In the public equity markets, top-performing and bottom-performing managers provide returns within a relatively tight band. For example, the 5th percentile of managers returns around 5%, and the 95th percentile is around 10%. Further, persistence is almost non-existent: the top-performing managers in one year are unlikely to repeat their performance in subsequent years, and neither are the bottom performers.
In contrast, the dispersion of returns is much wider in the venture capital (VC) industry. The 5th percentile of managers lose money, and the 95th percentile returns over 40%. Further, persistence is strong: the top-performing VCs in one year are likelier to repeat their performance in subsequent years than the bottom performers.
One study finds a correlation of nearly 0.7 between a VC’s return in one year and its return in the next year. This research isn’t alone; Morgan Stanley points to “other researchers, using different data and methods, [who] find continued evidence of persistence.”
This means that the best VCs are much more likely than the average public equity manager to generate significant outperformance. Fund selection is critical in VC and worth paying attention to a VCs track record. That said, there are many other factors at play in VC—the stage of the company, the industry, the quality of the management team, and so on—so fund selection is only a part of what goes into a successful investment.
Why does persistence exist?
There are a few possible explanations. For one, VCs invest in entrepreneurs, and entrepreneurs with a track record of success are more likely to be successful again. In fact, Harvard research shows that a successful VC-backed entrepreneur has a 30% chance of succeeding in his next venture, while first-time entrepreneurs have only a 21% chance. Accessing these serial entrepreneurs is a key to successful VC investing, and the best VCs have a network of them.
Another explanation is that early VC success “leads to investing in later rounds and larger syndicates,” which means that top-quartile VCs have greater access to deal flow. This preferential access gives them an informational edge, leading to better returns. Access-constrained funds, or those with greater access to privileged opportunities, outperform across the board.
Further, a recent Oxford Journal paper theorizes that “successful funds receive continuation contracts that tolerate investment failure and encourage innovation.” In other words, the best VCs are given more leeway to take risks, which leads to more success.
The simplest explanation is that top-quartile VCs are better at what they do. They have a superior understanding of the startups in their portfolio and are better at working with entrepreneurs to help them grow their businesses. These advantages compound over time, leading to better and better performance.
This isn’t to say that all VCs are created equal; the best have a rare combination of skills, experience, and networks. But if you’re looking to invest in VC, it’s important to consider persistence. The best funds have a strong track record of delivering superior returns and are more likely to do so in the future.
Gridline considers all these factors when curating a selection of professionally managed alternative investment funds for individual investors. With lower capital minimums, fees, and greater liquidity, Gridline is the most efficient way to gain diversified exposure to non-public assets.