Did Cambridge Associates Just Bust Two Long Standing VC Myths?
Cambridge Associates (CA) recently released a new report containing data about VC performance that runs counter to conventional wisdom among those who invest in the venture asset class (known as Limited Partners, or LPs). While the report ultimately argues that most Family Offices are likely better off increasing their allocation to the venture asset class, there are two pieces of data within the report that I found much more interesting than the overarching conclusion.
The first is that the best performing institutional investors have increased their average allocation to VC to 15% of the total portfolio, nearly double the size of the average allocation in 2009 (figure 2 in the report). This contradicts conventional wisdom among LPs which generally states that while a small allocation of a portfolio to venture is healthy for diversification, that exposure should be less than 10% of the overall portfolio because venture is the riskiest asset class.
Second, while name brand funds continue to perform well, new and emerging managers account for the majority of the best performing funds for each vintage (figure 3). This flies in the face of a long-standing myth in VC that only the well established, name brand funds are able to generate top tier returns.
This data is compelling because it directly contradicts some long-standing core tenets about investing in the venture asset class. Even more fascinating is the nuance behind the data that the report fails to address. Because of that, I want to dive into both of these and see if we can unpack each in more detail.
Increased Allocation to Venture
According to the data laid out by CA, LPs are increasing their exposure to venture relative to other asset classes. While I have no data of my own to support this claim, this does seem to resonate with what I have been seeing in the market during our fundraising process in 2019. However, the question is whether this increased exposure is due to a purposeful, strategic decision or a result of market conditions that have forced LPs to stretch beyond their target thresholds.
I believe it’s a little bit of both.
Let’s start with the conscious, strategic decision of allocators to increase their exposure to VC. Driven by low interest rates and a public market that many believe to be frothy, many institutional allocators are looking to other asset classes for yield. It’s hard to hit a target of 8% or 10% return investing solely in bonds and equities if interest rates are at record lows and public markets are already at all time highs. Meanwhile, VC as an asset class has performed quite well relative to other asset classes, especially over a long-time horizon.
Given the ubiquity of tech companies in today’s economy (7 of the top eight companies by market cap are tech companies) and the fact that more value is accruing to private investors rather than in the public markets (see figure 6 and page 7 of the report), there is reason to believe that VC could continue to outperform relative to other asset classes going forward.
However, the increase in allocation over time is not solely driven by LP’s desire for more exposure to VC, market conditions are forcing allocators to increase their exposure whether they want to or not.
Driven by companies staying private longer and therefore raising larger rounds in the private markets, many VC’s have responded by raising larger funds of their own (or opportunity funds in addition to the core fund) in order to get and maintain ownership in the key companies that drive most of the returns. While LPs are not required to increase their investment size into a fund as that fund scales, many choose to do so. After all, if a manager is able to raise bigger funds, presumably they have generated superior returns (even if they are only paper gains) and why wouldn’t you as an LP want greater exposure to a manger that is performing so well?
Compounding this effect is the fact that the average time between fundraises for venture funds has decreased dramatically over the last 10 years. Historically, conventional wisdom was that VC funds would raise a new fund every three or four years. However, the pace of investing has increased substantially in recent years (whether this trend is good or bad is a topic of a separate post) to the point that many venture funds are going back to market every two years. This means LPs need to re-up sooner and more often then they might have originally planned.
And then there is the biggest market factor of all, the fact that VC backed companies are staying private much longer and in doing so, LPs are not receiving distributions they otherwise would have. Venture Funds are supposed to have 10–12 year lifecycles but many are extending well beyond that because there are still valuable companies in the portfolio that have yet to exit. Thus, they have an ever-increasing amount of capital tied up in more and more funds. This lack of liquidity for LPs means they aren’t receiving returns they would normally use to recycle back into venture but also allocate to other asset classes in order to re-balance their portfolio. In short:
New & Emerging Managers vs Established Brands
Many believe that the well-established name brand venture funds consistently are the best performing funds year to year. Sure, there are occasionally new managers or funds that break into the upper echelon, but the conventional wisdom is if you are not investing in one of these established funds, you are better off avoiding the asset class all together.
The rationale (right or wrong) goes as follows. Venture is driven by the power law with a very small portion of companies accounting for the vast majority of the returns in the asset class. Thus, in order to have a well performing fund, a VC must invest into at least one of these small number of hugely successful companies. And since the best entrepreneurs would naturally want to work with the best and most successful investors, these brand name funds will get the lion’s share of the best deal flow. These funds will also be able to attract the best talent to further help them attract and evaluate the best companies. Thus, it becomes a reinforcing cycle whereas only a handful of venture funds will deliver top tier results.
Yet, this is the second time CA has released a report with data that flies in the face of this long-held belief. The first was in 2015 and here again in 2020. These two reports both show that for any given for any given vintage year, the majority of the best performing funds are actually new and emerging managers rather than the established firms.
So, are LPs actually better off concentrating on new and emerging managers rather than established funds? The answer is yes and no.
First, let’s discuss where emerging managers might have an advantage over established funds. One of the most (perhaps the most) critical characteristics in determining success of a manager is access to a network of the best entrepreneurs. While established funds have brand recognition to attract entrepreneurs, newer managers often come out of different pools of talent. Founders Fund is an excellent example of this, having deep ties to the “PayPal Mafia,” which went on to create a number of amazing companies. Having intimate knowledge of and relationships with those talent pools is a big advantage that newer funds can leverage. Other ways new funds might have advantages could be experience in new markets and technologies, pioneering new models of investing, or they are simply hungrier because they haven’t made a name for themselves yet.
Lastly, emerging funds tend to be smaller and thus invest at earlier stages. Very few managers are able to raise a large fund right out the gate and thus most start at the seed or pre seed stages. As a result, these smaller funds invest at lower prices which, if they get into the right company, have higher upside potential than established funds who have raised very large funds and therefore invest the majority of their capital at later stages.
This line of reasoning combined with the data in the CA report would suggest LPs should forget investing in established funds and focus exclusively on emerging managers. Well, not so fast.
While I love these types of reports and think CA generally does a great job of analyzing data to find new and interesting conclusions, there are subtleties the report fails to address. Most notably, selection bias.
What the report does not take into consideration is the fact that there have been so many new funds launched. In November 2019, Samir Kaji released an updated list of all micro funds (funds sub $100m in size) and the list is up to nearly 1,000 funds. While this isn’t a perfect count of new and emerging managers, new funds tend to be smaller in size, so this is a good proxy. With so many new funds relative to the number of established funds, the odds are stacked in favor of new and emerging funds to be the majority of the top list.
What the report doesn’t show is what percentage of new and emerging managers are not in the top quartile. It would be an interesting analysis to compare on a relative basis, how likely is it for an emerging manager vs established manager to make the top quartile. My assumption is that there are a wider range of outcomes for new and emerging managers so while there will be some spectacular successes among newer fund managers, it is likely the case the established funds generate a more consistent return.
Another subtlety the report fails to address is scale. The simple fact is that newer funds tend to be smaller in size and TVPI tends to favor smaller funds. It’s much harder to generate a 3–5x return on $500m than $20m. For that reason, it is more common to see smaller funds able to produce larger returns purely on a multiple basis.
Rather than an either-or conversation, I think this report gives strong credence to the fact that LPs should constantly look to include some emerging managers. Much like an LP might diversify its portfolio by geography, stage or sector, it should also have a mix of emerging and established managers. Furthermore, some of those small funds may go onto become some of the best new franchises over time and the best way to get into the next great fund is to already be an investor.
