In Venture Capital, It’s a Mean Game
JPMorgan recently released their latest “Guide to Alternatives” [you can check it out here] and, despite a dismal 2022 in which the asset class fell more than 20%, venture capital (VC) far outperformed other alternatives. Its 10-year annualized return (+19.1%) outpaced second-best private equity by 370 basis points.
While that 19% annualized return sure looks appealing (past performance is no guarantee of future results), the point of this post is to highlight how hard it is to achieve. As the same report shows, the results in VC vary far more widely than any other asset class.
Looking back to other time periods, we can see that VC hasn’t always had such lofty performance, but it still has shown attractive overall results, particularly relative to investing in the public market (14.8% average IRR over the 30-year period between 1984-2014). Such a return would have placed firmly ahead of most fund managers given the median return for global VCs was under 10%.
Clearly, VC is an asset class driven by outliers and subject to wide results, so getting that mean return is easier said than done. What, then, is the best investment approach?
Source: Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds, Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke, November 2020.
This table provides summary information on the sample of funds and their average performance. All data is provided by Burgiss. The sample includes 1,329 VC funds. Funds are classified by their vintage year, which is defined as the date when the fund first draws down capital from its investors. The % unrealized column measures the ratio of the remaining net asset value (NAV) reported by the fund to the sum of the cash returned to investors plus the NAV. The cash flows and NAVs are updated as of June 30, 2019. For each vintage year three performance measures are provided. The average Internal Rate of Return (IRR); the Multiple of Invested Capital (MOIC), and the Public Market Equivalent (PME) return. The MOIC is defined as the ratio of (a) the cash returned to investors plus the remaining NAV, to (b) the cash invested by investors. The PME is computed in the same way as Kaplan and Schoar (2005), using the total return of the S&P 500 as the market index.
Quality Deal Flow Matters, But So Does Fund Size
Research has shown that a VC firm’s ability to consistently outperform across several funds is influenced by access to higher quality deals. Success begets success even though it may be hard to evaluate whether a manager was simply lucky and in “the right place at the right time.”
“Even with no unusual ability to select investments or to nurture them to success, this access advantage allows successful VC firms to invest in more promising startups, thereby perpetuating their initial success.”
[The Persistent Effect of Initial Success: Evidence from Venture Capital]
Reputation matters to attract quality deal flow, but the type of deals also influences performance. As a VC firm’s reputation grows and it pulls in more assets, some may be tempted to raise larger funds, forcing many to target later rounds from startups that are able/willing to take larger checks. In turn, these larger funds tend to see a drop in performance due to their exposure to larger and relatively de-risked companies (as opposed to investing in companies earlier in their development). (See: Venture Capital Is Ripe for Disruption, Is Bigger Always Better When it Comes to VC Funds?, and Why Fund Size Matters in Venture Capital Returns).
Smaller Funds Have Outperformed But Have a Wider Range of Outcomes
So how do you get access to the right deals if the most reputable VC firms are growing too large and drifting out of early-stage rounds?
Avoid Single-Manager “Index” Plays
If the goal is to create a well-diversified portfolio consisting of hundreds of early-stage companies, why not just hire one manager who can do it all for you? As noted earlier, access matters, and it’s very unlikely one manager, no matter how deep his/her network, will be able to create a pipeline that robust and properly vet out the all the bad apples. Further, while your goal may be to build a large and robust portfolio, you’re not going to find many General Partners (outside of Fund of Fund managers perhaps) that’ll take that approach. And they shouldn’t!
Top-performing funds are not only smaller but also more likely to have concentrated portfolios (See: Why Venture Capital Does Not Scale). Given the likelihood that only a few companies will generate the entire return of the fund, spreading out into too many investments would require an impractically high hit rate (i.e., need to pick more winners) as every individual success story would be less impactful towards the overall portfolio return. GPs are thus incentivized to have more concentrated portfolios.
Emerging vs. Established Managers [Probably Both?]
Smaller funds are often associated with emerging managers, defined as firms launching their first vehicle or that have only a few vintages on their resume. Data from Cambridge Associates does suggest that these emerging managers tend to outperform more established firms (many emerging manager’s pitch deck have probably used the below image). However, there’s also evidence to argue against that notion (per PitchBook, and StepStone), noting emerging managers higher variability in performance as well as greater difficulty raising needed capital in challenging markets such as the one we’re in today.
Top-10 VC Funds By Vintage Year (Based on Net TVPI)
Ranking as of June 30, 2019
Source: Cambridge Associates LLC Private Investments Database.
Notes: Pooled total value to paid-in capital (TVPI) multiple is net of fees, expenses, and carried interest. Fund order is determined as funds raised under the same strategy and does not include friends and family funds. New fund is defined as the first or second fund, developing fund is the third or fourth fund, and established fund is the fifth fund and beyond. Vintage years formed since 2016 are too young to have produced meaningful returns. Vintage years with less than 40 funds in the sample have fewer than 10 funds in the first quartile; in 2009, the first six funds are top-quartile, the last four funds are second-quartile.
To VC or Not To VC
Successful venture investing is best achieved by improving the odds your portfolio is exposed to the statistical outliers. VC is a “mean” game because achieving the average return will more than likely beat 50% of the managers out there; it may even get you in or near the top-quartile. In VC, it’s okay to be average…in fact, I think it should be the goal!
However, the best approach to this asset class likely requires investing more capital in funds that are smaller, more concentrated, and may be run by managers with limited track records. Investing in the right managers, and ideally avoiding the worst ones, demands extensive due diligence. Further, reducing portfolio risk requires establishing a structured investment program that deploys capital across several years, ensuring you don’t fall victim to poor market timing (See: The Vintage Year Power Law).
For those hoping I’d endorse venture capital as a fixture in any client’s asset allocation, I’m sorry to disappoint. It’s simply not for everyone. Any advisor that says otherwise is rashly following the “more alts is better” herd. For investors that have the desire and the ability with which to pursue VC, our Investment Committee at SineCera Capital is happy to provide guidance. Alternative investment due diligence is one of our core competencies, and nowhere is it more important than venture capital.
Best Regards,
Adam J. Packer, CFA®, CAIA®
Chief Investment Officer | SineCera Capital