Can Growth Metrics of Portfolio Companies Be Incorporated in Traditional VC Fund Performance…

Can Growth Metrics of Portfolio Companies Be Incorporated in Traditional VC Fund Performance Metrics? And Why?

Introducing Growth-Adjusted TVPI (GA-TVPI): A New Metric for Evaluating VC Fund Performance

In venture capital, traditional metrics like TVPI (Total Value to Paid-in Capital) and IRR (Internal Rate of Return) have long been the gold standards for measuring fund performance. However, these metrics often miss an essential aspect of portfolio evaluation: the operational growth of portfolio companies.

Recently, Tambi jalouqa, Managing Partner at Propeller, sparked an insightful discussion by proposing a new metric called TARRPI (Total ARR / Total Paid-in Capital) to better capture the performance of companies within a VC portfolio, particularly in sectors like SaaS, where growth metrics such as ARR (Annual Recurring Revenue) and gross margins are critical.

Tambi’s suggestion is a refreshing take on how we might think about venture fund performance, especially in markets where ARR and other growth indicators drive value. However, there are opportunities to build on his idea and refine it further.

In this post, I want to delve into why TARRPI might not fully capture all aspects of fund performance, propose a variation that I’m calling Growth-Adjusted TVPI (GA-TVPI), and discuss how we might incorporate growth metrics into traditional VC performance evaluations.

Why TARRPI is a Great Starting Point but Needs Refinement

Tambi Jalouqa’s TARRPI idea stems from the need to go beyond traditional metrics like TVPI, which sometimes fail to capture the growth dynamics of portfolio companies until new funding rounds or exits occur. TARRPI is calculated as:

This approach rightly emphasizes the operational growth of portfolio companies, particularly for SaaS businesses where ARR and gross margins are crucial. However, there are a few areas where TARRPI might not provide a complete picture for evaluating VC fund performance:

1. Lack of Contextual Relevance for Fund Returns

While TARRPI focuses on ARR relative to invested capital, it does not account for how this translates into actual or potential cash returns for LPs. High ARR growth does not necessarily mean a company is on the path to a profitable exit or favorable valuation. For instance, a portfolio company could have strong ARR growth but remain far from profitability or positive cash flow, affecting its exit prospects.

2. Ignores Valuation Changes and Exit Potential

VC fund performance is fundamentally measured by both realized and unrealized returns, which are influenced by exit valuations, market conditions, and liquidity events like M&A or IPOs. TARRPI doesn’t directly capture these elements. Thus, it may provide a skewed view of the fund’s potential if high ARR growth doesn’t translate into meaningful exit multiples or actual liquidity.

3. Overemphasis on ARR as a Single Metric

ARR is undoubtedly a critical metric for SaaS companies, but it doesn’t provide a full view of a company’s financial health or growth potential. Important factors like customer acquisition cost (CAC), churn rate, customer lifetime value (LTV), and burn rate are not considered in TARRPI. Without these, TARRPI could overestimate the attractiveness of companies that have high ARR but unsustainable business models.

4. Misalignment with Traditional LP Expectations

Limited Partners (LPs) are usually more interested in the potential financial returns of their investments, which come from increases in the value of fund holdings and eventual exits. TARRPI, while innovative, doesn’t directly link to these outcomes, which can make it less meaningful compared to more established metrics like TVPI, DPI (Distributions to Paid-in Capital), or IRR.

Building on Tambi’s Idea: Introducing Growth-Adjusted TVPI (GA-TVPI)

Inspired by Tambi’s idea, I propose a slight variation — Growth-Adjusted TVPI (GA-TVPI) — that aims to bridge the gap between traditional metrics and the forward-looking potential of growth. GA-TVPI integrates the foundational elements of TVPI with key growth metrics, providing a more comprehensive view of fund performance by reflecting both realized and unrealized value.

How VCs Use Markups to Calculate Unrealized Value

Before we delve into the GA-TVPI, we need to clarify one thing. To calculate the unrealized value of their portfolio companies, VCs often use markups, which are valuation increases based on subsequent funding rounds. When a portfolio company raises a new round at a higher valuation, the VC “marks up” the value of its existing investment proportionally. For example, if a company raised its Series B round at twice the valuation of the Series A round, the unrealized value of the Series A investment might be marked up by a similar factor.

However, these markups are subject to market dynamics and can fluctuate based on factors such as market sentiment, growth prospects, and macroeconomic conditions. This is why relying solely on unrealized values (and adjustments like GA-TVPI) can sometimes be misleading — because they are not guaranteed until an actual exit occurs.

What is GA-TVPI?

GA-TVPI is designed to provide a more holistic view of VC fund performance by incorporating growth metrics that indicate the future potential of the portfolio. Instead of focusing solely on ARR like TARRPI, GA-TVPI adjusts the unrealized portion of TVPI to reflect growth rates of key performance indicators (KPIs). This adjustment offers a clearer picture of both the realized value and the potential growth-driven value of the remaining portfolio.

GA-TVPI is defined as:

Where:

• Realized Value: The portion of the fund’s value that has been converted into cash or distributions to LPs through exits.
• Unrealized Value: The current valuation of the remaining investments in the portfolio.
• WAGR (Weighted Average Growth Rate): A composite measure of growth rates for key metrics like ARR growth, gross profit growth, and net revenue retention (NRR) growth. The weights can be adjusted based on the fund’s strategy.

How GA-TVPI Builds on TARRPI and Addresses Its Limitations

1. Addresses the Lack of Contextual Relevance for Fund Returns:
   Building on TARRPI: TARRPI’s focus on ARR growth is a great starting point, but GA-TVPI goes further by incorporating both realized value (cash returned to LPs) and growth-adjusted unrealized value. This not only considers current valuations but also adjusts for potential future growth, providing a more comprehensive view of how growth could translate into favorable exits and returns.
2. Considers Valuation Changes and Exit Potential:
   Enhancing the Idea: GA-TVPI retains the unrealized value component of TVPI, which already reflects current valuations that factor in potential exit scenarios. The growth adjustment shows how strong growth could impact future valuations and liquidity outcomes, making the metric more dynamic and reflective of market realities.
3. Avoids Overemphasis on ARR as a Single Metric:
   Refining the Concept: GA-TVPI incorporates a Weighted Average Growth Rate (WAGR) that includes multiple growth metrics (ARR growth, gross profit growth, NRR, etc.). This approach ensures a balanced view, avoiding over-reliance on a single metric and presenting a fuller picture of potential sustainability and profitability.
4. Aligns Better with Traditional LP Expectations:
   Connecting to LP Needs: GA-TVPI builds on the well-established TVPI metric, which is already widely understood among LPs, by adding a growth perspective. This alignment with LPs’ expectations of potential future returns based on growth dynamics offers a more meaningful and relevant measure than focusing on ARR alone.

The Argument Against GA-TVPI

Despite building on Tambi’s idea with GA-TVPI, as a VC myself, I recognize that there may still be challenges to adopting it as a primary metric:

1. Complexity and Lack of Standardization:
   GA-TVPI introduces complexity that might not be easily understood by all stakeholders, especially LPs accustomed to more straightforward metrics like TVPI, DPI, and IRR. The subjectivity involved in selecting growth metrics and their weights could lead to inconsistent applications and make it difficult to compare across funds.
2. Potential for Misleading Interpretations:
   GA-TVPI might overestimate potential value if growth rates are high but unsustainable. The adjusted unrealized value might not accurately represent the likelihood of exits or actual cash returns to LPs, particularly in volatile market conditions.
3. Overcomplication of Fund Reporting:
   The introduction of growth-adjusted metrics could complicate fund reporting and distract from the core performance indicators that truly matter: actual and potential returns.
4. Lack of Focus on Cash Flow and Realized Returns:
   Ultimately, LPs care most about the return of and return on their invested capital. Metrics like DPI (which measures distributions to paid-in capital) directly reflect cash returns, while TVPI provides a clearer picture of potential future payouts. GA-TVPI, focusing on growth-adjusted unrealized values, may not always correlate with actual cash outcomes.

Preferred Fund Metrics

Given these considerations, as a VC, I would add GA-TVPI as a complementary metric to the traditional metrics I use. However, I would be transparent about its interpretation in my LP reports and clarify what growth metrics were used and the weights assigned to them.

At the same time, I would rely on a combination of well-established metrics that are widely understood and trusted by the industry:

1. Traditional Metrics:

• TVPI (Total Value to Paid-in Capital): Measures both realized and unrealized returns, giving a comprehensive view of the fund’s current value.
• DPI (Distributions to Paid-in Capital): Focuses on realized returns, providing LPs with a clear understanding of how much capital has been returned.
• IRR (Internal Rate of Return): Accounts for the time value of money, showing the rate at which LPs’ capital is compounding over time.

2. Supplementary Metrics:

• Gross Multiple of Invested Capital (MoIC): Reflects the multiple of returns before considering management fees and carry, offering a pure view of investment performance.
• Net Multiple of Invested Capital (Net MoIC): Accounts for fees and carry, giving LPs a realistic sense of their net returns.
• Public Market Equivalent (PME): Allows comparison of the fund’s performance with public market indices, helping to contextualize returns in relation to broader market performance.

3. Operational Metrics at the Company Level:

• I would still focus on company-level operational metrics to assess the health and growth potential of portfolio companies, including ARR Growth Rate, Gross Margin, Net Revenue Retention (NRR), Customer Acquisition Cost (CAC), and Customer Lifetime Value (LTV).

4. Scenario Analysis and Sensitivity Testing:

• To complement traditional metrics, I would use scenario analysis and sensitivity testing to forecast potential outcomes based on varying market conditions, growth rates, and exit multiples.

Conclusion: A Collaborative Effort to Evolve VC Metrics

I genuinely appreciate Tambi Jalouqa’s effort to push the conversation forward by proposing TARRPI. It brings a valuable perspective on how growth metrics could be incorporated into fund performance evaluation. Building on his idea, GA-TVPI attempts to provide a more holistic view by integrating both traditional and growth metrics. While it may not replace established metrics like TVPI, DPI, and IRR, it can serve as a complementary metric that offers additional insights into a portfolio’s growth potential.

By keeping the conversation open and collaboratively refining these ideas, we can continue to evolve how we evaluate VC fund performance, ensuring we capture both the current and future potential of our investments.

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