activity in Fund VI, this, along with the promotion of the new generation, should be initially implemented when raising Fund V. In that way, the ecosystem will enjoy an entire fund cycle to absorb the changes. The firm would still enjoy the reputation of the former management structure as it slowly transitions the new management into place over a 2–4 year period.

From an how perspective, having spent considerable time interviewing numerous fund managers on the topic, we have seen that successful generational shifts have focused on laying the right structure — setting clear roles, responsibilities, timelines and appropriate compensation for the old generation and the new one, always in consent between all parties. In particular, successful transitioning managers have been able to form a strong “game plan” around the following parameters: (1) time commitment, (2) defined roles, (3) defined deliverables, and (4) economic alignment between partners. While each one of these topics mandates a full post of its own and encapsulates many variances between firms, we ultimately have seen these focus points repeat themselves with the successful managers. When surveying managers on the topic, we have seen a similar line of thought on the topics.

Overall, the development of a thoughtful generational transition strategy and a flawless execution of such is that what set the renaissance managers apart. There are more details to the topic and plenty of literature has been written, but these are the few basic parameters which we now look to see in managers which are going through a generational shift.

To conclude: we hope that this blog post has presented an insightful framework on manager selection in venture capital, and particularly in the Israeli ecosystem. Of course, this is quite an initial framework and the task of investing in venture capital managers is extremely complex and ever evolving. But sticking to the parameters identified here should allow investors to design a strategy which is inline with the actual characteristics of the asset class — invest in top quartile managers, over time, but be aware of the emerging and renaissance managers.