The majority of angel investors… effect of carry

If you’ve been following along with the posts in this series (part 1, part 2, part 3, part 4, part 5, part 6, and everyone’s favorite part on taxes) it’s a safe bet you like angel investment data a bit too much – but are excited about the chance to dig ever deeper.

We’ve been discussing these analyses at our VentureSouth meetings this month, to both positive feedback and constructive criticism – so I’m adding this postscript to tackle one particular issue: carry.

The specific criticism is: to exclude fees and carried interest from the presentation about the data is misleading (to what degree, only the data would show). Of course to your credit you did mentioned it [in part 3]… but I would say to offer conclusions with assumptions about this unaccounted for cost is not nearly as useful. Particularly if your point is to pair the idea that angel investors aren’t making money, which to me is clearly examining the issue from a bottom-line perspective.

This is a fair criticism, and so we offer below some additional discussion to address it.

First, some background. Private markets investment return information (like angels but also private equity and venture capital) is almost always presented as gross returns, at least at a headline level. This chart, popular recently on “VC twitter” and the benchmark angel returns data everyone, for example, show gross returns. This is because it’s simpler, and it’s impossible to compare across aggregates when every class and fund has different fee structures.

Now, this overstates net returns. However, as carried interest is charged as a percentage of a gain (and usually after accounting for relevant management or other fees), it cannot turn a positive result into a negative. In a VC fund, carry applies when the fund overall returns a positive result – it reduces gross gains a little, but cannot switch a >1x ROI to a <1x. (That isn’t usually true of public market investing, where fees charged on “assets under management” still apply even in loss-making years. In that respect, VC/angel is better than public markets.)

Similarly, for individual angel investments, a >1x ROI deal cannot become a <1x ROI after carry, even on returns that are close to 1x. For example, in a group that charges a 10% carry, a gross 1.050x ROI investment becomes a net 1.045x ROI – still >1x.

However, in this specific analysis (of the incidence of aggregate losses), there’s a unique set of scenarios where carry could move someone from an aggregate “win” to a “loss”: where 1 or 2 deals create big gains but other investments lose enough capital to exceed the net gain but not quite enough to exceed the gross gain. This seemed pretty unlikely to me before adding my caveat in the part 3 blog post. But it’s good to check assumptions, so does it actually make an impact?

We re-ran the analysis to include carry and it moved two investors from the “win” to the “lose” category. So 40 out of 389 (10.3%) became 42 (10.8%). Not zero, but I think fair to say pretty rare, and not (in my opinion) a material change. The earlier conclusion that only a small minority of angel investors lose money (through VentureSouth) still seems justified to me.

In fact, both those individuals had small portfolios (2 and 3 investments respectively), which reinforces the conclusion about the importance of diversification: 2-3 companies is a risky portfolio!

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