Case 036Alternatives and private marketsCore

Two years into a venture fund, a client's statement shows an IRR of minus 12%. With fees of 2% on commitment and no exits yet, rebuild the J-curve and show when it should turn.

The situation

Farida Kapasi committed Rs 1 crore to an invented early-stage venture fund two years ago. The fund charges a management fee of 2% a year on the full commitment, Rs 2 lakh a year, for its ten-year life. It has called Rs 20 lakh for investments in each of its first two years, plus fees, so she has paid in Rs 44 lakh.

Her year-2 statement values the portfolio at Rs 36.4 lakh, after the fund marked down two early holdings. No company has been sold. The statement shows a net IRR of minus 12%, and Farida has called to ask whether the fund is failing. For the rest of the fund's life, use the illustrative calls, valuations and distributions in the table below.

Your task

Explain where the minus 12% comes from, rebuild the J-curve on the illustrative path, and say when the IRR should turn positive and what would tell you the fund really is in trouble.

Quick check

What is the biggest single reason for the minus 12% at year 2?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The minus 12% is mostly fees and time, not failure. Farida has paid Rs 44 lakh, of which Rs 4 lakh is fees, and the Rs 40 lakh invested is valued at Rs 36.4 lakh after early markdowns. On the illustrative path, value crosses paid-in during year 4 and the fund ends at about 2.17 times the money, an IRR of about 12.6%. The warning signs are different: no follow-on rounds at higher prices by years 4 to 5.

Step 1Why does a healthy venture fund start negative?

A new restaurant spends on rent, kitchen and staff for months before the tables fill; its first quarter always shows a loss. A venture fund charges fees on the full commitment from day one, while its companies take years to grow, so costs arrive before gains by design. Early-stage holdings are also marked down quickly when a round goes badly but marked up only when a new investor pays a higher price. That shape, dipping first and rising later, is the J-curveThe typical path of a private fund returns: negative in the early years as fees and write-downs land, then rising as holdings are revalued and sold..

Year 2: where the Rs 7.6 lakh gap comes fromPaid in40 invested+4 fees = 44Valued at36.4 portfolio value-3.6 markdownsFees are 53% of the gap and markdowns 47%; neither says the fund has failed.Fees are charged on the full commitment from day one; gains arrive only when companies grow.
At year 2 Farida has paid Rs 44 lakh, Rs 40 lakh invested and Rs 4 lakh of fees, and the portfolio is valued at Rs 36.4 lakh; of the Rs 7.6 lakh gap, fees make up Rs 4 lakh and markdowns Rs 3.6 lakh.
Step 2How does the J play out on the illustrative path?

Track three running totals each year: cash paid in, cash received, and what the remaining holdings are valued at. Net value is received plus valued minus paid in; it is negative until the holdings grow faster than fees and new calls add to the base. On the path in the table, net value bottoms at minus Rs 7.6 lakh in year 2, crosses zero in year 4 as later rounds price companies higher, and distributions from exits in years 5 to 10 take the total to Rs 217 lakh on Rs 100 lakh paid in.

YearPaid in, cumulativeReceived, cumulativeValuation of holdingsNet valueIRR to date
122019.0-3.0-13.6%
244036.4-7.6-12.0%
366060.0-6.0-4.7%
483088.0+5.0+2.3%
5905110.0+25.0+7.4%
69217128.0+53.0+11.0%
79447122.0+75.0+11.9%
89692100.0+96.0+12.5%
99814762.0+111.0+12.7%
101002170.0+117.0+12.6%
Rs lakh on a Rs 1 crore commitment, illustrative path. Net value is minus Rs 7.6 lakh with an IRR of minus 12% at year 2, turns positive in year 4 and ends at plus Rs 117 lakh, 2.17 times the money paid in.
Cumulative net value of the commitment, Rs lakh: the J40801200Y1-14%Y2-12%Y3-5%Y4+2%Y5+7%Y6+11%Y7+12%Y8+13%Y9+13%Y10+13%IRRYearYear 2: fees 4, markdowns 3.6, IRR -12%nothing has failed; the money is still being investedYear 10: +117, 2.17xcrosses zero in year 4
The commitment's net value dips to minus Rs 7.6 lakh in year 2, when fees and markdowns sit against money still being invested, crosses zero in year 4 and ends at plus Rs 117 lakh, with the IRR moving from minus 12% to about 12.6%.
Step 3What would tell you the fund really is in trouble?

The J is a shape, not a promise, and some funds never climb out. By years 4 to 5 you want to see several companies raising later rounds at higher prices from new investors; if the marks are still flat or falling then, the dip is no longer about fees. Ask the fund for its portfolio companies' latest round prices, compare the fund's year-by-year path with other funds started in the same year, and tell Farida plainly that year-2 IRR says very little either way.

Where candidates lose it

Candidates either reassure the client that it is just the J-curve, with no numbers, or treat minus 12% as a verdict. Both skip the one useful step: splitting the gap into fees and markdowns so the client sees what is actually happening.

The second miss is quoting IRR alone. In year 2, IRR on a small, young base swings wildly; the multiple of money and the direction of the marks tell the story better.

What the interviewer asks next

  • Why can the IRR look strong in year 4 while the money multiple is still barely above 1?
  • How would a fee charged on invested capital instead of commitment change the dip?
  • Farida wants to sell her stake in the fund now. What would a buyer pay, and why?

Company names and figures are illustrative.