Private Equity and Venture Capital are attractive options for high net-worth individuals and institutional investors seeking high ROI.
Did you know that Venture Capital is one of the best performing investments of the past 25 years?
Cambridge Associates reveals that from 2010-2020, the CA US Venture Capital Index generated an average annual return (AAR) of 17.2%, compared to the S&P 500’s AAR of 13.9%.
From 1995-2020, the returns differential is even more pronounced, with the CA US VC Index generating an AAR of 32.4%, compared to the S&P’s AAR of 9.1% and the Nasdaq Composite’s AAR of 11.3%.
The data is clear: Venture Capital is by far the best performing asset class of the past generation.
For investors with diversified portfolios, investing a small portion of their capital in high-risk, high-reward assets such as Venture Capital offers the opportunity for significant upside potential, with limited risk.
Here is how Venture Capital consistently generates market-beating returns.
What is Venture Capital?
Venture Capital is a form of financing given to high growth startups that are perceived as having the potential of generating substantial returns on investments. This financing is usually provided by high net-worth individuals, investment banks and specialized firms who have a high risk tolerance and expertise in scaling startups. Indeed, VC investments go well beyond simply injecting capital: these financiers also provide invaluable technical and managerial consulting services to their portfolio companies.
Venture Capitalists favor small companies in the seed or early phase of their development. While this is the riskiest stage of any company’s development, it is also the entry that provides the highest potential returns.
For example, Venture Capital firm Lightspeed Venture Partners turned an initial investment of $8 million into $2 billion when its portfolio company Snap Inc IPOed at a valuation of $25 billion. This represents a staggering return on investment of more than 250x, or 24,900% in a five year period ranging from 2012-2017. In contrast, the S&P 500 generated an average annual return of roughly 16.5% over the same timeframe.
Obviously, these are the types of returns that make Venture Capital investments so appealing.
Here’s how Venture Capital has outperformed equity markets over the past two and half decades.
Venture Capitalists Invest in Select Industries
Venture Capitalists seek high-risk, high-reward investment propositions.
These types of returns are only possible in sectors with explosive growth potential. Thus, Venture Capitalists focus almost exclusively on industries that are poised to revolutionize business and society. In fact, VC has always been skewed in favor of a select few industries and this still holds true. In 2020, five sectors accounted for 91% of the CA US VC index’s value.
Over the past 10 years, technology and healthcare are the two sectors that have generated the highest rates of returns. For example, if in 2010 you had invested $500 in the Invesco QQQ Trust, a leading Nasdaq-tracking index fund, your investment would now be worth more than $3000. This represents an ROI of more than 460%. Similarly, the S&P 500 Health Care index generated a total ROI of 305% from 2011 to 2021.
Venture Capital is well aware that these two sectors currently generate the highest ROI. Thus, the majority of VC funds are almost exclusively focused on startups operating in these industries.
The CA US Venture Capital Index concentrates 71% of its capital to these two sectors, compared to the Nasdaq Composite’s 52.5%. Over the past decade, the CA US VC Index’s exposure to these two sectors has increased, to the expense of other less explosive sectors, such as communication services, which has decreased by nearly 11 percentage points.
The IT sector’s resilience during the COVID crisis further boosted the index’s performances, with IT, healthcare and consumer discretionary each generating 50%+ returns this year. Since 2007, every healthcare vintage from 2011 onwards (with the exception of 2012-2013) posted annual returns of at least 50%.
In contrast, the Nasdaq Composite includes a much higher percentage of companies involved in the consumer discretionary (17.7% vs 6.7%), communication services (16.4% vs 6.7%) and other industries such as food and energy (9% vs 9.1%).
Thus, Venture Capital’s success is clearly determined by its willingness to go “all in” in the right industries, compared to equity funds that place a greater emphasis on diversification and accurately replicating an index.
Venture Capital Returns are Skewed
However, there is an important caveat to these facts.
The risks of investing in startups are much greater than the risks of investing in well established public companies. In addition, the holding periods are long, the fees are high and the capital is tied up and illiquid throughout. As a result, VC funds are required to outperform the major stock market indexes by a significant amount to make financial sense.
The reality is that Venture Capital returns follow the infamous “Pareto Principle”, which states that 80% of output is generated by 20% of inputs. Statistically, this means that out of 10 portfolio companies, only 2 will generate substantial profits. Similarly, out of 10 Venture Capital funds, only 2 will generate market-beating returns.
Thus, a few select funds – the top quartile to be exact – generate these types of returns. Cambridge Associates research reveals that since 2010, the top quartile of VC funds generated AAR ranging from 15% to 27%, while the AAR of the bottom quartile VC funds generated AAR in the low single digits. Investors investing in the bottom quartile probably regretted not pouring their capital in the S&P.
When we scratch under the surface even more, we observe that a small percentage of VC funds generate substantial returns. In the VC world, a 3x return is considered a good investment. Anything less is not considered worthy of the risks incurred. In fact, only 5% of VC funds are generating this so-called “venture rate of return”.
How can we explain this difference in performance? Proprietary deal flow.
Famous Venture Capitalists, such as Peter Thiel and Reid Hoffman, have deep networks and insider connections that give them unique access to the best startups in the world. Lesser known firms struggle to compete with the ‘best of breed’ Venture Capitalists who monopolize the attention of most startups seeking financing.
Indeed, obtaining financing from prestigious individuals and firms all but guarantees additional financing from other VC firms and increased public exposure, which ultimately result in higher chances of commercial success. It’s no surprise that Thiel, Hoffman and similar Venture Capitalists have their pick of the bunch compared to smaller firms who only have access to second-tier startups.
Additionally, not every investor willing to invest in Venture Capital will have access to these top-performing funds. Often, these “mega-funds” are reserved for industry insiders. Outsiders usually have to settle for smaller funds that post lower performances.
For investors, the ability to predict which fund managers will consistently pick winning companies is arguably the most important factor which will determine their investment success. Also, they need to find ways to access these funds when they do identify them. Admittedly, identifying the best performing equity funds is much simpler – and easier to access – but less lucrative.
The Best VC Funds Under-Diversify
Traditional investment theory advises to diversify your portfolio to reduce risk. Counter-intuitively, the best VC fund managers prefer not to follow this time-tested advice.
Indeed, in the world of VC, diversification does not offer meaningful rewards.
The top-quartile managers achieve exceptional results by taking aggressive risks. Their reasoning is that portfolios must remain concentrated in a select few companies so as not to dilute the potential winners. The fund managers who reduce risk through diversification will ultimately generate substandard returns.
Given the 10+ year life span of each fund, and the fact that capital floods to proven winners, it makes sense for managers to risk getting lucky with undiversified portfolios rather than diversifying. Indeed, diversifying is now proven to generate smaller rewards.
In addition, diversification is hard to execute operationally. Even the largest VC funds would struggle to manage a portfolio of 500 startups. Having a portfolio of that size means allocating few funds to each company and then struggling to provide adequate resources and consulting to each company.
In reality, VC firms have relatively limited human resources to work with. Many VC funds are comprised of just ten partners, with each partner managing 5-10 deals. Scaling partnerships to more than ten partners become increasingly complex because there are too many conflicting opinions and investment thesis to contemplate and allocate resources towards.
The Bottom Line
The bottom line is that Venture Capital is a high-risk, high-reward investment that boasts a proven track record of generating market-beating returns.
By investing in a few well-selected startups operating in high growth industries, fund managers are able to post mouth-watering returns.
However, investors must carefully select the funds they invest in and try to enter the privileged circle of the best-performing mega funds. Otherwise, they may be better off simply invested in major market-tracking indexes such as IVV or QQQ.
How to Invest in Venture Capital
Are you interested in investing in Venture Capital?
Traditionally, Venture Capital was reserved for accredited investors, financial institutions and specialized VC firms. However, the world of investing has changed and Venture Capital investing is now more accessible than ever.
In fact, a large number of funds and platforms offer the general public the opportunity to invest in Venture Capital projects:
- The Hercules Capital Fund (HTGC), a business development company focused on venture lendingn offers investors the opportunity to invest in a wide variety of startups.
- Horizon Technology Finance (HRZN) makes senior secured loans to venture-backed companies and pays out the interest payments as shareholder dividends to investors.
- MicroVentures’ crowdfunding startup platform provides investors the chance to invest in startups for as little as $100.
- AngelList and SeedInvest are firms that offer investment opportunities for both accredited and unaccredited investors.
- Forge, EquityZen, Crowdfunder, iSelect and FundersClub offer plenty of investment opportunities for accredited investors.
For accredited investors seeking more exclusive investment opportunities, connecting with an investment bank or a specialized Venture capital firm is an excellent option. These institutions have extensive connections, deep expertise and proven track records of delivering exceptional returns on investments.
For these reasons, they remain the preferred option for individuals seeking exposure to Venture Capital investments.