The Portfolio Rationale for Venture Capital & Private Equity

The Portfolio Rationale for Venture Capital & Private Equity

Bryan Slauko, CFA, January 2020

Most investors use technology daily and recognize its disruptive nature, yet venture capital remains a mystery for many investors who struggle to understand it, where it fits in investment portfolios or how to participate in it as an asset class.

While top-tier family offices may have the expertise to invest directly or the financial wherewithal to participate in traditional venture capital funds, typical family investors don’t have access. The size of investment required is too too large or their wealth advisors have ignored the asset class as it lowers their transaction fees.

    • When family investment portfolios lack allocation to private technology and innovation, it’s a missed opportunity for both the families and the founders in need of growth capital.

Traditional family investment portfolios consist of a mix of publicly traded stocks and bonds. Those looking for a component of high growth will typically invest in publicly traded growth and value stocks. This has been successful in the past. However, private capital has become much more central to institutional investment portfolios in recent years and companies have new funding options they haven’t had in the past.

    • More and more companies are choosing to stay private instead of raise capital through an IPO.

    • Individual investors now have less opportunity to invest in innovative, fast-growing start-ups with potential to generate big returns.

    • Making private equity and venture capital more accessible to individual investors is more and more important as a result of these trends.

The inclusion of venture capital as part of a private equity portfolio can have clear benefits and is becoming increasingly necessary to gain exposure to strong growth investment opportunities not available in the public markets.

4 REASONS TO INVEST IN PRIVATE EQUITY & INNOVATION 

Smart venture capital investing for families is not about investing in ‘tech’, the ‘tech sector’ or ‘tech start-ups’. It’s about investing is the fundamentals of high-growth companies with strong teams, sound business models, large target markets and a plan to use technology to innovate old ways of doing things. Focusing on these factors allows for sound growth potential to be added to investment portfolios.

Here are four reasons why family investors should allocate to private companies using technology to drive innovation and growth:

1) Significant inter-generational wealth will be created by the innovation economy.

      • Finding a way to participate as these companies commercialize and scale can be financially rewarding. Contributing directly to the engine driving transformation of our society is also rewarding.

2) Wealth creation in the innovation economy comes from pre-IPO companies.

      • Due to the emergence of the private capital markets, companies are staying private longer. Most of the value creation that used to occur on the public market now occurs privately. Getting in before an IPO is paramount today.

3) Venture capital is a good diversification strategy.

      • The factors that drive returns in public markets have little or no impact on private equity and venture capital. The addition of venture capital to the private equity portfolio can enhance returns and reduce risk.

4) Family investing in the innovation economy is good for the ecosystem.

      • When entrepreneurs take investment from a fund that provides transparency to who the end investors are, relationships can be cultivated that leverage expertise and connections to help businesses grow. Investors get educated on innovation. The ecosystem grows stronger to produce results for years to come.

TRADITIONAL PORTFOLIO APPROACH

Traditional family investment portfolios consist of a mix of publicly traded stocks and bonds with the mix dependent on the objectives of the individuals. Those looking for a component of high growth will typically invest in publicly traded growth and value stocks. As a strategy to generate higher investment returns, this has been successful in the past because:

a) there has been a strong supply of innovative and fast-growing companies needing to raise growth capital, and

b) going public has been one of the easier and most accessible ways to do this.

This fundraising strategy has been supported by the fact that for the past 30 years, publicly traded assets have historically commanded higher average valuations than privately held assets. This is demonstrated in the chart below comparing U.S. public vs. private company Enterprise Value/EBITDA valuation multiples.

Source: Neuberger Berman, S&P Leveraged Buyout Quarterly Review, S&P Capital IQ.

Higher public market valuations have been a critical factor in motivating companies to use the public markets and this has been the choice of many high-growth companies looking to raise funds. There are several reasons for higher public market valuations, including:

    • the fact that investors are willing to pay a premium for the higher level of liquidity and transparency they provide, and

    • the universe of investors in publicly traded assets is much broader, enabling the public markets to attract very large amounts of capital.

According to a Bain & Company, the benefits of going public have traditionally outweighed significant disadvantages, including:

1) IPO’s are expensive transactions with considerable fees to investment bankers and lawyers,

2) Being public adds significant costs in the form of higher compensation and many associated financial reporting costs, and

3) Many leadership teams do not enjoy the scrutiny from analysts, the quarterly reporting requirements and the short-term performance focus that all distract from a long-term, strategic focus on value creation.

THE EMERGENCE OF PRIVATE MARKET CAPITAL

Private capital has become much more central to institutional investment portfolios in recent years. According to Bain & Company:

“Over the past 20 years, private-market capital has grown at more than double the rate of public capital globally and, at the moment, there’s no slowdown in sight.”

 “Since the start of the current economic cycle in 2009, investors have allocated a staggering $5.8 trillion globally to private equity.”

“LPs have also been steadily increasing their overall PE allocations, a sign that they are confident in private capital’s long-term ability to deliver strong performance.”

The chart below demonstrates significant and continued growth in allocations made by institutional investors to long-term private equity in their investment portfolios.  

2 - Valuation multiples

Source: McKinsey & Company. Private Markets Come of Age. McKinsey Global Private Markets Review 2019.

The abundance of private capital available in the market today gives companies new funding options they haven’t seen in the past. This will likely impact how companies think about financing growth and long-term strategy for years to come.

  • As the supply of private capital looking for assets has placed upward pressure on private market valuation multiples, the disadvantages of the public markets have outweighed any benefits and the private markets have become the preferred way to raise equity.

 “This unprecedented amount of capital chasing a limited number of assets has driven average buyout purchase price multiples to record highs in recent years. It has also given companies financing choices they’ve never had before.” – Bain & Company

Uber is a great example. Uber raised almost $21 billion in venture capital and saw a private valuation of $76 billion before completing its IPO in May 2019. Uber’s valuation at that IPO was $82 billion. Uber was able to access private capital at strong valuations and stay private for much longer than traditionally expected. They completed an IPO not to unlock value or for access to capital, but because it had grown to the point that the public markets became its only option to gain wide-scale liquidity for investors and shareholders.

 “Given the choice, more and more companies are choosing to stay or go private. The number of US public companies has declined approximately 45% since its peak 20 years ago, despite a rise in the total number of companies. At the same time, the number of IPOs has plummeted.” – Bain & Company

Source: Bain & Company and Thomson Reuters

What’s Driving Capital to the Private Markets?

Private equity’s appeal is tangible, as the asset class has a history of outperforming traditional assets over time while providing valuable diversification.

1) Private equity has consistently outperformed public equities.

The chart below shows the MSCI World equity index of publicly traded companies alongside the internal rate of return for the Global Private Equity Index from Cambridge Associates, as of June 30, 2018. Past performance is not indicative of future results.

Source: Investment Quarterly. Private Equity and Your Portfolio. Neuberger Berman. January 24, 2019.

The MSCI World equity index is a broad global equity index that represents large and mid-cap equity performance across 23 developed countries. The Global Private Equity Index is calculated based on data compiled from 2,167 private equity funds, including fully liquidated partnerships, formed between 1986 and 2018. Calculations are pooled horizon internal rates of return, net of fees, expenses, and carried interest.

2) The addition of private equity has tended to enhance portfolio returns and reduce risk.

The factors that drive returns in public equity markets have little or no impact on private equity, enhancing its diversification potential. The chart below shows blended portfolio returns over 25 years, ending June 30, 2018. It highlights the positive impact of shifting portfolio composition from 30% bonds, 70% stocks and 0% private equity, to 30% bonds, 50% stocks and 20% private equity.

      • Note that as the allocation to private equity increases, the overall portfolio risk is reduced and portfolio return is increased.

Source: Investment Quarterly. Private Equity and Your Portfolio. Neuberger Berman. January 24, 2019.

Bonds, stocks and private equity are represented by the Bloomberg Barclays U.S. Aggregate Index, S&P 500, and Cambridge Associates LLC U.S. Private Equity Index, respectively.

A January 2019 Blackrock survey indicated 68% of their institutional clients in Canada and the U.S. intend to decrease their allocation to public equities to reduce public market risk within the equity portfolio.

Meanwhile, 47% of respondents intend to increase their exposure to private equity.

WHERE DOES THIS LEAVE INDIVIDUAL INVESTORS?

If the growth in the supply of private equity leads to a continued increase in private market valuations, there will be a continued reduction in IPO volume. Individual investors using traditional public market investment strategies already have less exposure to the small and middle-market companies that have been the bread and butter of private equity. They will continue to have less opportunity to invest in innovative, fast-growing start-ups with potential to generate big returns (such as Uber) as companies stay private longer. This cycle is demonstrated below.

  • Making private equity, including venture capital, more accessible to individual investors is gaining more and more importance as a result of these trends.

Generally speaking, individual investors that have a need for long-term growth in their portfolio can benefit from making an allocation to alternative private investments, including both private equity and venture capital.

  • BlackRock, the world’s largest asset manager with roughly $7 trillion of assets under management, finds that the appropriate private markets portfolio allocation can range from 10% to 40% of the portfolio depending on individual investor objectives.

  • The primary challenge, according to BlackRock, is that investors and advisors are far more likely to hesitate putting money into these alternative investments due to a feeling of uncertainty around the benefits of private alternatives and a lack of clarity around how specific strategies work in their portfolio.

A ROLE FOR VENTURE CAPITAL WITHIN THE PE PORTFOLIO

Asset managers often seek to diversify asset classes within their private equity portfolio by adding uncorrelated assets with potential to enhance returns. Venture capital shows historical benefits to private equity portfolios in a similar manner that private equity adds value to overall portfolios.

1) Venture capital returns have outperformed other asset classes.

Top quartile investment returns for venture capital have historically exceeded those for other asset classes when compared to top quartile managers across asset classes and time horizons, as demonstrated in the chart below. Significant inter-generational wealth has been and will continue to be generated by the innovation economy.

Source: The Case for Venture Capital. Invesco. Cambridge Associates Global Venture Capital, Global Private Equity, and Global Real Estate Benchmark Returns Report as of Dec. 31, 2015.

2) Venture capital can further enhance portfolio returns and reduce risk.

According to an OMERS Ventures study of U.S. venture capital and private equity returns, venture capital exhibits low to moderate correlation with private equity and large-cap public equity returns. OMERS identifies a correlation coefficient between:

      • Venture capital and private equity of 0.02, and

      • Venture capital and public equity (S&P500) of 0.37.

As the combination of public and private market equity can enhance portfolio returns, the combination of private equity and venture capital assets as part of a diversified portfolio of private equity assets can generate risk-adjusted returns superior to what is achievable through a standalone portfolio of 100% private equity.

      • OMERS Ventures’ analysis concludes that an optimal portfolio of private assets allocated between private equity and venture capital would, based on historical returns, have a split of 92% private equity and 8% venture capital.

These exact allocations will obviously depend on the investment objectives of the individual, but this is a good example to begin with for some context.

3) Family investing in innovation is good for the ecosystem.

When entrepreneurs are either funded directly by family offices, or by a venture fund that provides transparency to the end investors, companies get exposure to experienced entrepreneurs who have often been in their shoes. Expertise and connections get leveraged to help businesses and investors grow. Investors who may not have much experience with innovation today get exposure and become more willing investors in the future. The ecosystem grows stronger to produce results for years to come.

CONCLUSIONS

The inclusion of private equity in the portfolio of an individual investor has clear benefits and is becoming increasingly necessary in order to gain exposure to the growth opportunities and diversification benefits that support a long-term growth perspective. Similarly, venture capital, which is a sub-asset class of private equity and consists of investing in innovative and growth-oriented companies, is uncorrelated to traditional private equity and can play a meaningful role in reducing portfolio volatility and increasing returns.

  • A sample portfolio allocation may look like the chart below.

  • Private equity represents 20% of the portfolio, and venture capital represents 10% of the private equity allocation, or 2% of the overall portfolio.

 

Metiquity Ventures

MV is a Calgary-based early-stage growth equity fund partnering with innovators to modernize the regional funding ecosystem, unlock emerging growth potential and protect our families’ futures.

We partner with innovators in emerging innovation hubs who are creating long-term, systemic business value and are on the cusp of commercialization and significant growth, regardless of industry. We focus on early-stage investments where we can amplify the impact of our expertise and help partner companies accelerate growth by implementing the efficient use of systems, processes, and a well-defined purpose. We make meaningful lead investments in up-and-coming companies using technology to digitally transform and fundamentally disrupt the way traditional industries operate.

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