Investing in listed shares has long been popular with institutional investors. Being able to liquidate positions quickly and to diversify across hundreds of companies is perceived as valuable. However, private markets can deliver illiquidity premiums to investors taking a long-term view and in the current low interest rate environment, these premiums can contribute significantly to a portfolio’s returns. According to Cambridge Associates and Invesco, pension fund managers on average expect private markets to outperform public markets by 3-6% and the below figure shows that they do. This is the case for both the narrower S&P500 as well as the broader Russell 2000, which includes smaller and higher growth companies, more similar to what Venture Capital invests in.
THE CASE FOR VENTURE: RETURNS
*Twenty-Year CA Global Venture Capital (Top Two Quartiles) returns capped for scaling purposes
Sources: Cambridge Associates LLC Private Investments Database, Frank Russell Company, Standard & Poor’s and Thomson Reuters Datastream.
Notes: Pooled private investment periodic returns are net of fees, expenses and carried interest. Multi-year annualized returns are generated for time periods ended June 30th 2019.
Both private and public markets are equally volatile: instead of steadily declining returns over longer time periods that could be expected as booms and busts are smoothed out, the asset class returns trade off increases and decreases over different time periods. This happens in a complementary fashion, demonstrating why Venture Capital can offer great asset class diversification on a portfolio level. Another important benefit of private markets is the timing of exits: private market managers sell the portfolio companies on behalf of the investors at the most optimal time and deliver the cash back to their Limited Partners, instead of subjecting them to the whims of the market at the time when the cash is needed.
Even though there is evidence of “fat tails” of selection - the top two quartiles of venture managers outperform the average venture market by a large margin, demonstrating the value added to startup founders by experienced fund managers, even the average manager will end up outperforming the public markets over every time period. The outperformance is evident from as short as a 3 year period, but really crystallizes over long term horizons, where the margin extends to 7.2% annually over S&P 500. This makes venture capital a very suitable asset class for those wishing to maintain and grow their wealth with a long term perspective or over generations as it allows investors to capitalize on development of emerging technologies as they mature.
Within private markets, the asset class is divided into Private Equity / Buyout funds that buy majority ownership from existing shareholders of profitable slow-growing companies and Venture Capital funds that add new minority capital to companies that invest the additional capital in growing their global market share as fast as possible and are therefore unprofitable. Institutional investors often allocate significant amounts to private equity and less to venture capital due to the perceived risk of loss of capital from earlier stage or unprofitable companies. In Europe, only 10% out of the EUR80bn invested in private markets in 2018, went into Venture Capital according to Invest Europe.
Diversification within venture capital funds through investing in 20-40 companies reduces the risk of exposure to a single failure (although only 10% of capital was invested in VC, 57% of companies invested that year were by VC funds, displaying a 6x diversification factor over PE). Conversely, a single success may often return the capital of the entire fund, which is unlikely to happen in private equity, where companies grow at a steadier rate and significant value changes over a short time period are not common. Moreover, many venture capital funds execute a strategy of follow-ons by investing progressively more in the later rounds of their best companies. This strategy generates more exposure in the winners as they get progressively more de-risked on their journey to the exit, thus allowing the managers to deliver the steady returns illustrated above.
Private equity as an asset class is often very highly levered, while venture capital is not, balancing out those risks. Moreover, venture capital backed companies are often led by founders who still own significant stakes in the company and are therefore more highly motivated to exit the company than externally hired CEOs in private equity, who do receive some compensation at exit, but not to the same extent. That alignment of interest is one of the key drivers behind the high returns of the asset class that allows it to outperform Private Equity on a global basis as illustrated below:
RETURN AND LOSS RATIOS BY PRIVATE INVESTMENT SEGMENT:
Source: Cambridge Associates LLC Private Investments Database
Notes: Capital loss ratio is defined as the percentage of capital in deals realized below cost, net of any recovered proceeds, over total invested capital. Impairment ratio is defined as the percentage of invested capital realized or valued at less than cost.
The figure above also illustrates the journey that venture capital has taken as a relatively young asset class on a global basis. When in the early years (including the dot.com bust period) of 1991-2001 the Loss ratio was as high as 52%, the figure has decreased to 20% for the period of 2002-2015 as the asset class has matured. The Loss ratio also applies to individual transactions and underscores the benefits of diversifying within a professionally managed portfolio instead of investing in individual startups alone, as successes can balance out the Loss Ratios, resulting in profits for investors on the fund level. It is now below where Private Equity was in the previous period, while Private Equity has declined to a level of 8.6%, which may be too low on the risk-return scale to keep the return levels on par with previous periods. While that means the Gross Pooled IRR for Venture Capital has also decreased from 62% to 19%, it still outperforms Private Equity. PE delivered 15.5% over the same period (and fell below the 2.0x TVPI multiple that is generally required by institutional investors in the illiquid private markets). Venture Capital is now a less volatile and more sustainable asset class than before, suitable for institutional and other professional investors as well as family offices and high net worth individuals.
Pension funds in the US have been supporters of the Venture Capital asset class for a long time and VC has delivered real returns to them. Below are some examples from the portfolios of some of the world’s biggest venture capital limited partners (limited to government-related entities required to publish individual returns): for world’s largest LP CALPers, the second highest ever TVPI multiple was produced by a venture capital fund: Insight Venture Partners V, at 3.0x. For the Oregon Public Employees Retirement fund, Union Square Ventures delivered 66% p.a. IRR and Olympic Venture Partners IV 63.9% p.a.
In summary Venture Capital as an asset class has matured over the last 15 years and now globally outperforms both public equity markets as well as Private Equity funds. While individual transactions may have a loss ratio of up to 20%, Venture Capital funds diversify their portfolios so that returns from outperformers cover the losses from underperformers. This allows even the average Venture Capital fund to deliver high risk-adjusted returns and illiquidity premiums over the public markets, having the fund managers aligned with investors and exiting companies at the optimal moments.
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