Venture Capital Outperformance Requires a Targeted Approach

Authors: Sebastian Russo, VDK Capital’s Market Research & Analysis Intern from Stanford University / Richard Jones, VDK Capital’s Macro Strategist

Investment outperformance in any asset class is challenging, and venture capital is no exception. The key to VC outperformance, especially in comparison to public market investments, requires a targeted approach. The best-performing VC strategies focus on early-stage investments — not only do these strategies outperform on a comparative basis, but they also provide diversification benefits.

Aggregate Performance

Let’s look at some recent data published by Morgan Stanley and Cambridge Associates.

In this data, it is clear that making the right choices early on in the VC space leads to superior performance when compared to public markets. The 3-year internal rate of return (IRR) in VC dwarfs the returns in public markets. Beyond three years, in the five year to fifteen year time horizons, VC continues to perform strongly, holding its own against public market counterparts. It is important to note, however, that this is aggregate VC performance — there is no selection of funds in this chart.

Drilling down further, looking at a more targeted peer group (which includes US Growth Equity and US Buyout), the following chart shows that VC’s 3-year outperformance is still visible. And, again, as with the chart above, after this initial clear outperformance, out to the 15-year time horizon, VC returns are robust and comparable to public market performance.

This type of early outperformance in venture capital investments is intuitive — LPs and asset managers search for funds that perform in the top quartile of VC performers.

Here we can see the degree to which top quartile VC can outperform public indexes, like the Nasdaq. During the 2005–2015 vintage years, the average outperformance ratio was 23%.

The most pertinent question for asset managers, then, is to identify what venture firms offer top quartile returns. It’s impossible to predict what funds will return, but there has been some research characterizing which funds are most likely to offer superior returns.

Small, Early Stage Funds Are The Standouts

This data from a Preqin Global Venture Performance research review shows how smaller funds are more effective generators of high returns than larger ones. The authors hypothesise that one of the reasons for this is that venture can’t scale effectively. Past $500m in size, Preqin reports that funds inevitably do worse. They claim that the chief reasons for this underperformance at higher levels is a product of companies investing too much in single firms or in too many, which dilutes returns and lowers the amount of time that partners can spend with each firm.

Another indicator of success is fund stage: early-stage funds handily outperform later stage ones. The reasoning is simple — partners can access more equity at more attractive valuations; however, the risk is greater due to the youth of the companies taken on. From this data, it makes sense that firms aiming to maximise outperformance should engage in diversified portfolios of young companies, mitigating risk and maintaining upside potential.

Steven Kaplan, and his colleagues from the Chicago Booth school, demonstrate another success indicator of VC fund performance in a recent paper. They show that managers with established track records demonstrate persistence in achieving high returns. In essence, these GPs have vast experience and their expertise and success carries from fund-to-fund. This isn’t only because of manager expertise in deal selection and deal flow, but also because their reputation enhances portfolio companies’ reputation and market popularity.

In the conclusion of the paper, Kaplan identifies a critical misconception about venture outperformance: “At the same time however, VC funds with previous performance in both the top and second quartiles outperform the S&P 500. This is not consistent with the view that only very few VC funds outperform. In fact, previous funds that are above median appear to do so as do first time funds.”

Venture Capital Provides Diversification

Venture investment is pro-cyclical, but it only shares modest correlation with other asset classes. VC is a good method to achieve diversification, in addition to providing some cover when recessionary trends hinder public market performance.

This modest correlation hints at an important topic for investors — strategy during recessionary periods. Recently during COVID, and before during the GFC, VC performance has behaved much differently than public markets.

Venture Capital Is Attractive During Downturns

As policy controlling inflation has become front and centre for policymakers from the Fed to the Swiss National Bank, public markets are becoming more challenging to navigate. Additionally, the war in Ukraine and heightened geopolitical uncertainty have made it important for investors to consider putting more assets in alternatives that perform better than public markets.

In a recent survey by CoreData Research, roughly a third of European fund selectors are turning to private markets during this inflationary time because of their beliefs that private offerings will return more readily. Additionally, in 2021, the NVCA reported that “Q1 was the largest quarter on record with participation of non-traditional investors. Capital from these investors has helped drive the extension of the late stage as companies continue growth in the private market.” This kind of news is encouraging to the investor looking to get involved in venture capital commitments.

Looking back at the GFC period, an increase in seed funding is also evident. The macro challenges present at that time were different to the current challenges. The chart below, as with the more recent findings above, points to the robustness and durability of the venture capital space during economic downturns.

Conclusions

As stated at the outset, investment outperformance in any asset class is challenging, and this is especially true in venture capital. To succeed in the VC space requires a targeted approach. The data in this paper has shown that smaller, early stage investments are the best conduits for superior returns in venture capital. These funds provide the best way to access the top quartile of VC performance. By focusing on smaller early-stage funds, investors are more likely to reap the benefits of superior performance, in addition to diversification benefits, when compared to public markets.

The venture capital space is has also proven to be attractive to investors in economic downturns. In the GFC period, seed funding grew materially. And, in the current challenging macro environment, inflows into private markets such as VC are also on the rise. This trend underscores the belief among investors that VC forms an important part of any investment portfolio — in both supportive and challenging macro environments.