December 8, 2020

Why Venture Capital Is Doing So Well

With stocks and bonds offering meager futures, pension plans and other investors find under-appreciated VC beats another alt, private equity, which grabs all the attention.

Reported by Larry Light

Art by Lars Leetaru

Venture capital has fostered some of the most innovative businesses on the planet, bringing forth the likes of Apple, Facebook, Genentech, Google, and Tesla.

And while VC lacks the headline-grabbing panache of private equity (PE)—no one has penned dramatic tales like Barbarians at the Gate for venture deals—VC has proven itself over the years as a good, if oft-overlooked, opportunity for the risk-minded. One that actually outshines sparkly PE.

As a result, VC is increasingly finding favor with institutional investors. Over the past three years, global pension allocations to VC have edged up to an average 7.0% of portfolios this year, from 6.2% in 2017, Preqin data show.

One part of the appeal, analysts say, is that venture focuses on sexy areas. Venture-backed companies are heavily into technology (40%, by the account of research outfit Pitchbook) and health care, primarily biotech (20%). Another, more potent, attraction is that returns are good overall, even better than those PE brings in.

This means that pension funds and others, looking to meet increasing liabilities in coming years amid tepid outlooks for traditional assets such as stocks and bonds, have a new favorite, albeit one that’s been around for decades. Morgan Stanley, in a report, summed up venture’s attraction: “Historically, a majority of venture investments have lost money, but large gains by a few successful investments have allowed the industry to generate positive returns.”

Essentially, a VC firm creates several funds over time, usually lasting about 10 years, garners money from large investors to fill these kitties, then dips into them to seed startups with the fresh capital.

Upcoming public offerings illustrate how well things can work out. Food delivery outfit DoorDash is expected to go public this week and is priced at the upper end of the company’s range, which would give it a market capitalization of more than $36 billion. That’s similar to Ford Motor’s level—and would place DoorDash as more valuable than two-thirds of the S&P 500. What’s more, Airbnb, the temporary-stay home rental provider, is poised to follow in the next few days. Projected value: as much as $42 billion.

True, neither one of these young-ish companies has been consistently profitable. But they have demonstrated good management and resilience. DoorDash geared up to meet the surge in orders from stay-at-home people during the pandemic. And Airbnb, hurt in the earlier phase of the outbreak, has come back amid housebound folks’ growing zest for short get-away motor trips to nearby locales.

Then there are the clunker investments, some of them starting out hot then fizzling. Look at VC-backed WeWork, which rents out workspace, and once was a darling unicorn (privately valued at more than $1 billion). The business failed to deliver on its earnings promise and pulled its 2019 initial public offering (IPO). Its one-time private valuation of $47 billion was cut by 80% last year, and now no one is sure what it might be (likely a whole lot less, analysts say).

WeWork’s continued lack of profits, plus big questions about governance and the flamboyant conduct of its chief, Adam Neumann, thwarted the offering—and that was even before the pandemic put a curse on co-working spaces. Neumann left and lawsuits sprouted. This proved a major embarrassment for VC powerhouses SoftBank Group and Benchmark Capital, among others, which had poured large sums into the enterprise.

The Tweet Smell of Success

Many startups are called but few are chosen. Not every VC investment turns into a Twitter. With the chances high that a startup will fail, it’s a good thing that venture firms are so picky. On average, venture firms look over 200 possible investments yearly, and pick just four, says a report in the Journal of Financial Economics. Indeed, startups with VC backing tend to fare better than angel-backed or other forms of sponsorship, according to a study by Morton Sørensen, a professor at Dartmouth’s Tuck School of Business.

VC has more winners than private equity, but also more investments that are money losers, the Morgan Stanley study concluded. Venture capital firms concentrate on relatively young and immature companies, and helping entrepreneurs build their businesses is a labor-intensive exercise. PE deals are for more seasoned companies with good records, brand identity, and, often, black ink. Both alternative investments find growing favor among institutional investors, although PE gets more attention.

That said, venture tends to be slightly more profitable than PE, under a measure called “public market equivalence,” which gauges how these privately held assets would be valued if they were public. VC averages 1.4 times the public market, and PE 1.2 times, per Morgan Stanley.

Among pension funds, VC has been a strong performing investment. That’s why public plans such as those of Hawaii and Illinois are deepening their involvement.

Consider the Los Angeles County Employees Retirement Association (LACERA) (assets: almost $61 billion), which has been investing in venture since 1986. As of June, it had $1.4 billion in nine active VC fund relationships, or about 2% of the total portfolio. LACERA has earmarked another $500 million for investment, but the venture firms haven’t called for that money to be deployed yet.

Over the three-plus decades that LACERA has been involved in venture, the pension plan has reaped an impressive annual 22% internal rate of return. One of the VC firms the fund invests in, for instance, is Canaan Partners, which in the past has supported the likes of dating site Match Group, whose stock has climbed 11-fold in the last five years, and pioneering online advertising business DoubleClick, which Google bought in 2008 for $3.1 billion.

At LACERA, venture is a key part of its effort in the non-public arena, which also includes other categories of private equity, illiquid credit, infrastructure, and real estate investments. “We enhance the risk-adjusted return profile of our growth portfolio through prudent venture investments,” CIO Jonathan Grabel said. LACERA has an active in-house private equity co-investment program and is exploring the potential addition of late-stage venture opportunities.

Venture also has been a big winner for endowments. Brown University (assets: $4.7 billion), which outpaced the other Ivy schools for the fiscal year ending June 30, logged a 12.1% advance overall.

VC, which is almost 18% of Brown’s portfolio (up from 4% 10 years before), was the best performer for the endowment, an analysis by investment research firm Markov Processes International showed. In fiscal 2020, VC returned 11.8%, compared with the next best, private equity at 9%, and No. 3 US public stocks, at 7.5%.

The Talent Scouts

VC firms are, in effect, talent spotters. They pinpoint a promising startup and invest a lot of money. But their involvement is far-reaching. They coach the young companies, and founders view the guidance as either overbearing, invaluable, or both. Still, once a startup gets picked as a VC investment, the company can’t be assured the VC firm won’t end up dumping it.

The CFA Institute suggested in a report that “venture capitalists must shed their least-promising assets very early in the life of a fund’s investment period,” typically in the first four years. “Three-quarters to 90% of a VC portfolio will deliver negative or negligible returns.” The objective is “to focus exclusively on its most likely home runs and not spend much time on or assign any more capital to the dogs in its portfolio.”

Seeking to reap the fruits of this tough love, investors in VC funds, like those in PE ones, traditionally pay 2% of assets in yearly fees. They also part with 20% of the profits for when a company goes public or is sold to an acquirer, the most common forms of exits.

How can investors find a good VC firm? Track record. The firms are informally grouped into three tiers. The top tier, composed of 20 or so firms, generally raise funds from $300 million to $500 million. This elite group contains storied organizations such as Andreessen Horowitz, Sequoia Capital, Accel, and Kleiner Perkins.

“Your goal is simple: Get to the highest tier you can,” advised venture investor Jyoti Bansal, the founder of AppDynamic, a tech provider that’s now part of Cisco, in a blog post. Kleiner Perkins, founded in 1972, has made a total of 1,136 investments, 240 of which have gone to IPO. Some its prominent recent investment choices include Beyond Meat and Uber.

Capital raising for venture funds has taken off in the past decade. Back in 2010, the funds raised $31 billion globally, a figure that ballooned to a peak of $129 billion in 2018, data from research firm Preqin indicate.

Amid concerns about slowing economies around the globe, that shrank to $102 billion last year. In pandemic-ridden 2020, many VC funds took write-downs in the first quarter, but then their fortunes improved, noted Venture Capital Journal. In 2020, through December 1, their capital has nudged back up to $107 billion.

The situation in the US, which has the most VC action, followed a similar trajectory: VCs raised $19 billion in 2010, and this year through November hit $70 billion, Pitchbook stats find. The 2020 raises are fewer in number but larger in dollars, with 294 funds raising money this year, versus 482 in 2019, likely meaning that some VCs are more cautious lately.

Raising money is not hard nowadays for these firms. “The funding environment is lush,” said Alex Pomeroy, co-founder of venture firm AGO, which has gathered $100 million. The acronym stands for Aspiration Growth Opportunities. Like all VC players, he eyes prospective investments with one big question: “Is there a path to profitability?”

Many investors ruefully remember how VCs plowed good money into wifty dot-com startups in the 1990s, only to see them blow up. In 2020, key AGO investments are Aspiration, a socially conscious bank, and Blue Bottle Coffee, a premium java retailer and distributor, which show lots of promise.

These days, VC funding comes in stages, depending on a company’s progress. DoorDash’s initial round was $17 million, which valued it at $72 million. After that, it got $2.4 billion in seven rounds. The latest was $400 million, bringing its value $16 billion. And this is despite $450 million in losses last year.

Amazon, backed by Kleiner Perkins, went public three years after its founding, with a market cap of $660 million (in 2020 dollars). Had you bought shares back then, in 1997, you would have reaped more than 2,000 times your money through Monday.

As AGO’s Pomeroy put it, “our best bets are when we get involved early and are deeply tied to a company.” Nothing ventured, nothing gained.