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December 8, 2014

Should you invest in Venture Capital?

In our descent through the rings of the alternative investment universe, we have found that hedge funds don’t really deliver (see here). So what then to make of Venture Capital? Venture Capital investing is all about finding the next Google or Apple when they are still a start-up and then participate in their explosive growth until they become large companies. Sounds exciting? Investors who are looking for alternative investments will often hear a similar pitch about why it makes sense to invest in these types of early stage funds. But do the lofty goals hold up to close scrutiny or should most investors shun VC funds?

At Ipanema Capital we like to look beyond the marketing pitch and separate fact from fiction.

The true investment performance of Venture Capital funds is far from stellar

Cambridge Associates, which manages and advices money for endowments, has compiled data from more than 1,000 venture capital funds and the results pretty much say that you would have been better off in an equity index fund. At the 1, 3 and 5 year mark, the S&P500 would have beaten the US Venture Capital index. Only at the 10 year mark, did the Venture Capital index outperform slightly. However, it is probably fair to argue that the small-cap Russell 2000 index is a better comparable index and here the performance even at the 10 year mark is approximately the same.

Tabelle English

It is only when you go back more than 15 years that the VC Index shows some true outperformance. However, this includes the dot-com bubble and we would argue this once-in a life-time event is heavily distorting those results.

Need to adjust for risk

To make a fair comparison, investors should also adjust the VC performance for the much higher risk compared to a broad equity index fund. We see several reasons for the higher risk of VC investments:

  • VC funds are highly illiquid and the average life-cycle of a fund is around 6-8 years. This means investors can be locked-up for many years before they can access their money.
  • Poor distribution of venture returns means that only a small number of VC funds are actually offering an attractive return while the majority of VC funds languish. The problem really is that there is only a limited number of attractive investment opportunites and more money flowing into VC funds is not going to change this (on the contrary). A broad study from 2004 to 2013 looking at more than 20,000 financings has revealed that 65% of all VC investments are actually loss-making. Only 4% produce the big winners with returns >10x. We think this distribution of returns makes it very hard from the outside to pick the right VC fund ex-ante.

Right skewed distribution

  • The math simply doesn’t work when you take an average fund. Based on the above distribution of returns, if you start with $100m and invest across 20 companies, you will end with about $206m after the normal life-cycle of a fund. On an annualized basis, this is only a 10% IRR. However, this return is before fees and costs. If we subtract another 1-2%, it means that the end-investor in the VC fund will only realize returns around 8-9%. Hardly stellar.

Venture capital funds maybe an interesting alternative for Ultra-High-Net-Worth-Individuals who want to diversify their investments but for the average retail investor, we would argue that VC investing is not suitable.

Our take-away from various VC return studies is still overwhelmingly positive for the average investor though:

  • Simple works best. Most investors will be fine with only 4 asset classes: equities, corporate credit, government bonds and property.
  • There is no need for exotic investments. Equities in most cases deliver similar returns on an after fee, risk-adjusted basis.

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