How Venture Capital Fits In Your Investment Portfolio
Venture capital (VC) has been around longer than you may think, first emerging as an alternative to credit financing after WWII. It wasn’t until the 1970s, however, that it evolved into an asset class closely tied to funding the disruptive industry of the day—personal computing. The first venture capital firms included Kleiner Perkins Caufield & Byers and Sequoia Capital, both founded in 1972—rapidly on the heels of the invention of the microprocessor. While millions were invested in venture capital during the 1980s, especially in Silicon Valley, it took the Internet to provide the fuel for the concept to really take off.
The venture capital model is a form of private investment that typically invests in startups and companies with exceptionally rapid growth potential and the ability to maintain that trajectory well into the future. Those who traditionally invest in venture capital have evolved. What was a handful of investment firms along the US coasts, has transitioned to participation from large technology companies launching their own strategic venture funds (including Microsoft, Google, Salesforce, Intel, Red Hat, and recently, Intuit), family office / endowment / state pension fund participation, a surge in Angel investing networks to support the earliest stage of development, and most recently, greater involvement from more “Main Street” investors, through various Reg-A and crowdfunding platforms and products.
Venture capital investing continues to grow and gain traction. VC in the U.S., for example, raised nearly $330 billion in 2021–roughly double the previous record of $166.6 billion set in 2020, undoubtedly driven by the increased appetite and “new breed” of venture capital, and burgeoning interest.
How Venture Capital Can Fit into a Total Investment Strategy
Venture capital is contributing to improved portfolio diversification for a rapidly increasing number of investors. Gaining access to venture-backed companies as part of an investment portfolio strategy is a way for investors to participate in high-growth opportunities and benefit from the value creation that can take place in private markets.
Traditionally, these investments have not been represented by a “go-to” platform and can’t always be accessed by calling your investment advisor and purchasing them–as is possible with various equity and debt investments. However, for several reasons, the VC model of the past is beginning to change, and many are looking for greater access.
Expands the pool of investment options for investors
The number of public companies listed in the U.S. in the mid-1990s was close to 8,000. By 2020, the number dropped to approximately 4,500. Much of the decline can be attributed to consolidation through acquisitions and the dotcom bust that led to fewer IPOs. Although the rate of attrition has stabilized in recent years, there is still a gap between investment dollars available and investments that can fulfill long-term investment goals. Some of these dollars are finding their way to venture capital as an investment strategy that are not typically directly influenced by public market trends and to access a growing number of early-stage business verticals.
Higher risk could lead to higher return potential
Venture capital investing provides the potential for long-term gains–especially in disruptive technologies–and wealth creation within private markets that has been elusive until now for most investors. Venture investors also take on more risk. Investment risk is typically represented by annualized standard deviation and was 40.2% for venture capital compared to 22.0% for the S&P 500.*
Limits the liquidity profile but broadens diversification
Investing in venture capital can limit the liquidity profile of your portfolio but can diversify the types of investments. This diversification, if positioned strategically and with proper diligence, can be accretive to the overall risk / reward profile of a given portfolio.
How to Add VC Investing to Your Portfolio
Become a Limited Partner in a traditional VC fund structure
The traditional GP/LP structured fund typically includes a 5-to-10-year time horizon, 2/20 management fee and carry, and a return profile that targets a low-teen to 30% or greater IRR profile (depending on investment thesis) and can have a <30% to 50% or greater standard deviation (risk) profile. Both individual and institutional investors participate in these structures and can, depending on relationships and the size of investment, potentially access funds of varying sizes, stages, and targeted industries.
Invest directly as an Angel investor
Some investors are looking to be directly involved in the startups they invest in so they can choose to invest as Angel investors, typically investing $250,000 or more and being more active in advising the company. Access to these kinds of investments is more likely to come from involvement in Angel networks directly or personal networks.
“Alternative” vehicles and products
There is a movement in the democratization of access to venture capital, as is happening throughout the product and market landscape in the financial services industry. We will dive deeper into these topics another time, but we wanted to call out three types of vehicles that we are tracking.
Crossover products. We have covered this topic before, in our The Rise of Crossover Investing blog post. In general, a crossover strategy enables investors to potentially participate in pre-IPO and post-IPO gains and an opportunity for early investment into rapidly up-and-coming vertical segments—which typically are not available in the public markets. This creates a more liquid strategy for investors who are potentially interested in investing in VC, but don’t have the appetite for a 5 to 10+ year time horizon. The crossover concept is gaining traction and credibility, evidenced by Sequoia Capital’s announcement in late 2021 that it was in the process of restructuring its holdings in the U.S. and Europe into an open-ended crossover fund. The firm will continue to invest in high-growth startups at various stages and will now continue to hold its investments long after a company’s IPO.
Crowdfunding platforms, Reg A products. In 2012, the Jumpstart Our Business (JOBS) Act was passed by Congress. The JOBS act enabled businesses to raise up to $1 million via equity crowdfunding, allowing companies to publicly raise capital from a pool of small non-accredited investors. The JOBS act also expanded Regulation A, allowing companies to issue up to $20 million of equity from non-accredited investors without registering with the SEC. Crowdfunding platforms and Reg A products have increased access to venture capital for both investors and startups.
Unique fund structures (rolling, interval, etc.). There are a handful of unique fund structures that are starting to appear across the investment landscape, including rolling (Reg D) funds and interval funds. A rolling fund allows managers to share deal flow with investors on a quarterly subscription basis while netting carried interest over a multi-year period. Unlike investing in a traditional fund, rolling funds offer investors two distinct features: 1) investors follow a flexible, quarterly investment schedule rather than a one-time commitment to a fund and 2) investors can subscribe for future quarterly investments in advance and easily commit more or less capital as their investment goals change. An interval fund is a 40 Act, closed-end fund, that can be structured in a way that is offered only to accredited investors, or structured more commonly in a way that is offered to all investors. It intends to create more liquidity for investors by periodically offering to buy back a percentage of outstanding shares at net asset value (NAV). If successful, this is a way for retail investors to access institutional-grade alternative investments with relatively low minimums.
The evolution of venture capital investing continues and access to venture funds and rapidly growing verticals is now available. To learn more about how investment into these early-stage opportunities may make sense in your own portfolio or, if you are an investment advisor, in your clients' portfolios, visit DCA Asset Management for more information.
*Source: Yahoo! Finance, S&P 500 data (SPY), Venture Capital data (LDVIX); for the 3-year period ended December 31, 2021