Investing in Venture Capital

TL;DR: Investing in venture capital (“VC”) can provide a compelling opportunity for investors seeking alpha through a high return, high-risk asset class that often locks up capital for 10 years or longer. To invest in venture capital, is to invest in innovation.

Venture capital has notable overlap with Private Equity. However, at Compound we discuss and allocate to these asset classes separately due to their distinct risk and return characteristics. While both asset classes describe equity ownership of private companies, VC focuses on higher growth startup companies that are usually tech-focused and earlier in their life-cycle. For more on Private Equity, please reference this article.

So what is venture capital?

In the simplest terms, VC is just part of an asset class, but it is also a key component of how we build portfolios to achieve long term goals, where appropriate (see the framework below).

At its core, venture capital involves investing in private firms with exceptional growth potential, even if they lack a product or revenue at the outset. Typically centered around technology companies or those with a technological element, venture capital aims to identify and support the most promising next-generation ventures.

Venture investment embodies substantial risk and reward dynamics, albeit with nuanced variations based on distinct strategies. Venture funds often aim to secure net annual returns upwards of approximately 20-25% or beyond, catering to the aspirations of their limited partners.

Nonetheless, the majority of venture backed companies yield returns at values below the initial investment or, at times, yield a full loss of capital. To counterbalance this inherent risk, VC fund managers usually rely on a select few companies that demonstrate exceptional gains. 

When considering allocating to venture in your portfolio an essential facet to bear in mind is the dispersion of returns across various funds, as visually depicted in the accompanying chart. The spectrum of potential outcomes in VC is notably the broadest, underscoring the critical significance of adeptly selecting the optimal venture manager and fund and having diversity within the asset class.

The below chart showcases the dispersion in fund returns across each asset class. The dot showcases the median return level of the asset class and 50% of returns are within the box. The lines showcase the values on both the upside and downside, the top and bottom quartiles.

Investors and funds bring a variety of skills and value-add to VC. The best VC managers have long histories of sourcing and investing in numerous unicorns (companies valued over $1 billion) across multiple cycles. These top-tier firms have ample experience identifying the right ideas, market fit, and people to create category-defining companies. Importantly, they add value to their portfolio companies by making key customer introductions, assisting with executive hiring initiatives, and other critical strategic needs.

_{Source: https://www.caisgroup.com/articles/performance-dispersion-in-alternative-asset-classes. Fund data trimmed by removing funds in the 2.5% return tails of each asset class depicted. Analysis is based on the remaining 95% of funds, capturing approximately 2 standard deviations from the median, assuming a normal distribution of fund returns. HFR, Constituents of the HFRI Composite measured by Rate of Return since 1990 and consists of Macro, Relative Value, Equity Hedge, and Event Driven. Preqin, Private Equity data represented by mature funds (minimum 10 years) and consists of Buyout, Venture, Growth, Fund of Funds and Secondaries (minimum 7 years); Private Debt data represented by mature funds (minimum 3 years) consists of Direct Lending, Mezzanine, Special Situations and Distressed Debt; Real Estate, data represented by mature funds (minimum 10 years ) consists of Core, Core-Plus, Value-Added; Infrastructure data represented by mature funds (minimum 10 years) consists of Core, Core-Plus and Value Added. All returns measured by internal rate of return (IRR)% since inception of funds analyzed. Bloomberg, Fixed Income funds represented by US focused open-end funds. US Equity funds represented by open end funds, Large-cap and Small-cap strategies, and Global Equity funds represented by broad focus market cap classified funds. Return data is representative of 10-year annualized total returns.}

Why invest in venture capital?

For qualified investors with the liquidity, investment objectives, risk tolerance, and time horizons appropriate for VC, there are a number of advantages to investing:

• Ability to invest in the “innovation economy” and next generation technologies early in their life cycles.  VC offers a gateway to allocate capital into emerging sectors that may remain inaccessible to public market investors until the sectors mature. Notably, a substantial portion of returns often materializes pre-IPO. For instance, the growing field of venture capital investment in artificial intelligence is exemplified by OpenAI, the force behind Chat-GPT. OpenAI recently secured a multi-billion dollar investment from Microsoft, valuing the company beyond $29 billion. While public market investors can now access Chat-GPT through Microsoft, VC investors like Khosla Ventures have enjoyed a 4+ year involvement, capturing the complete trajectory of value creation leading up to this juncture.
• Outsized opportunity  for high returns compared to other asset classes. Venture capital offers a remarkable chance for substantial returns in contrast to other asset classes, with potential net returns reaching 20-25% or beyond. However, it's essential to acknowledge the direct relationship between increased return potential and heightened risk, as most individual VC investments are prone to failure, and locating significant winners to offset these losses lacks assurance. The transformation from a concept to a multi-billion dollar company is a protracted process, often spanning more than a decade for full liquidity and rare, at best. Therefore, meticulous selection of suitable managers and opportunities remains a critical determinant in achieving enhanced risk-adjusted returns.
• Early-stage venture capital strategies may provide attractive opportunities to deploy capital amid heightened public market volatility. While all venture capital strategies are ultimately dependent on IPO markets or M&A activity, the impact on earlier-stage strategies is typically deferred until later in their fund life. Deploying to early-stage strategies where interaction with public markets 10-12 years out can be attractive, especially during times of market turbulence. 
• Top performing venture capital firms usually add significant value to portfolio companies. Leading firms provide companies with support through decision making, networking introductions, and sometimes even technical expertise. Additionally, skilled managers can choose to exit portfolio positions during the right market conditions to command a higher valuation. Given the substantial variation among manager performance, the art of sourcing and having access to the right opportunities and resources is pivotal.

What are some of the risks and downside of investing in venture capital?

A diversified investment approach with proper due diligence and collaboration with experienced professionals can help mitigate risks that come with VC.  It’s incredibly important to understand and consider such risks including but not limited to: 

• Illiquidity: Venture capital investments come with a lock-up period that can extend beyond a decade, restraining access to capital for other needs during this time. Planning for cash flow becomes crucial to align liquidity tolerance with immediate and long-term requirements. This trade-off for investors in funds allows fund managers to pursue long-term investments in private companies.
• Limited transparency: Typically, investors lack visibility into the investments and lack decision-making influence in venture capital. Choosing a seasoned fund manager becomes paramount to navigate this challenge effectively.
• Elevated fees: Venture capital funds encompass management and performance fees. The management fee, around 2% of committed capital, finances the firm's operations and often surpasses public market equivalents. Carried interest, a performance fee, constitutes the VC fund's share of gains (usually 20% or more) from portfolio investments. Understanding fee mechanics outlined in the Limited Partnership Agreement is essential.
• Vintage and concentration risk: Performance divergence can occur among funds from the same VC firm due to market cyclicality. Funds investing during periods of high valuations may struggle for top-tier returns. Private funds, especially VC, are more susceptible to cyclical and macroeconomic pressures, underlining the importance of diversifying investments across vintages. Investing in a limited number of startups can lead to concentration risk. If one or more of the investments fail, the overall portfolio's performance could suffer significantly.
• Greater risk of loss: Venture capital's 'power law' nature indicates that a few investments drive substantial returns while many may incur losses. A VC portfolio often balances numerous losses with a few high-return ventures, making it inherently risky. This structure encourages many investors to opt for fund of funds or VC funds instead of direct investments.
• Valuation Challenges and Market Uncertainty: Accurately valuing early-stage companies can be challenging, potentially leading to overestimation or underestimation of their worth. Venture capital is particularly sensitive to market fluctuations. Economic downturns can lead to diminished valuations, impacting the potential for favorable exits through IPOs or acquisitions. The timeline for exits is uncertain. While some startups may achieve quick exits, others might take longer than expected, tying up capital for extended periods.‍
• Regulatory and Legal Risks: The complex regulatory environment can expose venture investments to legal challenges or compliance issues, impacting investment performance.

What are the different venture capital strategies?

Most venture strategies correspond with the lifecycle of the companies they support or the industry or secretary they specialize in. Of course, there are many other strategies and approaches that fund managers adopt to invest in venture.  The main strategies include:

• Angel: Angel investors are usually individuals who invest their own capital in startups, typically providing smaller amounts of funding compared to institutional venture capital funds. They often play a mentorship role as well.
• Pre-Seed/Seed: Seed capital involves providing initial funding to startups at the very beginning of their journey, often during the idea or prototype stage. Seed investors take on higher risk in exchange for potential high returns.
• Early Stage (Series A/B): This strategy focuses on providing funding to startups in their initial stages of development. Investors enter at a very early phase, often before the company has a proven product or significant revenue to help the startup progress and develop.
• Growth Stage (Series C/D): The market fit has been established and the company needs capital to grow quickly through organic means or accretive acquisitions.
• Late Stage (Series D+): The company is of scale and has a realistic path to profitability. An IPO or other exit may be targeted in the near term. Investments are made in more mature startups that have already developed a product, demonstrated revenue growth, and are closer to achieving profitability.
• Corporate Venture Capital: Established companies set up corporate venture capital arms to invest in startups that align with their strategic goals. This can provide startups with access to resources, expertise, and potential partnerships.
• Industry/Sector-Focused: Some funds specialize in specific industries or sectors, such as technology, healthcare, or clean energy, leveraging their expertise to make informed investment decisions.
• Impact: Impact-focused venture capital aims to invest in companies that generate positive social or environmental outcomes alongside financial returns.
• ‍Venture Debt: Venture debt involves providing loans to startups alongside equity investments. It can be used to extend the runway between funding rounds or for capital-intensive projects.

Keep in mind the strategies and descriptions are fluid – some managers and investments they make follow different paths. For instance, fundraising rounds don’t always fall into simple categories nor do they always progress linearly they may include other fundraising structures like convertible notes. 

An important consideration with industry or sector-focused managers is the diminished diversification inherent in these concentrated investment approaches.  Investors should understand the associated risk.

The global venture market is dominated by US firms, and notably Silicon Valley, but markets such as Latin America, Asia, and Europe have seen their venture industries scale substantially in recent years. According to Pitchbook, US venture capital investment reached $247 billion in 2022, while EU venture capital investment was $110 billion. California accounted for 41% of US venture capital investment in 2022.

How should you invest in venture capital?

There are a few ways to invest in VC. 

Most investors gain access through traditional venture funds, fund of funds, or direct transactions. The majority of investment options within this category will require you to be a Qualified Purchaser. 

Traditional venture  funds are investment vehicles that pool money from limited partners (LPs. VC funds are known as drawdown vehicles, meaning capital is provided and invested (capital calls), over time (~4-6 years). This means that when a fund invests in a transaction, the LPs will need to provide capital - often with just a few weeks’ notice. These structures are usually illiquid for 10-12 years or longer. As always, diversification with managers, vintage, and strategy is critically important when building out a portfolio that includes an allocation to venture capital. 

Fund of funds allocate capital across numerous underlying traditional venture funds, providing access to multiple managers via one investment (and one K-1). Investors must rely on the fund of funds manager’s selection expertise and access to get desirable allocations. Fund of funds can be attractive to investors with less capital to commit across potential deals. A primary downside with fund of funds structures is that investors pay two levels of fees, both at the fund of fund level and on the underlying funds. For example, a fund of funds may charge a 1% management fee and 10% performance fee in addition to the 2% management fee and 20% performance fee charged by each underlying fund manager. Additionally, the time to liquidity is likely to be 12-24 months longer than investing in a single fund as fund of funds may need time to distribute proceeds and wind down the fund.

Direct transactions refer to making VC-style investments on a one-off basis. There are a couple of different ways to access direct transactions. For instance, you may make Angel Investments in an opportunity sourced through your network or community. Furthermore, you may also have the ability to co-invest alongside managers (co-investments), which you typically only have access to if you’re an investor in the main fund. In either case, a primary advantage of direct transactions is that they generally have low or no fees. 

Selecting opportunities to invest in requires a great deal of time, capital, and expertise. Having an allocation in direct investments may make sense, but for most investors it can be best to consider these investments as “passion projects” and not a core part of your investment strategy that contribute to reaching your financial goals.

The bottom line

Venture capital can offer substantial returns and early access to cutting-edge companies and emerging technologies, accessible to qualified investors with the requisite net worth and capital commitment. However, the allure of VC investing is balanced by inherently high risk, with the majority of underlying investments facing future failures. The crux of successful venture investing lies in astutely structuring your portfolio, prudent manager selection, and optimal diversification. 

Delving into VC warrants thorough consideration, considering the diverse avenues for investment.

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_{Disclaimer: Compound Advisers, Inc. ("Compound") is an investment adviser registered with the Securities and Exchange Commission (“SEC”). An adviser’s status does not represent any endorsement of the SEC or any expertise simply by having the status as a registered investment adviser.}

_{This content is provided for informational purposes only and should not be construed as financial or investment advice. The information presented in this piece is based on historical data and current market conditions as of the date of writing, which may change without notice. Investing in venture capital involves inherent risks, and individuals should carefully consider their own financial situation and consult with a qualified investment advisor before making any investment decisions.}

_{This educational piece does not constitute an offer or solicitation to buy or sell any securities or investments. The content should not be relied upon as the sole basis for investment decisions and does not take into account the specific objectives, financial situation, or risk tolerance of any individual.}

_{The performance of venture capital investments is subject to various factors such as economic conditions, interest rates, market volatility, and technology and consumer trends. Past performance is not indicative of future results. The information provided in this piece is believed to be reliable, but no representation or warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability, or usefulness.}

_{Investors should be aware that investing in venture capital involves risks, including but not limited to market fluctuations, illiquidity, concentration risk, regulatory changes, and technology risk, layers of fees, lack of transparency, and conflicts of interest to monitor. There is no guarantee of investment returns, and the value of investments may fluctuate. Investors may lose some or all of their investment. Additionally, investing in venture capital may have different diversification benefits and correlation characteristics compared to other forms of investing.}

_{Individuals considering investing in venture capital should conduct thorough research, carefully review the prospectus or offering documents, and consult with their financial advisor to assess the suitability of any investment based on their individual circumstances and investment objectives.}

_{Investors are encouraged to seek professional advice and perform due diligence before making any investment decisions. Please consult with a qualified tax professional before making any tax decisions.}