Venture Capital after a downturn: The opportunities and risks

Sloan Smith, MBA, CAIA, CPWA®

Calendar year 2020 has been a year for the record books. Due to the COVID-19 outbreak we have seen historic and aggressive monetary and fiscal action taken by the Federal Reserve and the federal government. We have also witnessed a global struggle to find a way to keep economies afloat while mitigating this health crisis. However, one topic that has not garnered enough attention during this uncertain time is innovation. For example, in 2020 we have seen the rapid adoption of enterprise video communication services such as Zoom and Microsoft Teams. Currently, these two platforms average close to 300 million meetings daily. Telehealth is another area that has skyrocketed, with the use of this service up close to 50% since 2019. Both trends began as venture capital-backed ideas and are now showing tremendous growth during this precarious time.

Venture capital is a form of private equity investing that focuses on start-up, early stage, or emerging companies that have strong growth potential. Historically, venture capital has thrived after recessions and market disruptions.  After the 2001 dot-com bubble and the 2008 global financial crisis, companies such as Facebook, Tesla, Airbnb, and Uber were founded by entrepreneurs who capitalized on market inefficiencies. Similarly, we believe that venture capital investing offers appealing return potential coming out of the pandemic-driven recession. At the same time, venture capital investing bears risks that should be understood by investors before making an allocation.

Advantages of Venture Capital

1.       High Return Potential

Venture Capital involves investing in early-stage companies that are high growth and typically technology-focused. A venture-backed firm often receives multiple rounds of equity financing during their lifecycle (i.e., Series A, Series B, Series C financing). The goal is to see substantial revenue and income growth from these companies over time which will ultimately lead to outsized returns for investors. The target annualized return percentage for a diversified venture capital portfolio is typically between 15% and 25%, attractive figures for any allocator.

2.       Diversification

Venture Capital not only offers an attractive complement to other private equity allocations (i.e., leveraged buyout or distressed investments) but also to an overall portfolio.  Historically, venture capital returns have exhibited a higher correlation to the greater private equity asset class but a lower correlation to equities and fixed income.[1] Lower correlation figures may be driven partially by lack of daily pricing, but over the long-term venture capital has shown different results relative to public markets.

3.       Expanding Opportunity Set

Historically, only a hand-full of large venture capital firms were able to invest in companies founded by top-tier entrepreneurs. These venture firms were, in turn, typically required high investment minimums and charged high fees, making them inaccessible and too expensive for most investors. However, we have seen an increase in smaller, emerging venture capital managers that have “spun-off” from more established firms and started firms of their own. According to Cambridge Associates, as of the end of 2019 funds managed by new and developing venture capital firms continue to rank as top performers.[2] This trend has led to a greater need for rigorous due diligence to identify top performers, which are difficult to identify and access.

Disadvantages

1.       Illiquidity

Venture capital investments have very limited liquidity.  Similar to other forms of private equity, investors should expect a holding period of ten years or more. It often takes years for entrepreneurs and their venture capitalist-backers to grow early-stage businesses into highly valued enterprises. However, investing in venture capital should offer an “illiquidity premium,” meaning annualized returns should exceed the performance of public stock market indices like the S&P 500.

2.       High Fees

Venture capital fund managers typically charge meaningfully higher fees than managers in traditional asset classes like stocks and fixed income.  A typical venture capital manager will charge a management fee on invested capital between 1%-2% along with an incentive or carried interest fee of 20% of the fund’s positive returns.  However, in many cases venture capital managers only collect the incentive fee if the fund’s return exceeds a specific threshold, such as 10%.  It is important to note that total fees on a venture capital investment are even higher if allocating to a venture capital funds of funds. That is because the fund of funds manager charges a fee on top of the underlying venture capital managers.

3.       Returns Vary Significantly Among Managers

Historically, there has been a wide gap between the returns of strong venture capital managers and those of weaker managers. In 2019 Cambridge Associates found that the difference in annualized returns between a top quartile and bottom quartile global venture capital managers is around 50%.[3] This substantially exceeds the discrepancy among other private equity strategies (25%) and global public equities (5%). Therefore, it is paramount to identify and invest only with the top performers in the venture capital space.  

We believe that venture capital is an intriguing asset class going forward. During the global pandemic we have seen the world change through numerous technological advances, and it seems like this trend will only continue in a post-pandemic world. Allocating to venture capital can improve portfolios considering long-term returns could exceed what is typically found in private and public equities. However, it is important to understand the risks of the asset class and to only invest in top tier venture capital strategies. We will have to see how venture capital performs in the coming years, but it seems likely that technological innovation will continue apace and hopefully reward both entrepreneurs and investment portfolios. 

[1] “The case for venture capital”, https://apinstitutional.invesco.com/dam/jcr:1f35880c-bdf9-42ea-8afe-ab69b85bc7a4/The%20Case%20for%20Venture%20Capital.pdf

[2] “Venture Capital Positively Disrupts Intergenerational Investing”, https://www.cambridgeassociates.com/insight/venture-capital-positively-disrupts-intergenerational-investing/

[3] Ibid

Figure 1 (Return Dispersion in Venture Capital as of June 30, 2019)[4]

[4] Ibid

Figure 2 (Growth of Venture Capital during recessions with high unemployment)[5]

[5] “Silicon Valley Bank: State of the Markets Q2 2020” https://www.svb.com/trends-insights/reports/state-of-the-markets-2020-q2-report