Venture capital — an attractive and proven asset class for long-term financial returns
As the “Endowment Model” has become broadly adopted by US institutional investors, venture capital (VC) has proven itself as a powerful instrument for long-term financial returns and value creation. Most institutional investors and long-term capital allocators in Europe have yet to adopt the same model, and venture capital remains somewhat of an under-communicated, unfamiliar and opaque asset class. The mechanics that make venture capital successful are similarly unfamiliar. This article outlines the case for VC from a European and Nordic perspective with a view to inspire larger allocations.
TLDR version
As this is a long and data-rich story, here is an outline:
- VC has driven returns for the Endowment Model + proven itself
- The Power Law dictates winning investment strategies
- VC delivers top returns for consistent, diversified and selective LP allocations
- 🇪🇺 returns are on par w/🇺🇸 and 🇩🇰🇫🇮🇮🇸🇳🇴🇸🇪 tops in efficiency 💪
- Call to action: Join the ride 🚀
VC drives returns in the Endowment Model
David Swensen pioneered the Endowment Model at Yale, where he served as the Chief Investment Officer (CIO) of the endowment from 1985 until his passing in 2021. The model emphasizes diversification across different asset classes, including a higher than conventional capital allocation to alternative assets such as venture capital, buyout and hedge funds to enhance returns and reduce risk through diversification.
During Swensen’s reign at Yale allocation to alternative assets in general and venture capital funds in particular, increased. In 2020 venture capital became the largest asset class, making up 23% of the endowment’s total assets, while other alternative assets combined for 41% of the total. Lakestar has produced an excellent report on the Endowment Model seen from a European perspective. I have borrowed some diagrams.
Yale’s endowment experienced remarkable growth as a result, achieving some of the highest returns among institutional investors and relative to market benchmarks. The fact that venture capital has been the best-performing asset class over approximately the same period was an important contributor to this success.
Swensen’s performance and investment principles, outlined in his book Pioneering Portfolio Management, have had a significant impact on the field of institutional investing, and his approach has been widely studied and emulated by other endowments and institutional investors. In the period 1999–2020 private equity, including venture capital, growth equity and buyout, has significantly outperformed public markets in all geographies. Accordingly, US endowments and institutional investors have increased their allocations to private equity, inspired by the Endowment Model, with the largest and most successful endowments leading the way. By 2019/’20/’21 private equity and venture capital allocations/targets, as a percentage of total assets, looked like this:
Venture capital’s fit as an asset class for individual investors is naturally dependent on short-term liquidity needs, and for some institutional investors, e.g. pension funds, regulatory constraints may limit allocations. The attractiveness of venture capital is nevertheless gaining recognition and traction. In the UK nine major pension funds plan to invest at least 5%/£75B of their assets into startups and VC firms according to Sifted. Calpers, the biggest US pension fund and a pioneering venture investor, plans a multibillion-dollar push into venture after a “lost decade” according to FT.com. Beyond lost returns from being under-allocated to VC recently, Calpers sees diversification and higher interest rates putting pressure on leveraged buyout returns as venture advantages.
“If you look at the highest performing private equity programmes, many of those have extremely high proportions of their private equity portfolio in venture. So bearing that in mind, Calpers should be participating more in venture”, Anton Orlich, Managing Investment Director for Growth and Innovation, Calpers (from FT.com)
In Norway, KLP has stepped up venture investing impressively over the last half-decade, including becoming an Alliance investor 🙏👊. Unfortunately, the Norwegian financial regulator is conservative in terms of allocation guidelines and cost accounting for all types of private equity, as covered by Shifter.no (in 🇳🇴) — not a showstopper, but an unfortunate friction point. Finland is overperforming within Europe with three institutional venture investors, Elo, Ilmarinen and Varma, on Sifted’s top list.
The fact remains that European institutional investors lag behind institutional investors in other regions with respect to private equity, including venture capital, both in terms of target and actual allocations. See diagram below. It is shocking to learn that European pension funds overall have allocated less than 0.02% of their capital to venture capital 🤯 according to Lakestar. European institutional investors are thus under-allocated to private equity and massively under-allocated to venture capital today.
Assuming similar performance and allocations going forward, European pension holders will miss out big-time relative to pension holders in other markets. See example below comparing US, Canadian and German pensions.
The power law — the law of gravity in VC
If there is a single concept that is critical to understand in venture capital it is the power law distribution of investment returns and how it drives fund returns and investment strategy. The power law forms the statistical basis for successful startup investing and is analogous to the law of gravity in venture capital, as it is impossible to escape. The concept is much talked/written about and is well-known within VC. To non-VC investors, it is less familiar and a bit counterintuitive. The return profile for “normal assets”, such as listed shares, mature private companies, currencies, bonds, etc., can be approximated by a normal distribution. Capital can be allocated accordingly to generate investment returns and index allocation/investing makes sense as a result. Startups are simply not “normal assets”, as the return profile for startup investments follows a power law distribution. The different return distributions from a statistical perspective require a different model for capital allocation aligned with the underlying statistics to be successful, as is the case for VC investing. It is worth noting that the power law distribution is found not only in startups but also in other hit-driven businesses such as books, music, movies, video games and even historically in whaling, as presented in the book VC: An American History, by Thomas Nicholas.
“When Peter Thiel writes of the heavily skewed distribution association with modern VC that ‘a small handful of companies radically outperform all others’ he might just as easily be describing the whaling industry two centuries earlier”, Thomas Nicholas, author of VC: An American History
The diagram below shows the power law distribution and the normal(ish) distribution.
Correlation Ventures, a US data-driven VC, publishes one of my favorite diagrams in the industry with the most comprehensive dataset proving the power law, now based on 35 000 realized investments. The diagram below clearly shows the power law distribution, even if the distribution overall has improved since the 2019 diagram version due to the exceptional market performance in ’20 and ’21. It is important to understand that this dataset includes only startups that have raised venture capital, which must be considered “premium” startups. VenCap recently published a similar and interesting dataset on X based on 11 350 investments. This means that the overall return distribution for all startups will be even more skewed to loss-making investments. Various sources claim that 50–90% of startups fail, yet failing startups raise less money than successful ones.
Just like power law distribution has been statistically proven for startup returns, the impact on VC portfolio/fund returns has also been proven. The TLDR version is that the big winners, “the outliers”, drive fund returns. Chris Dixon, a partner at A16Z, has written a good blog post about this topic called “Performance Data and the ‘Babe Ruth’ Effect in Venture Capital“, where the individual investment returns are likened to “strike out” (loss-making investment), “hits” (positive return investments) and “home runs” (>10x multiple) in baseball. The post shows that the power law effect on fund returns has a high correlation with “home runs” and virtually no correlation with “strike outs”. See graphs from the blog below, showing exactly this. The data source is Horsley Bridge, using historical data on the distribution of investment returns across hundreds of VC funds since 1985. The source data shows that “~6% of investments representing 4.5% of dollars invested generated ~60% of the total returns”.
The power law and its impact on fund returns dictate the conditions for viable VC investment strategies, where the key elements are outlined below.
Venture capitalists can in principle produce fund returns through both selection and adding value as active investors to impact outcomes and portfolio returns. There is no shortage of VCs with great self-confidence, believing/claiming to be instrumental to the trajectory of startups. However, VC’s value-add impact is in most cases marginal relative to the efforts of founders and teams. In terms of securing fund returns, VC’s biggest impact is clearly in the selection and portfolio construction. The word selection is often used even if it’s not an accurate description of reality.
The power law is a highly skewed distribution of outcomes, as is the supply and demand of capital for startups. Many startups struggle to raise funding, and overall the demand for capital is bigger than the supply. For the best startups — or at least the perceived winners — the situation is the opposite; investors want to invest, and the supply of capital is bigger than the demand. In these situations, the process for a VC is: Identify opportunity -> Get access -> Get chosen. Getting chosen by the best founders is the single most important job for a VC to generate returns. This is ultimately what the investment strategy and value proposition to founders need to focus on. This is also where great VCs excel relative to other investors in the market looking to invest.
It should be noted that an alternative strategy could be to aim for being “contrarian and right” — i.e. capitalize on great opportunities that no one else sees. This potentially has an even bigger upside due to lower valuations at investment, but has a significantly higher risk for multiple reasons and typically requires even more capital and tolerance for financial risk.
The general characteristics of potentially big winners are:
- Large total addressable market — at least within the next 10 years
- Potential to become the category winner
- Aligned with long-term trends to enable compounding growth
- Potential for fast scaling/growth
- Founders and teams uniquely positioned to capture the opportunity
- Potential to return the fund
Exceptional returns through consistent and selective VC allocation over time
Venture capital is an important component of the endowment model and its success, as seen above. The underlying reason is simply that venture capital has been the best-performing asset in terms of returns both overall and among alternative assets over the latest decades. See diagram of alternative assets returns below.
While venture capital has the best median returns of the asset classes, it also has more dispersion in performance from top-performing assets to bottom-performing assets, which means that selection impacts returns significantly. JP Morgan Asset Management’s Guide to Alternatives documents very similar performance, where venture capital is ranked as the best-performing asset class for the period 2013–2022 with an IRR of 19.3%, but also with the highest variability and volatility.
A significant part of the variability in the returns of venture funds relates to the timing of investments and exits, which broadly correlates with the vintage — the year each fund was established. This specific variability relates mainly to macro market trends and cycles, even if the asset class has also improved with the ecosystem's maturity. See diagram below showing dispersion between and within VC vintages. Even within vintages, there is significant variability, caused by different investment strategies, execution and the hit-driven nature of venture capital.
Venture capital is an industry with some well-known brands and franchises, primarily in the US. It is easy to think that getting top brand allocation is the path to success. While seeking brand allocation is a reasonable path, variability in returns also applies to large brands; VC funds are undoubtedly assets deserving the disclaimer “past performance may not be indicative of future results”. Data actually shows that smaller funds outperform larger funds across all quartiles to many’s surprise. See diagram below showing IRR for different fund size brackets based on a dataset from Pitchbook of 1500 funds, vintages 2003–2022. It turns out that the power law is unkind to large funds, as it becomes increasingly hard to find big enough winners to return large funds. Most top VC brands have increased fund sizes and assets under management massively over time, with some notable and top-performing exceptions in USV and Benchmark sticking to their strategies and positioning.
Based on this data and the fundamentals of venture investing, the logical guidelines for investing in venture funds are:
- Allocate capital consistently over time
- Spread allocations across multiple funds/managers
- Pick funds/managers with strategies and the ability to get access and allocation in future big winners as the critical dimension
Europe and the Nordics are performing great
Venture capital may look like mainly a US/Silicon Valley phenomenon to outsiders. Even today the US is by far the biggest startup ecosystem and market, and the US is home to both the biggest tech companies and the most famous venture capital firms. Surely this is also where the big returns can be found, right? A significant proportion of institutional investors around the globe think this way and seek allocations in the leading US VC franchises as LPs. After 5 years in Silicon Valley, I am also a big fan of the ecosystem that pioneered the model and has led the way since day 1. However, Silicon Valley has inspired and produced the playbook for startup founders and investors around the world, who have raised their game. The steady rise of the European tech ecosystem is under-communicated. Today Europe accounts for a significant share of global VC funding, as can be seen from the diagram below, up from a minuscule share two decades ago. This has happened as the prominence of China/Asia has faded, and global investors have discovered the relative stability and large pool of tech talent in Europe with an attractive mix of cost, quality and productivity. The rise of Europe is most pronounced in early-stage investing with the anticipation that late-stage funding will follow.
What is even more impressive is that data shows (see below) that European VC returns outperform US VC returns both over the short- and long-term, which is a great reason to invest in Europe. The causes are hard to specify, but it is likely that the lower costs in Europe make company building more capital efficient, translating into returns.
While Europe is on a roll in terms of growth and performance, the Nordics is clearly one of the most progressive and advanced tech ecosystems in the region. Unfortunately, there are few datasets on Nordic venture capital performance. To address this situation the Nordic Venture Network created the Nordic Venture Performance Index (NVPI) to establish a credible Index showing the actual returns from the Nordic Venture Capital market. The index is meant to be an efficient tool in marketing the Nordic venture capital and startup market leading to more investment into innovative Nordic companies. The NVPI includes 10 venture capital firms, 43 funds and 835 portfolio companies, analyzing the period 2000–2020 based on complete cash flow information from all participating funds. The latest data from 2021 can be seen below.
It is difficult to compare data from different indexes and time periods. The published NVPI numbers don’t include data from 2021, the strongest venture capital year in recent history, or later. Given the strong NVPI performance before ’21, it’s reasonable to assume that the Nordic performance will be equal or better than the overall European venture capital performance shown above.
Nordic tech is also punching above its weight in terms of generating unicorns, where it is broadly on par with the US, while Sweden is surpassing the US on a per capita basis. Unicorns are significant, as they are the big winners needed to generate strong returns from the power law distribution. The Nordics are more capital-efficient than other tech hubs in building unicorns — generating more than twice as many unicorns per € invested than the UK and is significantly more capital-efficient than the US. The Nordics market is generating “Olympic champion startups”, not national champions.
This performance is further supported by data showing that Nordic capital efficiency means that value is built most efficiently in the Nordics among European regions.
The Nordic startup ecosystem has reached maturity and the talent/capital flywheel is now turning at high speed. The outside world is taking notice, as shown by recent articles from Sapphire Ventures and Marcau Partners. The conclusion is simple: The Nordics is a great place to build and invest in tech startups! 💪
Join the Nordic journey
Venture capital may not suit all investors due to the natural illiquidity and high variability/volatility. For long-term term investors that can stomach these characteristics for parts of their capital base, venture capital is an exciting and highly-performing asset class that can make a difference for total returns. This is particularly true if you also believe that tech will continue to be a strong force changing the world and growing faster than other market segments.
We believe that the case for venture capital is strong. We hope this is more apparent from the outside when reading this article. Consider this an open invitation to engage if you have a genuine interest in VC, want to discuss opportunities in the Nordics, or learn more about our activities at Alliance VC. Feel free to reach out to me directly or in any of the Alliance channels online.
(This is an English-language variant of a Shifter.no article in Norwegian.)
