To Make Money in Venture Capital, Invest In Illiquidity

In venture capital, it pays to be right. But it pays even more to be right and contrarian.

As the FT has reported, this year’s Graham & Dodd award recognizes the discovery of a new way to identify stocks that are poised to outperform the market. Traditionally, there have been three widely-held beliefs about the most valuable stocks:

• Cheap stocks outperform more expensive stocks;
• Small stocks outperform larger stocks; and
• Winning stocks tend to keep winning, and losers tend to keep losing.

Now, there’s a fourth factor:

• Less liquid stocks outperform more liquid stocks.

This makes sense. Investors should earn a premium for holding an illiquid stock over a long period of time. According to the FT, for 3,500 public stocks, “the least liquid quartile, from 1972 to 2011, returned an average of 16.38 per cent, compared to 11.04 per cent for the most heavily traded stocks, and 14.46 per cent for the universe of stocks under control.”

Not bad. But, how does this translate to private stocks? The FT article has an interesting clue:

[L]iquidity tends to overlap with “newsworthiness” or “popularity.” Stocks at the centre of attention like Google or Facebook are highly unlikely to show up as low-turnover stocks for many years to come. Stocks that are neglected and ignored will be relatively illiquid.

In private markets, the stocks of unpopular or ignored companies tend to suffer from illiquidity. Founders whose companies or target markets are unpopular or overlooked have a harder time trading their stock for investment capital than founders building companies in the hottest sectors.

Yet, in venture capital, it’s these highly “illiquid” investments that make the most money. Some of today’s most valuable venture-backed startups, like DropBox, AirBnb, and Uber, were unpopular with investors when the companies were seeking their very first rounds of financing. Likewise, investing in the consumer internet in the wake of the bursting dot.com bubble was unpopular in the extreme. Just ask founders who were trying to raise money during that time. But, those were the very years when Facebook and Twitter raised their first outside rounds.

Early investors in these companies have earned huge liquidity premiums, largely for investing in technologies or in sectors that were unpopular and being right. It seems that a contrarian’s taste for illiquidity coupled with a long-term mindset is one of the sweetest recipes for success in venture capital.

photo credit: Randy Son Of Robert