Demystifying Venture Capital Investing
Bryan Slauko, CFA, February 2020
Most investors use technology daily and recognize its disruptive nature and potential to produce strong investment returns, yet venture capital remains a mystery for many investors who struggle to understand it, where it fits in investment portfolios and how to participate in venture capital as an asset class.
Ignoring venture capital is a missed opportunity. Significant inter-generational wealth will be created by the innovation ecosystem. Furthermore, venture capital can be a good portfolio-enhancing diversification strategy. Rather than ignore venture capital and miss opportunities, investors should make time to:
1) understand the nature of investment returns in the venture capital industry and
2) consider historical investment return data across types of fund managers.
These factors, studied below, will help demystify venture capital and inform better investment decision making. Third-party data referenced in this report will demonstrate the following:
1) An Invesco study of over 1,000 venture funds formed between 1969 and 2015 showed that the highest returns were generated by funds with less than $100 million under management.
2) A Cambridge Associates study of 1,800 investments concludes that seed and early-stage funds have accounted for the majority of investment gains in every year studied between 1995 and 2012.
3) The same Cambridge Associates study concludes that new and emerging managers have accounted for 40% to 70% of total returns earned between 2001 and 2012.
4) A Kaufmann Foundation study of their 21-year history of venture investing concluded that limited partners invest too much capital in under-performing funds an frequently misaligned terms that encourages VCs to raise bigger funds and allows them to lock in high-levels of fee-based personal income even when the GP fails to perform.
The key takeaway – bigger is often not better when it comes to investing in venture capital funds.
THE NATURE OF VENTURE CAPITAL INVESTMENT RETURNS
If a decision is made to invest, how do investors choose a venture capital investment strategy, or a fund manager, to allocate their money? There are several factors to consider and these will be summarized below. But first, it is critical to understand the nature of investment returns in the venture capital industry.
1) At the fund level, venture capital returns are extremely skewed towards the returns of a few stand-out successful investments.
2) The number of failed investments does not detract from a fund’s overall returns.
3) Market-beating returns have historically come from top quartile performing managers.
4) Historical data shows that a majority of top returns have been generated by new managers, seed-stage funds and small funds managing less than $100 million.
Horsley Bridge, a significant LP in many U.S. VC funds, studied 7,000 of its investments made between 1975 and 2014. This study revealed that:
a) 60% of the total investment returns generated by these investments were earned by only 6% of the investments.
b) These investments each earned more than a 10x return on the capital invested.
c) Roughly 50% of deals done returned less than the capital invested in them.
This is demonstrated in Figure 1 below.
Correlation Ventures completed a study of 21,640 financings spanning the years 2004-2013. This study, illustrated in Figure 2, found that:
a) 65% of venture capital deals returned less than the capital that invested in them.
b) Roughly 4% of deals returned a 10x return or greater.
Venture capital returns are clearly not normally distributed like conventional financial portfolios, where the bulk of the portfolio generates its returns evenly across the board. If returns are skewed towards a few stand-out investments, and the number of failed investments doesn’t matter, what are the implications for building a successful venture capital investment portfolio?
Based on the Horsley Bridge data:
1) The most successful funds who generate greater than a 5x portfolio return generated 90% of that return from companies that returned more than a 10x on the capital invested. This is illustrated in Figure 3.
2) The most successful venture capital funds invest in companies that generate bigger wins. Average performing funds do not see as many outsized results.
3) At the same time, the most successful funds allocated roughly the same share of their capital to companies that returned less than the original capital invested in them.
4) All the funds that generated positive overall returns in Figure 4 had 40% to 50% of their capital invested in companies that returned less than the capital invested in them. This is demonstrated by the yellow line in Figure 4.
5) Successful funds recognize portfolio companies that are on a path to failure early, and divert their time, resources and follow-on capital to the successful ones.
A successful venture capital portfolio needs to maximize your chances of getting not just positive returns but returns from companies that display the potential for significantly outsized results greater than 10x on the original investment.
How can an investor maximize their chances of doing this? When investing in a fund, a big part of the answer lies in the selection of the fund manager.
What types of venture capital fund managers can investors choose from in an effort to generate these returns?
Some common ways that fund managers differentiate themselves include:
a) Large funds vs. smaller funds
b) Early-stage focus vs. later-stage
c) New funds vs. established funds
d) Portfolio construction approach
Before evaluating these approaches, let’s review current trends that will help to influence manager selection.
VENTURE CAPITAL FUND TRENDS
1) Large increase in supply of later-stage venture capital.
The amount of dollars invested in venture capital has grown significantly over the past 5 years, as demonstrated in Figure 5 below.
2) Significant increase in later-stage valuations and deal sizes.
The quickly growing supply of capital looking for later-stage assets has placed further upward pressure on valuations and deal sizes. This is demonstrated below.
Series D valuations have increased by 140% since 2015 while the average Series D deal size has grown by 73% to $50 million over the same period. See Figures 6 and 7 below.
Series A and B valuations have increased by 79% and 89%, respectively, since 2015, while the average Series A and B deal sizes have increased by 95% and 85%, respectively, over the same period. See Figure 8 and 9.
Seed stage deals have seen the lowest increase in pre-money valuations over the past two years, at 30%, while the average seed stage deal size remains relatively small at $1.1. million.
Despite the relatively high top-quartile returns that venture capital has experienced in the past, performance is not equal across different types of funds. Performance across fund approaches is examined below.
LARGE VS. SMALL FUND PERFORMANCE
Larger funds generally need to invest in larger deals to deploy the capital efficiently, yet large VC funds most often fail to generate market-beating returns. An Invesco study identifies average global venture capital fund returns over the period from 1969 to 2015, based on fund size.
“Moderately-sized funds are in a better position to participate in prudently-sized rounds and are therefore uniquely suited to potentially generate consistent, strong returns.” – Invesco
This is demonstrated in Figure 10 below.
Figure 10 (Small Funds Have Outperformed Large Funds)
Large, traditional venture capital funds typically invest in bigger transactions where they can invest more dollars in each company. This inevitably pushes a fund’s capital into larger, later-stage rounds at higher pre-money valuations, which are being pushed even higher given the amount of private capital in the market today. The potential for these funds to achieve hefty returns is diminished given the competition for deals.
The Kaufmann Foundation analyzed their twenty-one-year history of venture investing experience in nearly 100 VC funds and concluded that limited partners invest too much capital in underperforming venture capital funds on frequently mis-aligned terms. According to the Kaufmann Foundation report:
The typical 2 and 20 structure, which pays managers a 2% fee on committed capital, pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the General Partner fails to return investor capital.
This potential misalignment of interests may explain the performance results in Figure 10 for funds with greater than $400 million under management.
SEED & EARLY-STAGE VS. LATER STAGE FUND PERFORMANCE
Investment stage is an important determinant of venture capital investment strategy and performance. Venture capital funds range in strategy from investing early in companies in the seed-stage, where they may be pre-revenue or have limited revenue, to later-stage where they have established customers and millions in revenue.
Cambridge Associates completed a study of the top 100 global venture investments, as measured by total gains per year, from 1995 to 2012. 1,800 investments were analyzed representing 1,211 companies, 682 funds and 265 global venture capital fund managers. This study concluded that:
Seed- and early-stage investments have accounted for the majority of investment gains in every year since 1995. This is demonstrated in Figure 11 below.
Figure 11 (% of Total Gains Generated by Initial Deal Stage)
Seed- and early-stage funds invest at lower valuations, leaving more upside potential to generate the types of returns demonstrated above. Much of the additional risk these earlier stage companies present can be diversified through portfolio diversification.
Current technology trends also support the need and opportunities for seed-stage funds, as the cost of getting a company off the ground has never been lower.
The costs of building technology-based companies have declined significantly in large part due to easily accessible, scalable, cloud-based computing capacity that has removed entrepreneurs’ need to invest substantial capital in infrastructure hardware.
Today’s entrepreneurs often need smaller initial investments of $1 million or less.
Appropriate seed-stage fund sizes are smaller today as a result and have opportunities to capitalize on this trend. Large, traditional venture capital funds cannot execute on these deals efficiently.
NEW FUND VS. ESTABLISHED FUND PERFORMANCE
Some believe that a small number of venture capital fund managers account for most of the investment return created in any given year. The truth is that more and more new managers are creating significant investment value for limited partners, as demonstrated in Figure 12.
According to Cambridge Associates, between 2001 and 2012, new and emerging fund managers consistently accounted for 40% to 70% of the total returns earned over that period in the top 100 global investments.
Figure 12 (% of Total Gains Generated by Fund Status)
Overlooking new and emerging managers may lead investors to miss attractive opportunities with managers that can provide exposure to substantial value creation.
APPROACH TO PORTFOLIO CONSTRUCTION
The first element of portfolio construction is the choice between two broad strategies:
a) Invest for diversification.
Managers using this strategy diversify their portfolio across a very broad array of companies to help mitigate risk.
b) Invest with conviction.
Managers using this strategy concentrate investments into a smaller portfolio to be in a better position to help their portfolio companies and their fund win big from success.
A diversification strategy involves making anywhere from 25 to 100 or more smaller investments to mitigate risk and identify follow-on investment opportunities.
These funds do not act as lead investors because they make too many investments to manage the workload.
Due diligence is limited.
They make smaller investments.
They generally do not take Board seats as they don’t have time to proactively monitor a large portfolio.
Any value-added is typically limited to high-level advice and reactive in nature.
Diversification strategies often look for momentum as a positive signal before making an investment. Due diligence and ongoing involvement are limited. This makes minimal proactive impact on the distribution of portfolio investment returns. The strategy relies on diversification to limit losses and mitigate risk, and the large number of investments to hope for a big winner.
A conviction strategy involves a smaller portfolio that may range from 10 to 30 companies, and a strategy to change the distribution of companies in which they invest. In other words, they employ active strategies to enhance portfolio company success.
These funds often act as lead investors.
Managers believe that with a small portfolio, they can more effectively add value and increase the likelihood for success.
They attempt to source better deals.
They attempt to make more informed and better investment decisions.
They add value through a mix of advice, governance, network, positive signalling and other more hands-on means.
To evaluate a diversification vs. conviction strategy, one may consider its potential impact on the extremely skewed distribution of venture capital investment returns demonstrated if Figure 1 and Figure 2.
Managers employing conviction strategies believe they can positively impact the distribution of portfolio investment returns through three primary means:
1) Adding Value.
Strategies for adding value such as coaching, improving operations, sales support, board support and strategic networking are common. Rather than invest randomly along the curve, the goal is to move investments up the curve as demonstrated in Figure 13.
Figure 13 (Add Value)
2) Sourcing Better Deals.
Investing in deals from a better-sourced distribution of companies will lead to higher expected returns. This has the effect of shifting the entire distribution in Figure 14 higher. Building high-quality and selective networks, focusing on a specific geography, and proactively reaching out to top teams are common approaches.
Figure 14 (Source Better)
3) Making Better Investment Decisions.
Picking better investments is the best way to achieve outsized results in the seed stage given these companies are not yet proven at scale. Better investing switches the chosen investments from the light grey to the orange bars further left in Figure 15. Picking better investments is primarily a factor of good judgement. It is also a function of doing research, developing insights and having a correct industry thesis. All of which inform sound judgement.
Figure 15 (Invest Better)
A critical element to making better investment decisions is effective investment due diligence. More time spent evaluating the management team, product, business model, market potential and exit potential allows managers to see things others don’t see, enables better decision making and stronger judgement. This is supported by an Angel Capital Association study of 3,097 investments and demonstrated in Figure 16, which shows the impact of time spent on due diligence.
The overall multiple of equity invested in companies where a high amount of due diligence was completed was 5.9x, compared to an average of only 1.1x where a low amount of due diligence was done.
Companies need more than just money from their investors. Ongoing investor participation post-investment can have a significant impact on investment returns. This is demonstrated in Figure 17, which shows the impact of investor participation on portfolio companies in the same Angel Capital Association study.
The average multiple of equity invested in companies with investor participation was 3.7x, compared to an average of only 1.3x where there was no investor participation.
Fund manager selection is critical for investors making an allocation in their portfolio to venture capital. In the past, market-beating returns have typically come from top quartile performers. There is clear evidence to support the selection of:
1) New managers,
2) Seed-stage funds, and
3) Smaller funds managing less than $100 million.
New managers starting smaller funds can focus on smaller deals where there is significant demand today yet much lower supply of capital and less competition for deals.
It is difficult for managers to reliably pick winners. They can, however, construct portfolios that consistently generate strong returns. Portfolio construction requires striking the right balance between the benefits of diversification and the manager’s ability to generate, support and create high-quality investments.