Perhaps you’ve taken an Uber somewhere. Or maybe you own phone or laptop from Apple. It’s also quite possible that at some point you’ve used the social media site Facebook.
What do all of these companies have in common?
Before they were household names, at one point all these businesses were startups. What’s more, some of the funding they received early on came from what are known as Venture Capital (VC) firms.
VC firms, and the funds they manage, can be thought of as private equity funds for companies that are just getting off the ground. But they’re considered a different subset of the alternative investment world altogether. PE funds invest in growing, established, or mature businesses. VC funds, meanwhile, take stakes in firms that one day may be large enough to be on the radar of PE firms. The goal of VC investing is clear: Get in close to the ground floor of what sounds like a world-changing idea or product. If it works out, the returns can be more than worth the risk.
Despite comprising many small companies, the world of Venture Capital is actually fairly large: According to one estimate, as of 2020 total assets under management stood at approximately $850 billion.
It may sound counterintuitive, but early-stage companies actually did quite well as a group despite the onset of a global pandemic in 2020. As per CrunchBase:
Startups closed out 2020 in a much stronger position than the one they started the year in, with global venture funding up 4 percent year over year to $300 billion. That growth came as industries disrupted by the global pandemic—work, health care, education, finance, shopping and entertainment—shifted dramatically to online services. That, in turn, created a boom for tech infrastructure and cloud services companies supporting this transfer, leading to a strong IPO and M&A market as companies sought to consolidate and compete.
Warren Buffet famously referred to the idea of investment diversification as “diworsification”. In other words, he believes that rather than spread your capital around into a large number of holdings, you should be willing to take concentrated positions in your best ideas. Otherwise, you end up owning too many investments and your returns will suffer as a result.
By its nature, Venture Capital doesn’t really have the luxury of following Buffet’s advice. Because whereas the Oracle of Omaha owns medium to large companies that aren’t likely to disappear by the next quarter, VC funds can have exposure to startups that don’t have this level of stability. Thus, VC funds tend to invest in a large basket of companies, with the thinking that even a few very successful investments can more than make up for the ones that end up as disappointments. Indeed, as finance expert Alex Graham has written:
Venture capital returns at a fund level are extremely skewed towards the returns of a few stand-out successful investments in the portfolio. These investments end up accounting for the majority of the fund’s overall performance.
The Investment Case for Venture Capital
Investors allocate money to Venture Capital because the potential returns can be very high. By taking a position in a nascent business that aims to grow exponentially, VC funds and their investors have the chance for gains that generally are not available from larger firms.
The prospect for such high returns exists for essentially two reasons:
- VC funds buy stakes when emerging companies are still small and thus have low valuations
- The companies are typically in an industry with the potential for explosive growth, such as information technology, biotechnology, or the so-called ‘sharing economy’ (think AirBnB, for example).
From an overall portfolio standpoint, VC can be attractive as it may provide meaningful diversification for investors. As with many alternative assets, this is a key aspect of what makes VC compelling: the potential for returns that are uncorrelated with the broad equity and fixed income markets.
What are the Risks?
With the chance for higher returns in Venture Capital comes elevated risk. The fact is that, depending on what estimates you believe, somewhere between 50-65% of firms that VC funds invest in will fail. For an individual that owns a stake in a Venture Capital fund, the risk is that the investee companies that become successful don’t manage to compensate for the ones that fail.
Another risk of investing in VC funds is their lack of liquidity. As with Private Equity funds, there can be long lockup periods and limited options for the redemption of units. This is necessary for the fund to be able to make capital commitments, but poses a problem for an investor that suddenly realizes they need their money back in a hurry.
Common Fee Structures
VC funds typically charge investors a management fee of 2-2.5%. In addition to this, they also charge a performance fee (sometimes referred to as “Carried Interest”), which can range from 15-30%, but is usually around the 20% mark.
What to Look for in a Good Manager
In our posts on private equity, hedge funds, and real estate, we’ve talked about some of the characteristics in a manager that an investor should look for. These qualities include:
- Industry expertise
- A solid track record
- A solid team behind the manager
With Venture Capital funds, there are additional attributes that prospective investors might want to consider. Venture Capital expert Alex Graham, in this fascinating post, makes the point that VC investing is fundamentally different than, say, public markets investing. He suggests that some of the people who run VC funds do so having come from more established companies, and fail to follow some of the key principles of investing in early-stage companies. One of the principles of VC investing that Graham identifies is that the bulk of returns will come from a sliver of a fund’s portfolio. Drawing on a study of VC performance, he writes that, “For funds that had returns above 5x, less than 20% of deals produced roughly 90% of the funds’ returns.”
Intriguingly, Graham notes that the best performing VC funds actually tended to also have the most “strikeouts” (i.e. investments that failed). But this, he observes, is essential to their success:
“if most venture capital returns are driven by a few home runs (successful investments that produce outsized results), then a successful venture capitalist should look to invest in those companies that display the potential for truly outsized results, and to not worry if they fail.
The takeaway for investors is this: When evaluating a potential VC manager, look for someone who is willing to swing for the fences often, because Venture Capital is not an asset class where singles and doubles will produce outstanding returns.
[Looking to invest in a Venture Capital fund? PitchBoard can introduce you to some of the savviest managers in the industry today]