Venture capital set for further growth

This month we focus on venture capital and growth equity investments. We highlight the trend toward increased allocation to these type of alternative assets, the ongoing evolution underway in these sectors, as well as their strong returns over the past decade. We also highlight the need to assess top managers, given the material dispersion of returns in these sectors.

We continue to recommend a full allocation to alternatives

In addition to maintaining our moderate risk-on stance, we continue to recommend a full allocation to so-called ‘alternative’ assets. For most portfolios with balanced-to-growth risk profiles, this equates to a 16-20% portfolio weight, while for larger corpuses with a more endowment-style profile this could mean an allocation to alternatives as high as 45%.

We group alternatives in three broad sub-sectors: hedge funds, private markets and real assets. As our regular readers would know, several times last year we focused on real assets, typically investments in unlisted real estate, infrastructure and sustainable resources. In particular, we focused on their defensive (inflation-hardy) features. While real assets are typically at the more defensive end of the spectrum, unlike government bonds, they continue to retain a relatively attractive expected total return of 5-6%.

Examining growth-orientated alternatives

This month we look to the more growth-orientated end of the spectrum of alternatives and consider the outlook for venture capital and growth equity.

Venture capital (VC)—Like private equity (PE), VC firms raise pools of capital to invest in private companies, with the goal of increasing value and profiting from their sale. In contrast to PE, where industries are typically more mature, VC involves investing in start-ups exclusively in the tech sector and usually includes mentoring management. VC firms typically take stakes of less than 50% in companies (while PE firms typically maintain controlling stakes). VC exhibits a higher degree of risk than PE, given the early-stage nature of the companies, but this can come with substantially higher levels of return.

Growth equity (GE)—GE firms also raise capital, mentor management, and invest with the intent of accelerating a company’s growth. Like PE and VC, these businesses are intended to be sold for profit. However, GE sits in the middle ground between PE and VC, and typically backs companies in more established markets—often with a proven product or service. Return profiles are similar to PE buyout, but with lower risk than VC.

Publicly-listed companies have become more mature

Since 1996, the universe of US publicly-listed companies has been declining substantially. And while this is not the case in other parts of the world, it is significant because the US comprises over half of the total value of the world’s equity markets.

While many factors are in play, robust merger and acquisition activity, increased costs (and regulation) of listing, and alternative and significant sources of (private) capital have reduced the relative attractiveness of listing and/or remaining listed. This has resulted in today’s listed firms typically being larger, older and more profitable than those 20 years ago, albeit they are operating in more competitive and more concentrated industries. Greenspring Associates notes that US VC-backed companies took eight years to come to market in the two years prior to 2020, compared with three years in the two years prior to 2000.

As for the implications for investors, Credit Suisse speculates that 

“the maturation of listed companies has also contributed to informational efficiency in the stock market. Gaining edge in older and well-established businesses is likely more difficult than it is in young businesses with uncertain outlooks. In turn, the greater efficiency may be one of the catalysts for the shift that investors are making from active to indexed or rule-based strategies”.

Investors not able to access private markets are potentially missing out on substantial gains

In addition, the trend of private companies staying private for longer means that investors who are not able to access VC and GE are potentially missing out on substantial gains. The chart below shows private technology companies that launch IPOs today are nearly 2.7x older than their cohort from 20 years ago. They are also generating 16.8x more revenue.

Tech companies doing initial public offerings (IPOs) are now more mature

To provide a practical example, Amazon went public three years after it was founded, with a market capitalisation of USD 660 million in today’s dollars. Investors who bought at the IPO and held their shares had made more than 1,800 times their money by mid-2020. Virtually none of the USD 1.3 trillion in value that Amazon built was in the private market. Uber, however, went public 10 years after founding with an initial capitalisation of USD 75 billion. By mid-2020, Uber’s share price had fallen below its IPO price, which means 100% of its value had been attributed to private investors, not public investors.

“Part of the justification for the belief in higher returns (or private over public) comes from the fact that the ratio of value created in the private markets, relative to that of the public markets, has increased versus what we saw decades ago”. - Morgan Stanely

The evolution of the VC and GE segments of the market has been a significant factor in this shift from public to private. Hamilton Lane suggests that the dominance of the traditional leveraged buyout (LBO) strategies at 58% of all private market commitments in 2010 has reduced markedly to 36% as at June 2020 (see chart below), whilst VC/GE has almost doubled from 13% to 25%. This equates to a four-times increase in fundraising from around USD 100 billion to over USD 400 billion in 2010 and 2020 respectively.

If we then look at the companies, new firms are growing revenue at faster rates over shorter periods, which has resulted in greater growth expectations and, ultimately, a rise in valuations. The median late-stage VC company in the US, for example, saw a 122% increase in its pre-money valuation in 2019 relative to 2010. Combined with the time-to-market trend noted earlier, the universe of so-called unicorns is expanding, which is creating a massive opportunity set for late-stage VC and GE investors.

Private markets total exposure by strategy

Technology remains the dominant sector within VC, and the COVID-19 pandemic has only accelerated adoption amidst already established secular tailwinds. For example, according to a McKinsey survey, consumer adoption of telehealth skyrocketed to 46% in April 2020. That was up from just 11% in 2019, with 76% of respondents highly or moderately likely to use telehealth in the future. Other emerging technologies within fintech, artificial intelligence and medical devices are also being widely adopted across the economy.

“The uptick in technology adoption resulting from COVID-19 has only accelerated the digitisation in market capitalisation that was already taking place”. - Tom Fitzherbert-Brockholes, Greenspirng Assciates

Accelerating tech adoption remains one of the key secular trends across the global economy and one of our key investment themes. Rapid increases in research and development spending, particularly as the US and China go head-to-head in a so-called technology war, are likely to provide a strong tailwind to the tech-heavy VC and GE investment sectors.

Consistent outperformance versus other private market strategies

In recent years, VC and GE have consistently outperformed other private markets strategies (see chart below) and have done so with similar risk profiles to buyout strategies, which typically focus on larger, more mature businesses.

The chart below shows the internal rate of return (IRR) of a selection of strategies within private markets but excludes several strategies, such as real estate, infrastructure, natural resources and mezzanine. VC and GE strategies have been highlighted in blue, green and grey to draw attention to their performance.

The IRR calculates the expected growth rate of an investment’s return. It is essentially a discount rate that makes the net present value of all cash flows equal to zero in a discounted cash flow analysis. Generally speaking, the higher the IRR, the more desirable an investment is to undertake.

Looking at GE, in particular, while it has the perception of higher risk, GE deal-level losses have actually outperformed PE buyout. This is because of their capital structures that have significantly less leverage, which increases efficiency toward achieving profitable revenue. More generally, it is also because of the increasing number of companies adopting recurring revenue business models that have been proving more resilient.

Pooled sub-asset class IRR by vintage year

Past performance is not indicative of future returns.

However, this performance comes with a caveat. While manager selection is critical across much of the alternative investment universe, it is arguably even more relevant in VC and GE, as depicted in the chart below, which shows that over the last 38 years, VC and GE have had the highest return dispersion of any other private market strategy. That is to say, the difference between the top and bottom-performing managers is the largest of any asset class.

Interestingly, performance persistence is also very high in VC, which means the best-performing managers continue to be the best performing. Ashton Newhall, a co-founder of VC specialist Greenspring Associates, notes that “the variables that allow the best managers to stay the best are materially different to clicking a button to buy a public stock. In the private markets, managers are chosen because of their ability to add value and actually impact the outcome of the investment, and that’s one of the reasons why there is a high degree of repeatability”.

Noting that this underperformance of the median manager has not been quite as prominent in the last decade, this does further reinforce the point that manager selection remains crucial looking forward.

Dispersion of returns by strategy and geography

Strong performance but manager selection is key

Established trends are shifting the growth investment universe toward private markets. This has resulted in more companies staying private for longer and public markets becoming more competitive and less efficient from an investment perspective.

VC and GE have evolved significantly, and look set to continue to grow further, driven by the dynamic and secular trends mentioned earlier, which have been boosted by the COVID-19 pandemic.

The performance of these sectors has been very strong over the past decade, but manager selection is key to achieve return expectations, given the significant deviations between top and bottom-performing managers. This means that it is critical to partner with allocators that can not only access the full universe but can also access top-performing managers—both established and emerging

This article was written with contributions from Martin Randall, Senior Investment Analyst—Alternatives.

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