Learning to Surf – The Ebb and Flow that Propels VC Returns

VCs need to invest in more capital-light Internet companies. No, VCs should be investing larger sums in capital-heavy cleantech companies. Wait, VCs need to evolve and re-invent themselves. Scratch that—VCs need to get “back to basics,” working their craft at a wooden hobby bench like Santa’s little helpers. Thin the herd: Ship half of the VCs to Algeria to ensure success for the rest…

Popular prescriptions to cure such VC market schizophrenia almost always include at least one glaring omission: Context.

So many discussions of venture’s ails consider the industry in isolation, exclusively from the practitioner’s perspective. It’s as if an individual investor reviewed their brokerage statements over the past two decades and concluded: “I sure was a better stock picker in the late 1990s.” The truth is VC’s success is connected and correlated to global financial markets and flows of institutional capital.

Simply put: markets work by supply and demand. VCs convert cash into a supply of stakes in startups. Mr. Market either seeks those stakes with demand or doesn’t. Just like the real economy, customers buy products or they don’t. What’s unsold is inventory stranded on balance sheets.

In the VC economy, stranded stakes suffer similar fates. In time, either the supply of startup stakes drops or demand rises. So, what’s caused the dearth of demand? There’s been no shortage of cash sloshing around the system seeking returns. Cash was lent and cash was borrowed. Cash was spent on houses that went up and then houses that went down. Cash was invested in fancy china and China’s fancies—to build mines and factories. Cash went into bonds, buildings, bridges and Brazil. But, cash decidedly avoided stakes for startups. Google Ventures’ Rich Miner likened VC to a produce provider. If consumers aren’t buying lettuce, it will make little difference if ours is organic.

“During the mid-1970s, when the new-issues market was all but dead, merger or sale was often the only exit available even for enormously successful ventures. During the early 1980s even the marginal cases found a warm welcome in the public markets.” –“The New Venturers,” John W. Wilson (1985)

What if hard work, investment acumen and company building skills had only a marginal impact on the performance of a portfolio of venture capital investments? Sounds like heresy, but the numbers lead many sophisticated asset allocators to just that conclusion. Theory says a particular investment category or class makes up the vast majority of the aggregate return, while individual managers produce only comparatively incremental “alpha.” Periods can be golden—despite the best efforts of some managers to muck things up. Even turkeys fly in tornados, while other periods are laden with lead—despite the most heroic efforts.

There is one large caveat: the top quartile of venture capital funds boasts a larger alpha versus the median participant than recorded in any other asset class. But VC managers focused on creating great companies (mathematically equivalent to the performance of the asset class + alpha outperformance) often disregard the importance of the impact of beta on their returns.

The assumption that asset allocation serves as a primary driver of returns extends to all segments of the investment universe. As one chief investment officer from a billion dollar university endowment said to author Steven Drobny in 2008:

“We should have all just been long 50 percent emerging market equities and 50 percent government bonds for the last 6-7 years and learned to surf.”

The fact that VC faces industry-specific and generational challenges obscures the most salient point: The VC industry won’t thrive without “healthy” public equities markets. And by healthy, I mean: flush with cash, future-oriented, and dense with demand and stake-seeking.

VC is an un-levered, un-hedged, one-way long bet on equities. There, I said it. Venture capitalists build portfolios of equity investments in private companies. And when equities are in the tank, there’s nowhere to hide. That’s not to say that the (over)funding of the VC asset class does not play some role in net returns, but it’s a relative drop in the bucket compared to the larger forces at work. If the multi-trillion dollar equity markets roar, it’s largely irrelevant whether annual venture capital flows are $20 or $40 billion. It’s like the mouse and the elephant, running together through the desert, when the mouse looked back and shouted to the elephant “Hey, look at all the dust we’re raising.”

VC’s rise to prominence coincided with the golden age of equities (1982-2000). You can’t tell the story of institutional venture capital without mentioning the rise of the largest end market for VC’s products—the U.S. equity markets, specifically the NASDAQ. Global investors shifted trillions of dollars in assets en masse from fixed income to riskier equity products, creating a large pool of buyers for new issues, stable shareholders for young, emerging companies and purchasing power for strategic acquirers armed with stock currency.

As an industry, venture capital has historically been highly correlated with the ebbs and flows of the public markets. Throughout its relatively brief, 50-some-odd-year history, venture capital has been called many things, but a vehicle for absolute return was never one of them. According to Cambridge Associates, U.S. VC funds averaged 3.82% returns from 1984 to 1990. During the same period, the NASDAQ produced an average 5.56% return. From 1991 to 1999, when VC returned an average 55.48%, the NASDAQ also delivered a robust 32.59% per annum.

But the golden age has gone into reverse: U.S. equities have been decidedly out-of-favor for the decade. The broad S&P 500 index has barely moved in nominal terms over the past decade, and that doesn’t tell the half of it. The S&P 500 currently trades at the level of March 1998, when gold was trading at $302 (currently: $1,230). It’s not much better when you compare U.S. equities against a basket of international currencies or even inflation-adjusted dollars. The most appropriate comp—the NASDAQ, teeming with tech and biotech shares—is 10 years later still down more than 55% from its March 2000 peak. Given venture’s high correlation with the NASDAQ, it should come with little shock that median VC returns would resemble the tech-laden index.

Might the flood of capital seeking safety in fixed income assets reverse? Will inflation rear its head? Will investors cease tolerating 1% fixed income yields? Will sovereign and municipal bond markets see more buyers or sellers? Is the S&P is undervalued? Will global capital flow back into U.S. equities?

If the answer to some or all of those questions is “yes,” we might be in for a very powerful wave in VC.

Peter is a Co-Founder and Managing Partner of Lux Capital, focusing on investments in energy technology, advanced materials and semiconductors. Read his past peHUB posts and follow him on Twitter.