peHUB Wire: Wednesday, June 30, 2010

Dan is on vacation for the rest of this week, so today’s guest column comes from Sim Simeonov:

With high-tech companies needing less capital due to advancements in technology, startup development methodology and online marketing, we have seen a Renaissance in angel investing. While angel investors participate in part for the excitement of engaging with entrepreneurs and placing bets on the future, they also do it for the expectation of significant financial returns. Various studies of angel investing published in the last decade estimate aggregate returns to angels on the order of 18-37% per year, well above market. The catch is that 50-70% of angels make less than what they invest. Returns are very unevenly distributed and this begs the question to what extent is portfolio theory fundamental to! angel returns.

The best data set with detailed investment & exit information comes from the Angel Investor Performance Project by the Kauffman Foundation. The data was collected by surveying angels who belong to angel groups. Cleaning the data and restricting to the domain I was interested in—first round investments in early-stage high-tech companies—yielded a data set about the returns of 56 angels with exits from 112 companies. The data show the type of skewed distribution one would expect from early stage investing:

• 75% of exits happened between 2001 and 2006. There is some reason to believe that the data may have a slight bias towards negative returns as 50% of investments happened between 1995 and 2000. Angels may have been buying high and selling low.

• 3.2x cash-on-cash return for all investments put together (total dollars out divided by total dollars in). However, returns are extremely sensitive to big hits. A lucky angel put $600K in a software company in three rounds from 1988 to 1994. In 1996 the company went public and the person got a nice 55x return. Removing this one company from the sample drops the aggregate cash-on-cash return for all angels nearly in half to 1.8x.

• Of the companies angels invested in, 63% were complete write-offs for the angels involved.

• 66% of angels made less than what they invested. 45% generated no return. The remaining 21% of angels received only 4% of the total returns (7% if you exclude the 55xer).

• 6% of the angels generated returns >10x that accounted for 68% of the total return (42% w/o the 55xer). The cash-on-cash return for that group was 36x with and 21x without the one big hit, in both cases more than ten times the average for all angels put together.

• The data includes only one super angel who had 29 exits generating 2x return. Most other angels had one or two exits and only a handful had three or four.

• Due to missing or overly granular investment and exit dates, it is practically impossible to calculate meaningful IRR numbers or to calculate returns in excess of financial markets.

The analysis suggests that angel investing as a whole can be quite profitable but, when dabbled into a deal or two at a time, it is more akin to gambling.

Without accurate data about angel investment portfolios, the next best option is to do Monte Carlo simulations of synthetic portfolios where thousands of hypothetical angels invest in thousands of hypothetical companies. The hardest part in setting up Monte Carlo studies is making good assumptions as they can pre-determine outcomes. Some have approached the problem by guessing probabilities of certain outcomes much in the same way VCs do basic portfolio presentations for LPs but with a bit more math in the mix. Rather than guessing, I chose to reverse-engineer a distribution of returns based on the data from the 112 companies. For the math-inclined amongst you, this involved piecing together a cumulative density function from three separate pieces: 60% chance of zero return, a logarithmic non-linear model for 0-10x returns and a combination power/exponential non-linear model for the long-tail of exits greater than 10x where not much data was available.

I ran a very simple Monte Carlo simulation evaluating the portfolios—ranging from 5 to more than 100 companies—of hypothetical angels. The average cash-on-cash return was right around 3.2x, exactly as with the Kauffman data, which is a good sanity check. Average returns don’t vary with portfolio size, which is to be expected.

Median returns vary substantially with portfolio size. Going from 5 investments to 10 investments increases median return by 68%, from right around 1x to nearly 1.7x. There are diminishing returns to growing portfolio size. Going from 10 to 15 increases median returns by another 40%. Doubling portfolio size from 15 to 30 adds another 50% but then in takes going all the way to a whopping 125 company portfolio to triple median returns compared to the 5 company portfolio. Similar conclusions apply with respect to other metrics. The probability of getting a return that’s greater than 2x doubles (from 34% to 69%) as one moves from a five company portfolio to a 50 company portfolio.

The data unequivocally suggest that playing like a super angel or an active seed fund as opposed to dabbling with the occasional angel investment is a key strategy to consider if financial returns are important. The data also call into question the behavior of some angel groups that do just a few investments per year.

This is not to say that volume investing—like throwing darts to pick stocks—should replace doing due diligence and the thoughtful development of investment theses. In fact, every Monte Carlo simulation of angel or venture investing I’ve seen, including mine, doesn’t take into account the various types of signaling that go on between entrepreneurs and investors and between investors themselves. For example, great entrepreneurs usually have over-subscribed investment rounds. A pure volume-oriented investor would find it difficult to compete for and win these hot deals, especially in a world where seed funds keep popping out like mushrooms after rain.

If you want to know more, let me know. I’m always curious to hear your thoughts. You can find me at @simeons or at FastIgnite.

Simeon Simeonov is founder and CEO of FastIgnite where he invests and helps entrepreneurs build great companies. Sim is also is an executive-in-residence at General Catalyst Partners and co-founder of Better Advertising and Thing Labs. Prior to that, he was a VC at Polaris Venture Partners and chief architect at Allaire/Macromedia (now Adobe).

Top Three

THL Partners has completed the sale of its majority stake in food supplier Michael Foods to GS Capital Partners for $1.7 billion. THL, which acquired the company in 2003,has retaineda 20% ownership position.

Riverside Co. has agreed to sell Teufel Speakers GmbH to HgCapital, a private equity firm targeting the European sector. Financial terms were not disclosed. Teufel is a designer and online retailer of loudspeaker systems in Germany. Riverside, of the U.S., invests in the smaller end of the middle market.

Highly-hyped location-based startup Foursquare just closed on a $20 million round of funding at a $95 million pre-money valuation. Andreessen Horowitz led the round, with previous investors O’Reilly AlphaTech and Union Square Ventures also participating.

VC Deals

Consert Inc., a Raleigh, N.C.-based smart grid technology startup, has raised $17.7 million in new VC funding. Backers include Constellation Energy, GE Energy Financial Services, Qualcomm Ventures and Verizon Ventures.

LeadDog Capital said Tuesday that it has committed to provide up to $30 million in capital to Blue Castle Holdings Inc. LeadDog, which focuses on private placements, will receive Blue Castle stock. Blue Castle is developing nuclear power plant projects in Green River, Utah.

Solargen Energy said late Tuesday that it raised $4.1 million in financing by issuing Series B convertible preferred stock, plus warrants, to two private investors: UMC Capital Corp. and Chinatrust Venture Capital Corp. Solargen is a solar development company based in Cupertino, Calif. UMC Capital Corp. is the investment arm of UMC, the Taiwanese semiconductor foundry. Chinatrust Venture Capital is a subsidiary of Chinatrust Financial Holding Co. Ltd.

Consert Inc., a Raleigh, N.C.-based smart grid technology startup, has raised $17.7 million in new VC funding. Backers include Constellation Energy, GE Energy Financial Services, Qualcomm Ventures and Verizon Ventures.

Calistoga Pharmaceuticals Inc. said Wednesday that it has closed a $40 million Series C funding. Quogue Capital LLC led the financing, along with existing investors Alta Partners, Amgen Ventures, Frazier Healthcare and Three Arch Partners and new investor Latterell Venture Partners. Calistoga develops isoform-selective phosphatidylinositol 3 kinase (PI3K) inhibitors for the treatment of cancer and inflammatory diseases.

Click Forensics said Wednesday that it has closed a $6 million Series C round of funding led by Austin Ventures. Sierra Ventures and Shasta Ventures also participated. Click Forensics, of Austin, provides online advertising and audience verification services.

Zayo Group agreed Wednesday to buy American Fiber Systems Holding Corp., a provider of metropolitan fiber network and telecom services. Financial terms were not disclosed. AFS was founded by David Rusin, the former president of Frontier Communications. AFS has received funding from Sierra Ventures, Lucent Ventures and North Atlantic Capital. Zayo of Louisville, Colo., provides bandwidth infrastructure and network neutral colocation services.

Buyouts Deals

The Carlyle Group has agreed to invest up to $190 million into industrial fishery China Fishery Group Ltd. (Singapore: B0Z.SI), via a private placement.

Palamon Capital Partners is selling online fashion retailer Dress for Less, people familiar with the situation told Reuters. The European mid-market firm has received approaches for the business, based in Germany, which it bought for an undisclosed sum at the end of 2007, the sources said. One said the business could fetch about 400 million euros ($488.2 million).

City Ventures has received a $100 million investment from an affiliate of Ares Management LLC. Ares will have a majority stake in City Ventures, a California urban homebuilder. Imperial Capital Group, which has previously invested in City Ventures, will retain its stake.

Babson Capital Management LLC said Wednesday that it has invested in the mezzanine debt notes of Collins Foods Finance Pty Ltd., a unit of Collins Food Group. Financial terms were not disclosed. The investment is part of a refinancing of Collins Food Group, a restaurant operator and franchisor based in Queensland, Australia. Babson Capital is an investment firm based in Springfield and Boston, Mass., and Charlotte, N.C.

Ryt-way Industries, a portfolio company of Wind Point Partners, has bought the food, beverage, equipment and manufacturing businesses of Cloud Packaging Solutions. Financial terms were not disclosed. Ryt-way, of Lakeville, Minn., is a contract packager of dry food products. Wind Poitnt is a Chicago private equity firm.

An affiliate of H.I.G. Capital has completed its investment in the Higher Gear Group. Financial terms were not disclosed. The High Gear Group, of Schaumburg, Ill., provides customer relationship management software to automotive dealers in the U.S., Mexico and Canada. H.I.G. Capital is a private equity firm with more than $7.5 billion of equity under management.

Firms & Funds

UV Partners, an early-stage venture capital firm, has changed its name to Pelion Venture Partners. The Salt Lake City-based firm is investing out of a $122 million fourth fund.

The Yarmouth Venture Group, which advises business managers in the micro-market, has opened a Boston office.

John Arlottahas joined General Atlantic as a special partner, with a focus on the healthcare sector. Arlotta is former chairman and CEO of Coram Inc. and NeighborCare Inc.

Gilde Buy Out Partners, a private equitygroup in Europe and the Benelux,said Wednesday that it has closed its latest fund at EUR 800 million. Gilde Buy-Out Fund IV was oversubscribed and received commitments from investors in the Asia Pacific, Europe and the U.S. MVision Private Equity Advisers acted as global placing agent and SJ Berwin was legal counsel to Gilde Buy-Out Fund IV.

Ryan Sprott has left DLJ Merchant Banking and has founded Great Range Capital, a Midwest focused private equity firm.