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March 30, 2017

Venture Capital and Crowdinvesting

With interest rates hovering around zero and equities suffering from occasional bouts of high volatility, investors naturally look for other opportunities. We often recommend to take a closer look at what large institutional investors do. For many years they have invested in private funds such as venture capital (VC) funds. Should individual investors add VC funds to their portfolio? Here we take a closer look at the historical performance of the European Venture Capital industry. In summary, the historical performance has been abysmal – to put it mildly. Despite the lure of investing in the next high growth company, Individual investors who focus on long-term financial planning should stay away from VC funds.

When T-Bills beat Venture Capital investing

We pride ourselves on being evidence-based. What does that mean? We will only invest for our clients in assets that have proven long-term risk/return characteristics. We don’t care for the promotional material of the investment industry. We need proof statements much better than “every once in a blue moon, a few of us get it right.”

Unfortunately in the case of VC funds, the track record for the industry is extremely poor. For the European venture capital asset class as a whole, we cannot find any historical evidence of a risk premium, let alone an illiquidity premium. Over a 10 year period, the 753 funds in a study by the European Private Equity and Venture Capital Association have only delivered an internal rate of return of 0,8%.

 3 year IRR5 year IRR10 year IRR
Performance to 20132.3%1.3%0.8%

We know there are all sorts of caveats. The returns look better for US VC funds (but only marginally)… The last study was done for the year 2013 and maybe the VC industry has performed miracles since then… But seriously, given these data, any self-respecting investor needs to think twice about VC investing. You also need to consider the following two risk factors:

  • Poor liquidity. The average life-time of a VC fund is 7-10 years. This means you are locked-up for an extremely long period of time and have poor transparency. However, your personal situation might change and in that case you cannot access your money. Even for clients who have a long-term horizon, we recommend investing mainly in assets with daily liquidity.
  • Loss of principal. A typical VC fund invests in up to 20 start-up companies. It is impossible to achieve diversification and a total loss of principal is not uncommon. Compare and contrast with an equity investment like the MSCI World where you invest in more than 2000 companies like Nestlé or Amazon. Yes, you will experience some volatility over time but it is virtually impossible to imagine a scenario where all these large global companies go out of business at once.

Crowdinvesting is for entertainment

Crowdinvesting is a sub-category of venture capital investing. Here, individual investors put their money directly into start-up companies, not via funds. While cutting out the middle-man is generally a good idea, we strongly advice against crowdfunding for any serious long-term investor. If you have some money to play with and want to have some fun, we suggest you go your nearby casino rather than sinking it into a crowdinvesting platform…

The regulatory framework is different in every country and I will restrict myself to the crowdinvesting landscape in Germany. In essence, investing is a bit of a misnomer here because on most of the popular crowdinvesting platforms in Germany you actually do not get equity. Investors in effect buy unsecured loans with some participation rights. This isn’t just semantics, we are talking about a totally different universe! With the unsecured loans with participation rights, you have full downside risk and only some of the upside of equity. Oh, and by the way, you have virtually no voting rights. Any serious investor would laugh at that proposition but sadly individual investors seem not to understand or care.

It gets worse. The local industry regulator BaFin does require a weighty prospectus for most investments. But not crowdinvesting. It is therefore doubtful that investors are fully aware what they are actually getting into.

Summary

Average investors have a hard enough time dealing with periodic losses in the stock market. Professional VC investors are often looking for 1-2 home runs in a portfolio of 20 or so private investments. Approximately 75% of all start-up companies fail and seeing an investment go to zero would be far too difficult for the majority of individuals to handle for the slight possibility of finding one or two big winners. We really only hear about the private company success stories and forget about all of the failed ventures it took to get to that one big winner. We think individual investors are better off sticking to the public markets.

Nobody has probably been more successful with private investments than Yale‘s endowment CIO David Swenson. But even he wrote in his book „Unconventional success: A fundamental approach to personal investments“:

Suppliers of funds to the venture capital industry generally realize poor risk-adjusted returns.

As we keep repeating: it pays to listen to what the best investors say.