Building a Venture Capital Strategy for a Private Equity Investor
Taking Advantage of Growth in Technology
As an asset manager and active LP in Venture Capital funds, we have lots of conversations with other LPs on how to build a strategy in the asset class. We wanted to publicise our thoughts here and are happy to discuss in more detail with whoever might be interested.
- Why invest in technology?
Out of all industrial sectors´ performance over the past 15 years, the two standout sectors have been information technology and software & services, both of which have outperformed against the general industry significantly. This should not necessarily come as a surprise given the growing importance of information technology over a wide range of sectors. Furthermore, as a relatively young sector, it continues to grow at a much higher rate than other industries.
The chart below shows how the MSCI Information Technology and Software indices have outperformed other sectors in the past:
2. How to get exposure: public vs private markets
Over the past few years, private markets have outperformed public markets for different reasons. One main reason is purely due to the fact that companies tend to go public at a later stage of growth, and therefore, most of the value creation happens when companies are still private. Also, given that private companies are generally thinly traded, there is a lot more scope for an illiquidity premium, which investors can charge.
The chart below shows the outperformance of private markets using public-market equivalent benchmarks:
3. How to get exposure: direct vs indirect
One of the biggest challenges for asset managers is to decide for each asset class if you want to invest directly and indirectly.
Obviously, the main benefit of direct investment is that it allows for a direct interaction with the company (or asset, in general) involved, which can be highly beneficial if you’re well-versed in the field or industry. However, the processes for direct investing can be very time intensive and require to build an own infrastructure and hire the right people inhouse, which is often more costly than the fees you pay to a fund manager. Also, geographic diversification is way harder, if you invest directly and don’t have “feet on the ground”.
As such, for asset management firms with limited manpower and infrastructure, it would stand reason to invest indirectly at least in asset classes which aren’t core to their strategy.
4. Allocation strategy: VC manager ranking
While the median returns from global venture capital firms have risen over the last years, one trend that has been noted is that the return spread between top-quartile and bottom-quartile fund managers have been widening, meaning that it is extremely important to spend the time to find the right fund managers to work with.
In general, past performance of a fund manager in Venture Capital has been a good guide to his future performance — which is not necessarily true for other asset classes. Reason for that is not only the ability of the manager, but also the brand top fund managers build which attract more high profile start-ups and founders.
This Preqin chart shows, that several firms are able to consistently perform in the top quartile:
5. Allocation strategy: small vs large managers
An important aspect of finding the right fund for investment is its size. Generally smaller funds have better alignment of interest with their LPs as managers don’t get rich on management fees and are incentiviced to generate returns and charge performance fees. In Venture Capital, historically smaller funds have yielded better returns for another reason: they are less reliant on blockbuster exits.
This chart from Silicon Valley Bank shows, how smaller VC funds (<$250m in fund size) had a lot higher chance to outperform than larger funds from 1981–2003:
6. The case for global diversification
While the US west coast, the home of Silicon Valley, remains the undisputed hub of global tech start-ups, due to its established ecosystem, there are other regions with growing importance. However, other cities in the US and Canada like NYC and Los Angeles, but also smaller cities like Austin and Toronto attract more VC funding as the start-up ecosystems grow.
On the other side of the Atlantic, the UK remains as the leading start-up city in Europe, but with the impending Brexit concerns has shifted the focus towards Berlin and Paris. Also, Scandinavia has had several success stories in the past and should be on every LP’s radar.
You would for sure miss out on VC returns, if you would not look at Israel, which has a strong track record in venture capital, with specialties in deep tech sectors such as cybersecurity.
Lots of potential and opportunity in VC is of course in Asia, where many interesting funds are based in China, and South-East Asia. In the Chinese region, the rise of internet giants such as Alibaba and Tencent stand as a testament to the burgeoning tech start-communities, and it’s heavily digitalised infrastructure provide a lucrative market for start-ups. As for SE Asia, it is certainly in its early days in terms of start-up investing, but given the rapidly developing economies in the region, coupled with large investors in the region such as SoftBank and Temasek, there is a huge potential scope for growth.
This chart shows how much of VC has been invested in which regions globally (and certainly shows, that you’d miss out if you’d only focus on the US!):
7. Building a portfolio
Based on our theses above, we invest in smaller VC funds which invest in technology globally. Obviously, there are thousands funds like this and you need to filter them out on several criteria.
In the chart below you can see which criteria we look at if we diligence a VC fund:
Investing in the top VC funds is surely easier said than done. To get access to funds, you need to build a relationship to management teams early on, and commit to them before they are so successful that their funds are oversubscribed and they stop to bring on new investors.
Here we have summarized our thoughts behind getting access to funds:
If you want to discuss investing in Venture Capital from the LP side, or if you are in the process of raising a VC fund that fits our investing criteroa, feel free to reach out.