Approaching Venture Investing – Historical Return Study and the Endowment Allocation

   By Denny O'Malley, Principal @VentureConnects      

In June of 2016, Pitchbook published this analysis on successful venture capital exits by city and by return. The piece is potentially valuable because financial information for privately-held early-stage companies tends to be very opaque.

Due to the unique and inherently risky nature of venture capital, this will not stand as an investment recommendation. However, it may shine some light on the space from the perspective of historical returns and provide some insight into where venture capital may fit within an accredited investor’s diversified portfolio allocation.

Let’s take a look at the 10-year study on venture capital returns. It provides the returns of successful exits, through acquisition or IPO, so it isn’t factoring in venture investments that didn’t make it. It’s important to keep that in mind while weighing the full risk of investing in venture capital; carefully consider the failure rate of early-stage companies could be 50% before investing in them.⁵

Here are the factors for inclusion in the study:

  • Full exit (acquisition or IPO) in last 10 years
  • Companies must have raised at least $500k in VC funding before exiting
  • Confirmed record of and amounts for all funding rounds to ensure accurate total invested capital
  • Confirmed amount for the exit (IPO value is equal to market cap at IPO)
  • Cities used in dataset must have had at least 30 companies that meet all of the above criteria

As shown below, venture companies included in the study that make it to an exit typically have had larger returns than public equities. This makes sense, as there is more risk involved with early-stage companies.          

Per the study, 71% of successful venture capital exits in the study generate 3x (200%) or greater return. For an accredited investor who can assume the risks of illiquidity and full loss of investment, the potential returns in the study are substantial.

For context, the annualized return of the S&P 500 index from 2005-2015 is roughly 7%.

When deciding where to put venture capital within a portfolio, an accredited investor with the capacity to take risks within their portfolio could use the endowment allocation model as a guide. Inexperienced investors should be careful with the endowment model as the investments within could be more illiquid, complex, and risky than traditional investments.

Approaches vary within endowment models, but for this piece I’ll use the Yale endowment, as it is one of the country’s largest and best-performing endowments. Below is the 2015 asset allocation breakdown and 10-year performance data as of June 30th, 2015.

                                                                                                                         Yale’s 2015 Asset Allocation and the average allocation of Educational Endowments²

“Alternative assets, by their very nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to [potentially] exploit market inefficiencies through active management. [However, the lack of price discovery can also increase the risks of allocating to the sector]. The Endowment's long time horizon is well suited to [possibly] exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.” ³

  • Yale Endowment

Yale’s Asset Class Performance from 2005-2015²

This is far from the typical balanced investment allocation, which has roughly 60% public equities and 40% fixed income. Yale’s endowment has the capability to invest across all asset classes, but many of these alternative investments may be difficult for an individual accredited investor to access.

Venture capital has become more accessible to accredited investors, however, due to the JOBS Act Regulation D rule 506(c) which was signed into law in 2012. That rule allows for private investments to be widely advertised, as long as the issuer of the investment certifies that the interested parties are accredited investors with $1M of investable assets, $200k of annual income, or $300k of joint income.

How would an accredited investor approach the venture capital space? It depends largely on what else is in their portfolio. Venture capital could possibly offset and increase the risk characteristics of the portfolio. However, a small allocation to venture capital within a diversified portfolio could have an impact.

To summarize, venture capital has recently become more accessible to accredited investors who may have the experience and capacity to take on the risk of greater illiquidity, risk, and complexity. Successful institutional investors have implemented venture capital as a part of their portfolios. As a part of a diversified portfolio, a small venture capital allocation has historically potentially had impactful returns. If this has piqued your interest in venture capital, contact Venture Connects to learn more –

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