Venture Capital in a Private Equity Portfolio
Written by OMERS Ventures managing partner Jim Orlando
Overview
Private Equity (PE) and Venture Capital (VC) represent two sides of the same coin. Although both are fundamentally about buying low and selling high, the investment approach taken by the two in pursuit of alpha are very different.
Unsurprisingly, this difference in investment approach has subjected PE and VC fund returns to varying market forces and cycles since inception, which in turn have shaped their investment habits and performance to date. VC returns were characterized by super-sized returns as the Internet was born, and then largely underperformed other asset classes after the dot-com crash. In more recent years, venture capital has achieved a renaissance of sorts as the mobile Internet has taken hold. Conversely, private equity funds had historically outperformed their public equity counterparts until recent years following the credit crisis of 2007 and 2008.
Given the historical performance of venture capital, coupled with the reality that the bulk of returns are generated by the top quartile (arguably even top decile) fund managers, institutional alternative asset managers tend to wonder if this particular asset class is worth their time and effort. So why do venture funds continue to exist? It all comes down to the pinnacle of any sound investment strategy: diversification.
As highlighted in the following sections, PE and VC returns are essentially uncorrelated. Consequently, when the two are deployed in conjunction as part of a diversified portfolio strategy, they can in fact generate superior returns for alternative investors than what is achievable through a standalone 100% PE or 100% VC portfolio. This is the guiding philosophy of the institutional investors who back the top quartile venture funds, and on whose behalf venture capitalists make investments in early stage companies.
The implication of this reality is that despite the volatility of venture capital returns, the potential for a home run and massive exit in a portfolio still makes it a very compelling strategy for a private capital investor.
Part 1: The Appeal of Private Equity and Understanding Its Returns
For years, well-diversified institutional asset managers have turned to private equity for superior returns versus public market returns. The promise of private equity is that it generates higher returns by trading off liquidity (private equity assets are not traded publicly and hence are inherently less liquid) and increased leverage (versus, for example, publicly traded counterparts). To illustrate, the average debt/equity ratio of the SP500 is 33%[1], whereas a typical leveraged-buyout is achieved with significantly more debt — typically around 75%, and sometimes as high as 90%[2].
The private equity industry has largely delivered on its “better returns” promise over the last few decades. Figure 1 shows the average IRRs achieved for private equity funds on a vintage year basis since 1990, graphed against equivalent IRRs of SP500 pubic market returns (where an investment in the SP500 in any one year is held for the typical life of a private equity fund, up to a maximum 10 years). Until recently, dollars invested in an average performing private equity fund (and retained for the life of that fund, due to the illiquid nature of the fund) will generate a higher return than the same dollars invested and retained in an SP500 index for the same period of time. As an example, $1 invested in 2004 in an average private equity fund would have been worth $3.13 at the end of 2015 (10.92% compounded annually for 11 years), versus $1.79 in the SP500 (5.41% compounded annually for 11 years).
Figure 1[3]: Private equity returns typically outperform public market returns. Private equity and public market returns are somewhat correlated.
Diversification in Private Equity
From a diversification standpoint, Figure 1 also shows that private equity returns are somewhat correlated to returns of the public markets. Private companies are of course subject to the natural ebbs and flows of the economy, just as their public counterparts are. The correlation coefficient (r-squared) between the two lines on Figure 1 is approximately 0.6 (statisticians consider anything above 0.5 to be “correlated”, and above 0.8 to be “highly correlated”).
Institutional asset managers often seek to diversify within private equity. There are numerous manager types and sub-asset classes that fund-of-fund managers can seek to diversify across. Some example diversification strategies include investing across different geographies (U.S., U.K., continental Europe, Asia, etc.), and in different manager-types (growth-oriented buyouts, turnaround practitioners, etc.). However, the most common diversification strategy is to invest across managers who specialize in different sizes of underlying assets; a typical institution would have investments and relationships across several different mega-buyout, large buyout, mid-market, and small-market buyout funds.
The degree of diversification that is achieved via this strategy is often overestimated. Figure 2 shows the average returns for private equity managers of different size specializations. As is readily apparent from the graph, these returns are highly correlated with one another. Table 1 shows the correlation coefficient between each of the various sub-asset classes. Returns for the buyout industry are strongly correlated to one another independent of the manager type, ranging from 0.7 to 0.9. Portfolio managers who believe they are achieving a degree of diversification by investing in different buyout sub-asset classes are simply mistaken.
Figure 2[4]: Returns between different sizes of buyout funds is strongly correlated.
Table 1[5]: Returns between different sizes of buyout funds is strongly correlated.
The high degree of correlation between the different sizes of buyout funds alludes to an opportunity for private equity investment managers to consider an alternative asset class for diversification. Ideally, this asset class is able to amplify overall fund returns when deployed in conjunction with private equity. It should also complement the highly specific core competencies of traditional private equity funds and the individuals that manage them. Venture capital is an obvious contender and the following section highlights how venture capital, if included as part of a broader private equity portfolio, can provide superior returns to institutional investors while simultaneously reducing the overall risk profile of the portfolio.
Part 2: Venture Capital in a Private Equity Portfolio
Venture capital as an asset class has had numerous ups-and-downs over the years; this is shown in Figure 3, which demonstrates a wide range of average returns over various vintage years. Returns are extremely volatile when compared against private equity, and manager selection is extremely important with the lion’s share of the better returns generated by the top quartile and even top decile managers. As described in the previous section, risk in venture capital investments is more related to technology risk (will the product or service that a venture-backed startup is building actually work?) and market-adoption risk (will customers actually buy the product or service that a venture-backed startup is building?).
Unlike traditional private equity, debt and debt availability does not play a role in venture returns as debt is typically not used in venture capital transactions, particularly early-stage venture investments. As shown in Figure 3, venture returns are not strongly correlated to public market or private equity returns (correlations of 0.37 and 0.02, respectively). As a recent anecdotal example of the lack of correlation, Apple’s world-changing iPhone was released in the midst of the 2007/2008 credit crisis. The credit crisis all but shut-down PE investment, whereas the iPhone launched the mobile web platform which has since provided for years of successful venture investment.
Figure 3[6]: Venture returns are not correlated to public market or private equity returns.
Given that private equity and venture returns are not strongly correlated, it is possible that a mix of the two asset classes can provide better risk-adjusted returns. Portfolio theory would suggest that an efficiency frontier and Sharpe ratios can be calculated; the optimum portfolio mix will be the point at which the Sharpe ratio is maximized.[7] This is shown in Figure 4 — the Sharpe ratio is maximized (and therefore the optimal portfolio mix is found) at the point where the Capital Allocation line intersects the efficiency frontier curve. The analysis shows that a modest amount of venture capital in a private asset fund managers’ portfolio achieves the optimal returns, and, based on historical returns, a split of 92% private equity and 8% venture capital is optimal.
Figure 4: Based on historical fund returns, an optimal portfolio consists of 92% private equity and 8% venture capital.
The key takeaway as a result of this analysis is to acknowledge that an investor’s appetite for risk in an investment is a function of returns that are controlled for volatility.
Venture capital does not have a history of consistent returns, but a modest exposure in an institutional investors’ portfolio can provide stronger return potential. This potential, coupled with the power of diversification in a broad alternative asset portfolio, is what keeps private investors coming back to venture capital.
Final Thoughts
Private equity has long generated superior returns versus most other asset classes, and is expected to continue to do so. Thus, it should remain a key part of an alternative asset managers’ portfolio. Private equity, however, does not innately offer the diversification necessary to secure and increase overall portfolio returns. Venture capital, which consists of investing in growth-oriented innovative technologies, is uncorrelated to private equity and can play a meaningful role in reducing portfolio volatility and increasing returns. The OMERS approach, with a modest long-term 10% allocation towards venture capital and implemented with a focus on reduced management fees and reduced volatility is a strong approach to successfully building value in alternative assets.
[1] Friedman, Benjamin M. The Changing Roles of Debt and Equity in Financing U.S. Capital Formation. Page 52. Chicago: U of Chicago, 1982. Google Books. Web.
[2] “Leveraged Buyout (LBO) Definition | Investopedia.” Investopedia. N.p., Web.
[3] U.S. Private Equity Index and Selected Benchmark Statistics. Cambridge Associates. June 30, 2014. Web.
[4] “Performance.” The 2014 Preqin Global Private Equity Report. New York: Preqin, 2014. 52+. Web.
[5] “Performance.” The 2014 Preqin Global Private Equity Report. New York: Preqin, 2014. 52+. Web.
[6] U.S. Venture Capital Index and Selected Benchmark Statistics. Cambridge Associates. June 30, 2014. Web.
[7] Roychoudhury, Saurav. “The Optimal Portfolio and the Efficiency Frontier”. Capital University. 2007. Web.
