Does it make sense to allocate assets to venture capital?
In the past 30 years, venture capital (VC) has been an increasingly important source of financing for innovative companies. In recent decades, companies like Amazon, Facebook, Google, Intel, Microsoft, Amgen, Genzyme, Starbucks, and Whole Foods have all received substantial funding from venture capitalists during their formative stages. Kaplan and Lerner (2010) estimate that roughly one-half of all true IPOs are VC-backed even though fewer than one quarter of 1% of companies receive venture financing. Gompers and Lerner (2003) and Gornall and Strebulaev (2015) estimate that public companies that previously received venture capital-backing account for one-fifth of the market capitalization and 44% of the research and development spending of U.S. public companies. Consistent with this company-level performance, Harris, Jenkinson and Kaplan (2014, 2015) find that, on average, VC funds have outperformed the public markets net of fees.
This article seeks to address a series of relevant questions for institutional investors – Does it makes sense to allocate assets to venture capital? Is overall portfolio performance enhanced by having an allocation to venture capital? Does the risk-return relationship provide attractive returns? What can institutional investors learn from the experience of other long-term investors in the sector? And finally, is allocating to venture capital through a fund-of-funds supported by the literature?
Strong Performance of Venture Capital
Any investor thinking about allocating capital to venture capital must answer two critical questions in determining whether the asset class makes sense. First, an investor needs to consider whether investments in venture capital have positive, risk-adjusted returns. And second, an investor needs to determine whether they can identify the best managers in the business.
The historical data on venture capital seems to bear out the potential to invest by creating alpha from the sector and provides a roadmap for how long-term investors can capture value in their portfolio from allocating capital into venture capital. First, the experience of the large university endowments demonstrates that venture capital investments do indeed provide the kind of diversification that modern portfolio theory highlights. While exits in venture capital are often dependent upon a robust public equity market, the factors that drive the ultimate return on venture capital tend to be distinct from overall market return factors. The role of innovation, patents, and new technology are the dominant forces that create the ability to generate high venture capital returns. As such, the returns on venture capital result from underlying forces that are distinct, and hence, provide diversification benefits in an overall portfolio for long-term institutional investors.
Do venture capital investments provide positive, risk adjusted returns? One way to assess this performance is to look at Table 1 which tabulates short, and long-horizon returns for venture capital, different stages of venture capital, private equity, and public markets. Over the most time horizons, venture capital has dramatically outperformed both public markets and private equity.
On an ongoing basis we monitor the number of unicorn exits listed on the Wall Street Journal’s Billion-Dollar-Club fact sheet. Between February 2014 and April 2019, 82 venture capital-backed unicorns exited. Of those 82 exits, we were able to find complete funding round data for 69 companies. “Complete funding round data” is defined as the total number of investment rounds a company had prior to an exit. Our analysis shows that if an investor had made just one investment into the very last funding round of these 69 unicorn companies, the average multiple would have been 1.4x. Alternatively, if an investor had invested early and remained invested throughout each funding round, the average multiple would have been 7.2x. The table below lists the return multiples for a range of different outcomes.
Return Multiples on Unicorn Exits
A number of papers starting with Gompers and Lerner (2000) have looked at a variety of methods to risk-adjust venture capital returns. Gompers and Lerner’s method adjusted for beta and multi-factor risk models and showed that venture capital investments had risk-adjusted returns in excess of 4% per annum. Koch (2014) follows a similar approach and shows that venture capital through 2010 also outperformed its riskiness. Kaplan and Schoar (2005) show aggregate PMEs above 1.0 for venture capital funds. Cochrance (2005) uses an alternative analytical approach and comes to a similar conclusion; adjusting for risk, venture capital investments outperform by nearly 5% per year. The critical element of these papers, however, is that they measure the performance of the entire industry. Given return dynamics and the potential for persistence in performance, a sophisticated institutional investor may be able to generate even higher returns. In the sections below, we’ll explore the courses of actions that an institutional investor may consider.
Experience of Endowments in the US
The most successful institutional investors in the US have historically been university endowments. Many institutions look to the investment strategy of endowments to improve overall performance. The 2017 annual survey of endowments portfolio allocations is summarized in Table 2. For large institutions (above $1 billion) venture capital makes up 7% of their portfolio allocation. For small endowments, the number falls to 3%. This experience, however, masks what the top performing endowments allocate to the sector. Yale University, often cited as one of the best performing institutional investors over the past 30 years, has a markedly different strategy. Table 3 tabulates Yale’s portfolio allocation over the past four years. From 2013 to 2017, venture capital went from 10% of the portfolio to 17.1% while leveraged buyouts fell from 21.9 to 14.2%. David Swenson, Yale’s Endowment CIO for more than 30 years, has written and spoken about the role that venture capital has played in Yale’s outperformance. In its 2017 endowment report, David Swenson indicates that returns on venture capital during the prior ten years were 14.2% and that he expected going forward returns of at least 16%. A recent Harvard Business School case study attributes half of the outperformance that Yale has enjoyed over this time period to its investments in venture capital.
Clearly, Yale, as a long-standing investor in the venture capital space has access to top performing funds that many investors might not be able to access. Given the high interquartile dispersion of returns and the highly persistent nature of returns, selecting and gaining access to the top venture capital firms is critical to success. In fact, it may not make sense to invest in venture capital unless access to top-tier funds can be achieved. Similarly, given the deep institutional due diligence required to evaluate potential managers, investors may have difficulty replicating Yale’s experience without a different approach.
One of the underlying drivers of performance for top performing funds is performance persistence amongst entrepreneurs. As recent research surveying top venture capitalists has shown, perhaps the most important ingredient for success as a venture capitalist is consistent and robust deal flow. In the long run, venture capitalists with strong access to high-quality entrepreneurs are more likely to outperform VC firms with "less access" to the best start-ups. Gompers, Kovner, Lerner & Scharfstein (2010) state that while "venture capitalists do add value to startups through the provision of mentoring and monitoring, the persistent differences in performance across VC firms appear to stem more from firms that have become known for their past success having better access to future sought-after deals than from the better ability of VC firms to select and nurture startups to success."
Additional research has focused on persistence of returns at the fund level. This research has attempted to identify which "asset classes" have the strongest pattern of persistence from one fund to the next and has shown that venture capital firms have exhibited the highest levels of persistence within private equity and across all asset classes. Venture capitalists spend time cultivating their reputations, building their networks, and proactively reaching out to the best entrepreneurs. These efforts create high-quality deal flow and the ability to generate value through sourcing and selecting. Top performing venture capital investors highlight the critical importance of having access to the best deals as one of the key reasons that performance persistence exists in venture capital, but not among publicly traded funds. Why? Investment firms who are investing in public equities need not compete for access to deals.
The Case for Fund-of-Funds
One natural question that an investor might ask is whether investors can replicate the performance of US endowments by utilizing a fund-of-funds. Funds-of-funds are typically maligned because of the additional layer of management fees. A recent paper by Ang, Rhodes-Kropf (2008) directly addresses this issue. They examine the returns of funds-of-funds relative to broad public markets and direct investments in venture capital or private equity funds. They find that, on average, funds-of-funds earn their fees, i.e., they seem to have selection abilities within the asset class in which they operate. Adjusting for funds-of-funds’ fees, they outperform direct investments, with the outperformance being the largest in venture capital.
The authors provide several potential explanations for why venture capital funds-of-funds may be able to “earn their fees”. First, the ability to evaluate venture capital funds is difficult. Much of the analysis of an opportunity requires detailed quantitative and qualitative analysis. The “human intelligence” requires networks in the industry that many investors may not have. Funds-of-funds investors may have the experience and connections to more fully appreciate the factors that drive performance. Second, long-standing funds-of-funds may have legacy relationships that provide access to the best venture capital managers. Venture capital is a relationship business and having experience in the sector matters for the most sought-after funds.
Domestic vs. International Early Stage Investing
The number of US VC firms has grown from 866 in 2006 to 1,167 in 2018 (NVCA 2019 Yearbook). US Venture fundraising has also reached record levels. Venture funds raised a record $55 billion in 2018, the fifth consecutive year to exceed $34 billion, foreshadowing continued high investment levels for 2019 and beyond.
The growth in the number of venture capital firms and fundraising is not only happening in the US, but in international markets as well. For example, over the last several years China has emerged as a principal player in the global entrepreneurial ecosystem. Chinese companies have attracted increasing amounts of global capital and it is partly due to major entrepreneurial initiatives undertaken by the Chinese government, China’s rapidly expanding middle class, and Chinese technological innovation.
One of our China-based venture capital fund managers recently reported that the total VC dollars deployed in China is starting to catch up to the US. According to Pitchbook 1Q 2019 Analyst Note, “China has seen a meteoric rise in technological innovation and VC activity in recent years. The country has established a major entrepreneurial ecosystem with domestic startups attracting massive levels of VC and with Chinese firms making sizable venture investments around the globe. In 2018, over 29.4% of global VC was directed into Chinese startups.”
Spur Capital is a US-focused fund of funds with modest exposure internationally to China, India, and Israel. It should be noted that while Israel is the smallest of these three countries, it is reputed as one of the world’s leaders in developing deep technology. China has recently drawn our attention as the number of early stage China-based venture capital funds have increased and are more easily accessible to foreign investors. To that end, several of our US-based venture capital funds have established investment teams in China in an effort to participate in the country’s blossoming entrepreneurial ecosystem.
Overall, academic research on venture capital over the past 25 years has demonstrated the importance of venture capital in the economy as well as the role that it can play in an investor’s portfolio. Recent research has demonstrated that for institutional investors, venture capital provides both strong diversification and positive, long-run, risk-adjusted returns. Our own experience at Spur Capital Partners has demonstrated that venture capital investments have had strong performance and that top-decile performance can be achieved fund over fund. The experience of US university endowments points to a long-run strategy that others can emulate. Funds-of-funds provide an opportunity to earn attractive returns and more than earn the fees that they charge. Finally, investing at the early-stage, whether domestic or international, is instrumental to long-term investment performance in venture capital.
Special Thanks to Our Contributor
Spur Capital has a successful history of building durable relationships with top-tier venture capital firms in early-stage technology and life science as well as uncovering up-and-coming firms. Limited partners are leading endowments, family offices, foundations, and institutional investors in the United States and Western Europe.
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Kevin J. Moore, Partner
Paul Gompers, Managing Partner