In the world of private markets, venture capital has become an indispensable link in the financial engine of innovation in recent decades. Venture capital investors offer young companies much-needed capital injections to continue their (expensive) growth strategies. The hope is that these ‘startups’ will turn out to be ‘unicorns’ in which venture capitalists realize a large multiple on their investment. Because on average 90% of startups do not ultimately succeed, investors face an increased risk of losing their invested capital. The question is therefore whether this risk outweighs the high returns that the asset class theoretically offers.
Over the past 22 years, this does not seem to be the case for the venture capital industry as a whole. To illustrate, global equity markets and private equity achieved annual returns of 6.5% and 11.8%, respectively, while venture capital achieved 4.1% (source: Preqin). Nonetheless, due to the large variation in returns of private funds, the average can paint a distorted picture of the underlying dynamics.
If the performance of venture capital funds is ranked among themselves and broken down by vintage year, a more nuanced picture emerges (see Figure 1). Firstly, the disappointing average returns of venture capital were primarily driven by funds before the financial crisis. Secondly, the dispersion in returns is much higher than with buyout funds. Finally, venture capital funds have systematically outperformed buyout funds since vintage year 2012.
However, the previous graph compared the total return between venture capital and buyout funds. This is a combination of (i) realized distributions and (ii) residual value in the portfolio. Figure 2 compares investment styles based on realized returns only. This is where one of the challenges of venture capital comes to light; translating promising companies into ‘cash’ distributions.
As it turns out, venture capital funds have yet to realize a large part of their total return. Only the best funds perform in line with (or better than) their competitors in the buyout field in terms of realized returns. An additional challenge is that the cash flow profile of venture capital funds is relatively irregular. The potentially high returns of successful start-ups should be reinvested in private markets. The unpredictability in terms of timing and size of these distributions complicates cash flow planning within illiquid portfolios.
The optimistic investor will probably argue that the realized returns of a fund at the end of its term correspond to the total return. After all, at that time, all the underlying companies in the portfolio have been sold. However, it is very uncertain whether all companies can be liquidated at their reported ‘fair market value’. For example, any decline in valuations will logically have a downward effect on market value and subsequent cash distributions. Unfortunately, venture capital is facing such a challenge.
Figure 3 illustrates the interim development of the total return of venture capital and buyout funds issued between 2013 – 2018. Initially, both investment styles showed similar returns, but after the COVID-19 pandemic, the returns of venture capital funds rose sharply. Nevertheless, in 2022-23 there was a substantial reversal in this trend (the multiple premium is now 0.3x compared to more than 0.6x at the end of 2021).
Although the aforementioned venture capital funds still show higher returns on average than buyout funds, it is unclear whether this is driven by realistic pricing. One of the disadvantages of private markets (or perhaps one of the advantages from a behavioral point of view) is the lack of day-to-day price formation. Only at the time of the sale or a new financing round is a ‘market price’ determined.
Fortunately, there are alternative sources of information that provide insight into the actual pricing within private markets. This information shows that the observed decline in venture capital returns in 2022-23 may not yet be the full correction:
- Secondary transactions – Sold interests in venture capital funds in the first half of 2023 were accompanied by a relatively high discount of 31% compared to previous years.
- Venture Capital index – Listed portfolio companies of venture capital funds fell ~50% since the peak.
- Listed trusts – Marketable ‘venture capital trusts’ are currently trading at a discount of ~60% to their net asset value. At the end of 2022, the discount was only 5-10%.
In short, alternative price sources show that there is substantial uncertainty regarding to the ultimate liquidation value of the active venture capital portfolios. Nevertheless, it is important to emphasize once again that the best-performing venture capital funds are indeed able to deliver high returns for their investors (see Figure 4). Therefore, steadfast investors in venture capital aim to implement the most successful funds while avoiding loss-making funds. As a result, returns of the entire industry are (in theory) only partially representative for them.
A logical approach, so it seems. However, in practice, the implementation of venture capital funds in investors’ portfolios is associated with major challenges. This is driven by the nature of the venture capital industry combined with the characteristics of the most successful funds. The process prior to investing in funds on the private market conceptually consists of the following steps: identification, selection and access.
- Identification – ~40% of venture capital funds that achieve a high multiple (>4x) are first-time funds. Unless they come from your own network, it is a major challenge to identify such parties in advance.
- Selection – ~60% of funds with multiple >4x are (i) first-time funds and/or (ii) have a size smaller than USD 50m. The provision of information of these parties is usually limited, which makes the selection more difficult. This increases the risk for the investor, as the volatile nature can also lead to negative outcomes (see Figure 4).
- Access – Finally, it must be possible to gain access to the fund in question. Many successful venture capital parties do not simply make their funds available to new investors.
Bluemetric Insight | Venture capital is an enticing asset class where investors can theoretically earn high returns by funding risky startups. Despite this, long-term (realized) returns have been disappointing. It should be noted that the best-performing venture capital funds do achieve high returns for their investors, although the practical implementation poses significant challenges.In recent years, venture capital has been characterized by increasing optimism with (i) rising valuations, (ii) strong performance ‘on paper’ and (iii) a higher inflow of capital. However, various indicators show that this tide is currently turning. All in all, the important lesson for investors is not to fall prey to ‘return chasing behavior’. After all, ‘results achieved in the past are no guarantee for future returns’.
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