Investing in early-stage companies demands a healthy risk appetite. Seven of ten investments will fail to return the money invested, two are expected to cover the losses, and the remaining firm should provide the anticipated 20-30% IRR that VC investors expect.
The potential upside is, of course, what fuels this market. As of writing, there are over 1,170 unicorns globally, each valued at over $1B, with a collective worth of $3.9 trillion. Success stories such as these make early-stage investing an attractive option for those looking to get in on the ground floor of potentially world-changing companies.
Even setting aside the outlier unicorns, the median private equity fund performance of 19% net IRR is more than triple the forecasted S&P 500 performance of 6% for the next decade. Top quartile PE performers do even better, with a median net IRR of +30%.
The potential rewards are significant. But so are the risks, as many in the bottom quartile of venture funds lose money. This does not mean, however, that VC as an asset class is inherently riskier than other types of investments. In fact, with the right approach, early-stage investing can be a relatively low-risk endeavor.
Portfolio theory-based construction
The actual risk of an asset class is the risk that remains after diversifying away all non-systematic risks. Investing in a wide range of companies and asset types makes achieving a high degree of diversification possible, mitigating the risk of any particular investment.
This is the approach taken by Gridline Alternative Portfolios. These portfolios are constructed using a Modern Portfolio Theory (MPT) framework, which considers each asset’s volatility and correlation to optimize for return. This results in a less volatile portfolio than the underlying assets would be on their own and has the potential for higher returns than a more traditional, 60/40 equity/bond portfolio.
However, the challenge with investing in many venture or PE funds is that they each come with high investment minimums and other access restrictions. These requirements are known to improve returns but make it challenging to build a truly diversified portfolio.
Gridline’s solution is to aggregate capital from multiple investors and use this larger pool of capital to invest in various alternative investment funds. This gives investors diversification benefits without the hassle or expense of going alone.
Indexing in private markets
This approach can be likened to indexing in the public markets. Just as investors can buy an index fund that tracks the S&P 500, Gridline’s portfolios provide exposure to a broad range of private market opportunities.
This type of indexing has been shown to outperform individual deal-by-deal investing, as a Kauffman Fellows study found. Further supporting the importance of private market indexing, one analysis found that businesses stay private 50% longer, on average. Moreover, equity raised pre-IPO has quadrupled since the turn of the century.
This growth owes to rising liquidity in the private markets, increasingly onerous public market regulations, and a flight to quality by global investors seeking to increase potential returns while lowering volatility.
Given these trends, it is more important than ever for investors to consider indexing to capture the returns available in private markets efficiently. Sign up for Gridline to gain access to these opportunities.