BGV recently moderated a panel hosted by Marcus Evans on the challenges faced by LPs in constructing an alternative asset portfolio around the Venture Capital asset class. The panel members included Matt Stepan with CFM, a financial advisory firm with $11Bn AUM, and Freeman Wood with Mercer Sentinel, a leading investment advisory consulting firm. The full webinar can be accessed at:
This entry is the second and final part of the blog focusing on the topic of sustaining returns in the Venture Capital asset class over time.
Context & Key Trends
One of the myths about Private Equity is that private equity does well in good markets and does worse in bad markets. The data below shows that private equity performance has outperformed public markets in both good and bad markets.
As we look into the venture capital asset class, we find a similar story. Since the recovery from early 1999-2000s the venture capital asset class has outperformed the S&P 500, with a constant increase in IRR and multiples across recent vintages (see charts below).
The chart below from Cambridge compares gains in their cohort of top 100 investments. They concluded that “success comes in all sizes”, meaning the group of top performers includes both large and small funds – ranging from small funds- less than 250M, to mid-size funds, and to larger funds – funds more than 750M. In recent years, funds of less than $250M have accounted for a good portion of value creation.
Cambridge has also looked into the performance of top quartile US venture capital funds by vintage years across new funds, developing funds (funds that are in their 3rd or 4th fund), and well-established funds. The cohort of top quartile venture funds contains a good mix of new, developing, and well-established funds.
This data runs contrary to the common notion that only well-established billion dollar funds provide good returns to investors. As investors look to deploy into this asset class, there is an argument to be made in having a basket of investments across big and large, new and established funds.
The topic we are going to discuss is the best practices our panelists and their clients have used to sustain returns in the venture asset class after they have made the manager selection decision.
- Matt, at CFM what has been your experience with key variables that led to sustaining performance over time with your VC fund investments?
- We have seen a few patterns that contribute to persistence of returns over time. These include: a) Relatively modest fund size – Smaller funds focused on a fewer number of portfolio companies with a thoughtful approach to how they deploy their capital. Larger funds tend to become less nimble. It is important to be nimble in the VC world because the startups are often going at a sprint and firms need to be able to react to that while being thoughtful; b) We have also seen consistent success from funds where the teams are focused within markets or sectors where they have a deep understanding of the trends transforming them. Our prototypical funds are ones with 3 GP’s, a team size of 10-15 people, a fund size greater than $100M but sub $300M with a focus on 3-4 sectors that the team knows well; c) From a portfolio construction basis, funds that have a mix of companies that are both solutions oriented and disruptive do well. Solution oriented portfolio companies with a good operational track record can often get to good M&A exits on an all cash basis. We have found that a balanced portfolio between disruptive IPO track startups and solutions oriented startups leads to a persistence of returns over time; d) Finally we believe that the personal character of the VC’s is also a determinant. Often times when companies begin not to perform to expectations, sometimes VCs step away too early instead of taking corrective action. While it makes sense to spend time with winners, we also believe that fund managers should be thoughtful in sticking with what they have invested in by taking corrective action instead of settling for a suboptimal outcome.
- Freeman, what are some of the best practices around risk control to protect the sustainability of returns over time that you suggest to your clients when they invest in Venture Capital?
- We have a strong belief that establishing transparency is important – in what is being invested in by the managers as well as how those investments are performing over time. Sometimes our clients fall into the trap of a “set it and forget it” mind set because they are dealing with committed capital but we believe that being proactively involved is critical after making the investment allocation. We advise our clients to perform on-site diligence as frequently as they are comfortable (at least once every 12 or 18 months) to see how the manager is controlling their risks and how the portfolio is performing.
- Matt, we have seen cases where investors have used various techniques to get to know the manager team using direct or co-investments. Can you comment on how CFM has scaled its venture fund relationship? Have you done direct and co-investments?
- We have had the opportunity to do both and have found that co-investments that are follow on investments (Series B and C) work better for us. These opportunities give us the time to get to know the company, the management team and track progress over time before making a co-investment decision. We have led a few direct investments but we feel that this does not align as well with our expertise and that VC firms are better suited to make such investments. Finally, we want to be viewed as a partner by VC firms and not as competitors. For all these reasons we have found co-investments to work better for us than direct investments.
- Freeman, what is the best way for your clients to get to know a GP at a fund?
- It is a combination of upfront diligence before making the investment decision and post investment relationship building. Often a combination of meeting the manager, understanding their expertise/edge, ensuring that there is an alignment of incentives and getting to know the supporting teams, the key processes (beyond the GPs).
- What has been you experience with trying time investments in the venture capital asset class.
- CFM – While industry data over time reveals that vintage year does play a role in investment performance, we have found that a sustained effort over the long term (ten years or more) results in consistent performance. If this is done well then distributions from earlier years end up funding current and future capital commitments. We have found the optimal strategy is to be patient, invest in the asset class for the long term and apply the best practices that have been discussed today to deliver good returns. VC investment is a marathon even though at times the VC markets may feel like a sprint but applying a consistent framework can lead to a persistence of returns. It is important not to get caught in the day-to-day sprint and stay focused on the long term.
- Mercer – I agree, timing is a double-edged sword – do it well and it can be lucrative, do it poorly and it can be very painful. Having a commitment and a process for an asset class for the long term enables LPs to smooth out timing differences and get to know the fund managers well. This is important. We have found that LPs who invest in different asset classes some times uncover best practices that can be leveraged to help their fund managers improve their performance. These types of long-term relationships are a win-win for both LPs and fund managers.