Venture capital is taking over other investment assets

Alexander Chachava, a Managing Partner at LETA Capital, explains how the pandemic affected startup financing and why the changes will be long-lasting.

We are entering an era of post-pandemics. The world is gradually adapting to the permanent turmoils and learning how to live in the new reality. The epidemic has affected all aspects of our lives and the structure of the global economy. Businesses were forced to restructure their core processes on the fly, while precisely monitoring the performance of financial instruments. On the other hand, the macro-trends that move the markets have remained unchanged. Meanwhile, the pandemic has revealed what is important strategically and what is tactical; even more, it defined the guidelines of economic development for the upcoming years. Let’s put ourselves in the shoes of an investor who wants to invest today, say, a million dollars in a potentially high-yield financial instrument.

The key question is: do the first-time investors who realized that money should work have appropriate tools for this? In fact, there aren’t many choices. We will deliberately ignore speculative or excessively volatile instruments (cryptocurrency, microlending, etc.), as well as rather conservative and low-yield instruments (government bonds and securities of “heavyweights”). Instead, let’s cover only those investment tools that can beat inflation.

One of the most obvious routes is to buy shares of public stock, the most appealing of which are listed on NYSE and NASDAQ. The NASDAQ technology sector is particularly attractive to investors. In the past decades, we have seen exceptional growth of the most valuable companies in this sector. For instance, Amazon shares have grown by 640 times since the IPO which took place more than 20 years ago, Google shares (now Alphabet) — by 50 times. In the past decades, public markets were the only channel to raise billions of dollars of financing required for further growth. Today, companies are in no rush to file for IPO, because venture capitalists are willing to continuously finance them, boosting their value to large-cap (company valuation of more than $10 billion). That is why a massive increase in the company value happens at the stage of private venture financing, and such companies come out to IPO having crazy multipliers and a capitalization of tens of billions of dollars.

At the same time, it is not uncommon for the market price per share to plummet for a long period of time post-IPO. For example, the share price of Uber at the time of IPO was $45, and now, almost a year and a half later, it is trading at around $30, in March — April even dropped below $14 per share.

In the past few years in the US has been developed a fairly large market for secondary shares of so-called pre-IPO companies. Some investors believe that they can easily get a 2–3x return when investing in growing private “multicorns” just a couple of years before their anticipated IPO, while the risks of such investments are low and the shares are liquid due to the secondary market. One could probably make some money, but the risks aren’t much less when compared to early-stage investing. WeWork’s capitalization crashed down from $47 billion to less than $5 billion in less than a year. Many seemingly successful companies, such as Palantir and Airbnb keep delaying their IPOs for years now and are also not immune from down rounds (when a company raises funding at a lower valuation than its previous investment round). When the down round happens, ordinary shares which were purchased on the secondary market will likely be diluted much more than the preferred shares from the latest rounds, the latter are protected from being diluted via liquidation preference and other instruments.

If we look at the statistics of an increase in the value of shares, the largest increase is demonstrated by investments at the early stages, which even exceed the equivalent of public stocks growth by orders of magnitude. At the same time, when it comes to early-stage investing, there are certain risks and downsides, one of the main ones is low liquidity. It won’t be possible to sell shares with a good yield until the later stages, or even before the exit, which might take six to eight years. Another downside is the high “mortality” of startups at the early stages, so only a portfolio strategy can generate healthy returns when investments are distributed among 15–20 startups backed by a specific investment approach. There is also a concept called “winner takes all”, where top-notch startups manage to attract top-tier investors and grow incredibly fast. Investing in such startups is always challenging, as one needs to win the competition over other investors, which is typically achieved not only with the price but rather with intelligence and reputation.

A professional venture capital fund is not so much an investment tool, but rather a fundamentally different way of interacting with portfolio companies where investors put their money. A professional venture firm assists in solving tactical and strategic issues of a startup, standing by for years, contributing to anything from new markets expansion to growth hacking, and most importantly, helping to build the right investment strategy.

There are several thousand venture capital funds globally for any taste and investment strategy, to each his own. Average returns of VC funds do not differ much from the returns of the public markets indices, oftentimes even lose to the latter. Venture funds need to be carefully handpicked based on both the investment strategy and their previous track record. It is not necessarily that the best returns are produced by the funds from Silicon Valley or by the largest Asian funds. For instance, our own LETA Capital I Fund, which started out back in 2012, was ranked in the top quartile of the U.S.-based funds vintage of 2012, while we invest in Russian-speaking tech and IT founders who operate on international markets (a detailed report on the results of our LETA Capital I Fund can be found here).

It is much easier for a venture fund manager to showcase decent returns on a small fund of $50–100 million, rather than on a multibillion-dollar fund. This statement is true only if the manager has appropriate experience and unfair advantages. A lot depends on the soundness of an investment strategy, those funds that are able to foresee hype rather than invest at the peak of the hype curve will always be ahead of the game. It can seem obvious that pretty much anyone with money can invest in startups themselves. Which is partially true, but this requires an expert understanding of the field of investment, as well as a team of analysts and scouts, because startup fairs rarely exhibit top-tier startups.

So where shall one with money go, whom to work with and where to invest? One could definitely take the risks, invest at one’s own risk, according to one’s own preferences, expertise and analysis of trends. This sounds like fun, engaging and exciting, but one needs to be ready to face the mistakes which are inevitable. And if this is the first experience, then financial losses can not be avoided. Nevertheless, one should always pick an industry or niche where he or she is highly knowledgeable.

There are also investor clubs. These are so-called “deal incubators” where companies raise at the earliest stages. There is nothing wrong with such clubs, but it is important to understand that club deals differ from classic venture capital deals in that each investor makes an independent decision and, therefore, faces all related risks, while the venture fund employs a professional team of experts: finance, legal, industry experts, analysts, etc. Another observation that might be useful for a first-time investor: top startups want venture capital money; startups will approach clubs and angels only if nothing works out with top tier funds.