Unpacking Alpha in Venture Capital — Chapter 2: A Brief History & Some LP Myths

The purpose of this chapter is to give a brief introduction to VC from an external lens and to state some of the myths that I think objectively, less informed pools of institutional capital have about the asset class.

A Brief History of VC

Put simply, VC is a class of professional money managers seeking to finance companies that lack the traditional assets, present ex ante uncertainty and display information asymmetry. The industry as a professional asset class dates back to the 1960’s and has a storied history and quite a concentrated genealogy. Venture capital has had a disproportionate impact on enterprise value creation. Notable academics identified that from 1999 through 2009, over 60% of US IPOs had VC backing whereas only 1/6 of 1% of all US enterprises are VC-backed.

In terms of historical performance, the 1990s was a truly stellar decade in the VC industry when certain “marquee” funds such as KPCB, Sequoia, NEA and Matrix Partners generated truly stellar returns with IRRs registering way in excess of 50%. Then the Dot.com bubble burst and the industry had a largely poor decade in the 2000’s. Current indications are that the asset class is performing well decade (post-GFC) both in absolute and relative terms.

Aggregate Global VC Performance — Source: Preqin — Global PE & VC Report 2018
KS-PME (versus Russell Growth Index) — Source: PitchBook Data, Inc. — PME Benchmark Report (through Q2 2017)

Venture Portfolio Math

For new investors in the asset class, a robust understanding on the returns profile of a venture capital portfolio is required and there is a certainly an educational component to this. VC is an asset class that requires a different approach to portfolio strategy given that the majority of positions are high risk, minority stakes and the probability of success of early stage companies is low.

Company returns to funds are Power Law distributed which is counterintuitive to conventional risk adjusted investing. Simply put, 80% of the returns come from 20% of the deals. With this in mind, it is hard for new LPs to get comfortable with this but it is a question of investment strategy to ensure that any investment has the potential to “return the fund”. The historical returns for the top 100 venture-backed exits shows this distribution as the majority of annual exit values are concentrated in the top 25 investments per year indicating that value accrues to the outliers results.

Source: PitchBook Data, Inc.

Where Are We in the Cycle?

Global venture capital fundraising and investment has experienced a long term growth trend since 2008/9. Deal activity is 3x the Dot.com period but we are still below peak Dot.com commitments (note, this comparison is distortive given the non-traditional capital participation in the asset class).

Source: PitchBook Data, Inc.

Focusing on the recent decade and taking VC as a whole (not splitting geographically at this stage) I consider there have been two major themes over the last decade in the asset class:

  1. the proliferation of broader participation at the earliest stages (angels, accelerators, crowdfunding etc.) and rise of the “lean startup” in a mobile driven era; and
  2. the influx of non-traditional capital at the later stages (Public market investors, Corporates, Sovereign Wealth Funds and the most high profile being the Softbank Visions Fund) and the rise of the “unicorn”.
Source: PitchBook Data, Inc.

Whilst certainly indicative of a broader interest in technology, the growth has been driven by a systemic search for yield via alternative assets in the face of depressed returns in traditional risk assets. With rates still expected to remain low and macroeconomic indicators (inflation & labour markets) still (somewhat surprisingly) depressed, my expectations are that capital will still be keen to search for risk assets and venture is at the top of this spectrum. Even if you argue we are at the brink of regime shift, this is still a good time to invest into VC as the vintages from 2010 onwards show how performance improved in the post-recession climate by virtue of adverse selection of only the best entrepreneurs.

That said, the result of these increases are that arguments have pervaded in recent years about another tech bubble. I am in the camp that we are not in such a bubble. Whilst certainly valid questions can be asked about the fundamental valuations of some of the current cohort of “unicorns”, I consider there has been a structural shift in the capital allocations between private and public markets in favour of private companies which now represent a meaningful asset class that investors should consider. And in the public markets, the position today is fundamentally different to the Dot.com bubbles largely as a result of better understanding of technology business models.

In my view, the net impact of this period of growth has been:

  1. to increase competition at all ends of the venture capital investment spectrum driving down persistence in performance (albeit pushing prices up)
  2. to bring more transparency and innovation to VC enabling new managers to emerge as alpha is more widely dispersed; and
  3. to accrue significant value to early stage investors which cannot be ignored.

For investors in VC funds, inflows and outflows are holding steady indicating VC can still deliver amongst the noise further making the case for participation.

Source: PitchBook Data, Inc.

My conclusion therefore is that there is no structural reason not to enter the asset class in today’s climate assuming you can solve for alpha.

Some LP Myths

You can’t access deals so you should do fund of funds (“FoF”): An obvious first port of call for an institutional pool of capital, looking at the asset class for the first time is FoF. Whilst this is certainly a valid route for those looking for passive exposure, for investors looking for more from a VC allocation, FoF or LP commitments have notable limitations, including:

  1. No guarantee of access: Whilst we will learn in the following section that the core narrative that investing in the brand name funds is not a guarantee of top decile performance, by function of persistence decline, it is also not possible to obtain allocations in the top performing funds (both by virtue of sizing and timing). Funds are capacity constrained and reward first LPs in..
  2. Diluted returns — VC FoFs perform in aggregate only in line with the median direct funds returns or below par when compared with direct, net of fees. On a risk adjusted basis, there is only marginal benefit to an allocation and I consider given the transparency of participants in the VC community and the limited pool of funds available, the FoF value add can be replicated on a cost-effective basis through the methodology I will describe in this series. As a result, there are no structural or informational barriers to investing direct and limited evidence to support detailed FoF value add.
Source: Preqin (FoF Sample (5–10 per vintage) & Top Decile) /FoF via PitchBook Data, Inc.

New entrants cannot win as they do not have a brand and no evidence of past performance: Selecting top performing existing managers with an expectation of performance persistence has the driving factor for manager selection historically as a result of the 1990s narrative. It has been considered that true manager performance can only be judged by fund 3 onwards. However, in the recent decade as the industry has matured, there is a raft of new evidence (see here, here and here) to support how new entrants have consistently performed well as alpha has been more broadly dispersed. In fact, new and emerging firms consistently account for 40%–70% of the value creation in the top 100 investments over the past 10 years.

Source: Preqin Report: Lift off! Launching a First-Time VC Fund with Institutional Support
Source: PitchBook Data, Inc.

You are locking capital away for 10+ years: This is a more obvious point but in my experience, some first time VC institutional investors still see challenges in the liquidity profile of the asset class i.e. that you don’t get any money back for 10+ years. In fact, evidence from top performing portfolios (i.e 5 -10x) are that average holding periods for investments are in fact around the 4.5–6 year mark. Whilst the technicalities of distribution mechanics are an important and highly negotiated components of a fund agreement (e.g. waterfall options, catch-up, claw-back) and must be considered to ensure GP-LP alignment (with geographic differences), capital is returned within the fund life cycle. This is also a dynamic area of venture capital with the pace of start-up growth accelerating, the advent of new more liquid fund structures and the increasing prevalence of VC secondary funds (mirroring PE maturation). I expect changes to come and LPs should demand this.

You must de-risk and do later stage investments to avoid losses: VC is an asset class that should be capacity constrained and the historical returns show the delta in performance between early stage and late stage. Venture doesn’t scale and value creation is derived from capturing businesses at the early stages pre-inflection point and the hyper growth phase.

The average valuation steps-up in the first rounds are also disproportionate to the cumulative probability of success. Accordingly, Series A still represents the best value and the benefits of pro rata ownership protection cannot be understated.

Source: PitchBook Data, Inc. — Global Median Pre-Money Valuations by Round (2012 — H1 2017) / TechCrunch Analysis of 15,600 U.S.-based technology companies founded between 2003 and 2013
Source: PitchBook Data, Inc.

To get real value you need to IPO (get permanent capital): This may be an institutional hangover from the Dot.com era and a misperception of how long term value is accrued but whether an IPO is the best exit or not is not a relevant question for an early stage venture capitalist. As noted earlier, there has been a structural shift between the private and public markets as high-growth companies actively pursue growth strategies without cementing long-term capital. An exit via M&A or IPO is still an exit and for early stage VCs, bets are placed with a view to the business becoming a +$1Bn business and having an exit probability. In fact, whilst times to $1Bn+ valuations are compressing, the time to IPO has expanded from 3.1 years in 2000, to nearly 10.7 years in 2017.

VC is geographically constrained to Silicon Valley: One of the most powerful narratives expounded by Silicon Valley VCs has been that it is important for startups to be located in and around the Valley. This is primarily due to network resource density. This has been an effective strategy creating jobs and wealth in California from net migration and now over 52% of founders of Valley start-ups are non-US. The historical exit data also shows the success of California as an ecosystem and there is no doubt this compound advantage will continue for the short to medium term. That said, new evidence supports that performance is improving in relative terms outside the US and it is now theoretically a relative assessment as to which ecosystems will generate the next generations of technology companies. Further anecdotal support for the advent of global VC hubs is showcased here.

Source: PitchBook Data, Inc.

Today, however the narrative is changing and the argument that the ability to monitor the portfolio company, to coach the management team, and to provide introductions depends upon the ability to interact frequently and locally is counter-intuitive. Analysis has shown that more reputable VCs, in general, exhibit less local bias and are comfortable with investing internationally and in fact out-performance has been driving by non-local investments. Whilst Silicon Valley has undoubtedly been the epicenter of technology innovation, other hubs of ideation, innovation and global problem solving are developing fast. One can see this in the explosion of venture financing in China (albeit the data here is notably more challenging).

Source: PitchBook Data, Inc.

The Next chapter seeks to go deep into dis-aggregating and un-bundling Alpha in VC and how to systematically generate Alpha in the asset class.

Thank you for reading!

Disclaimer: All the opinions are my own and do not reflect those of Jetstone Asset Management (UK) LLP. This document is provided for informational and discussion purposes only. It is not a solicitation or an offer to buy or sell any security or other financial instrument. Any information including facts, opinions or quotations, may be condensed or summarised and is expressed as of the date of writing. The information may change without notice. It may not be reproduced either in whole, or in part, without my permission. This document is not marketing material or is not used for the purposes of marketing. Copyright Ahmad Butt © 2018.