With the astronomical success of companies like Airbnb, Facebook, and Uber, it's no wonder that venture capital has become one of the most popular forms of investment in recent years. However, there's a lot that most investors don't understand about VC.
Legendary investor Warren Buffet has said, "never invest in a business you can't understand." As an asset class, VC is often misunderstood and shrouded in mystery. This can make it difficult for investors to truly wrap their heads around what they're putting their money into.
Let's take a look at some aspects of VC that many investors don’t understand.
VC on average beats the public markets
The public markets are often thought of as a safe bet. The traditional 60-40 portfolio split between stocks and bonds has produced decent returns for generations of investors. But in recent years, that portfolio mix has come under pressure. Stock prices have become more volatile, and bond yields have been historically low.
In fact, future generations of investors - namely Gen Z and Millennials - are expected to have dismal returns compared to their parents and grandparents. That's why more and more people are looking for alternatives to the traditional portfolio. Thus, the 33-33-33 portfolio has gained popularity in recent years. This portfolio allocates one-third of assets to each of three asset groups: stocks, bonds, and alternative investments.
The argument for adding alternative investments to your portfolio is simple: they offer the potential for higher returns than stocks and bonds while also providing diversification. One popular alternative investment is venture capital.
VC funds typically invest in early-stage companies that are too risky for the public markets. These companies are often unproven and have yet to generate revenue or profits. But because of the high risk, VC investing also has the potential for high rewards.
The average VC fund generates a 19% internal rate of return (IRR), according to Cambridge Associates. That's compared to an 11% IRR for the S&P 500 and a 5% IRR for 10-year Treasury bonds. And while VC funds can be more volatile than stocks and bonds, they also tend to outperform in both good and bad years. For example, during the 2008 financial crisis, VC funds lost an average of 26%. That's compared to a 37% decline for the S&P 500 and a 23% decline for 10-year Treasury bonds.
Moving beyond average returns, it's important to note that VC funds have a wide dispersion of returns. The top quartile of private equity funds generates an average IRR of 30.5%, while the bottom quartile generates an average IRR of just 10.5%. This dispersion is much wider than that of stocks and bonds. For example, the top quartile of large-cap stocks generates an average return of 13%, while the bottom quartile generates an average return of just 3%.
So what does this dispersion mean for investors? It means that there's a big difference between the best and worst VC funds. And it's important to understand which VC funds you're invested in. That's why it's important to diversify across multiple VC funds.
The public markets are often thought of as a safe bet, but they may not be the best option for everyone. For investors looking for higher returns and diversification, venture capital may be worth considering.
Smaller funds outperform larger funds
The venture capital industry has seen a lot of growth in recent years. And as the industry has grown, so has the size of VC funds. Today, there are a handful of mega-funds that manage tens of billions of dollars, all the way up to SoftBank's $100-billion-dollar-plus Vision Fund.
But is this growth sustainable? Can these large VC funds continue to outperform their smaller counterparts? The answer, according to a recent study by Invesco, is no.
The study found that once a VC fund grows beyond $400-500 million in size, performance begins to suffer. This is because it becomes increasingly difficult for these large firms to achieve "venture-type" returns when the majority of exit outcomes occur at relatively modest valuations.
So what does this mean for investors? It means that if you're looking for the best returns in venture capital, you should focus on smaller funds. The average IRR for small VC funds (under $400 million) was 19-20%, as compared to just 7.2% for large VC funds ($400 million to $1 billion). And for mega-funds (over $1 billion), the average return was an abysmal 2.4%.
Of course, there are always exceptions to the rule. But if you're looking to invest in VC, you're better off diversifying across multiple small and mid-sized funds rather than putting all your eggs in one mega-fund basket.
You don’t have to wait ten years to see your money back
Investing in venture capital can be a long-term play. Many VC funds have a 10-year horizon, which means you won't see your money back until the fund is liquidated.
But that doesn't mean you have to wait 10 years to see any returns. In fact, disbursements can begin as early as year five or six, with VC-backed companies going public on average 5.3 years after securing their first investment.
So why the long hold period? There are a few reasons. First, VC funds typically invest in early-stage companies that take longer to generate returns. Second, VC firms want to give their portfolio companies time to grow and scale before exiting. And finally, VC funds often reinvest a portion of their profits back into their portfolio companies (known as a "carry").
The carry allows VC firms to participate in the upside of their portfolio companies while also aligning their interests with those of their investors. Of course, not all VC-backed companies will go public or be successful. But for those that are, the potential rewards are high.
Individuals can get diversification in private markets
The public markets have long been the go-to destination for investors looking to achieve diversification. But in recent years, the rise of private markets has begun to change that. Today, there are a number of ways for individuals to invest in private companies.
One popular way to invest in private companies is through a fund of funds. These funds allow investors to deploy capital across a number of different VC funds, each of which makes dozens of investments. This type of investing provides instant diversification and can help mitigate risk.
For example, with Gridline, investors can deploy $100,000 across 10 different VC funds. Each of these funds makes 30 investments, meaning the investor is effectively invested in 300 different companies or just $333 per company. This allows investors to tap into far more deals than they could if they were investing directly in companies.
Similar to how Vanguard democratized access to the public markets, funds of funds are democratizing access to the private markets. For investors looking for diversification and high returns, private markets offer a compelling alternative to the public markets.