October 14, 2014
Interviewed by: David Snow
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Venture Capital Returns: Strong, But for How Long?

The public markets have opened up for venture capital exits in a big way, and this has led to a surge in medium-term VC fund performance. But is this outperformance real, and which investors will really benefit? Three performance experts discuss the current state, and the future, of VC in the institutional portfolio.

The public markets have opened up for venture capital exits in a big way, and this has led to a surge in medium-term VC fund performance. But is this outperformance real, and which investors will really benefit? Three performance experts discuss the current state, and the future, of VC in the institutional portfolio.

Venture Capital Returns: Strong, But for How Long?
Private Equity Performance

David Snow, Privcap: Today, we’re joined by Andrea Auerbach of Cambridge Associates, Erick Bronner of the Riverside Company, and John Clark of Performance Equity Management. Welcome all of you to Privcap. Thanks for being here. Our topic is the most important topic in private equity: performance. You don’t get into private equity as an asset class unless you want the performance, notwithstanding how much fun it is to be in it. Let’s talk about a subsector of private equity—venture capital—that over the past 10 years has received a lot of negative attention for its supposed underperformance. Some people have said that venture has gone through a lost decade as far as performance goes, despite its brilliant early history. Let’s start with a question for Andrea: what has changed in the past year by way of venture capital’s aggregate performance that you think will change people’s view of this asset class?

Andrea Auerbach, Cambridge Associates: Performance in venture capital has been strong, not just immediately recently, but over the last short, the short term.

Boxed item: 

U.S. Venture CapitalAnnualized Returns14.5%10.5%18.66%31.71%
S&P 500 Index20.88%8.04%6.10%9.02%

Source: Cambridge Associates

Let’s call it over the last three to five years, so the performance has been good and some of that has been the initial investments that were made during the doldrums you described. There was a 10-year, almost a lost decade, where performance in venture was trending negatively, and we’re up and out of that. A lot of investments that were made during that timeframe have come home to roost, have gone public with some fairly impressive valuations and have created a lot of the returns we’re seeing today.

Snow: John, as someone who oversees institutional capital, including in the venture capital asset class, what is your view of venture capital’s performance over the past two to three years? What’s been behind it and what does it mean for the way people should be thinking about this asset class?

John Clark, Performance Equity Management: Just the globalization, the innovation you’re seeing across a lot of different areas, whether it’s in mobile and enterprise and software; it’s an interesting time. If you’re in high-quality venture relationships, you’re starting to see and reap the benefits of that. So, our portfolio, similar to what Cambridge is showing, has had a great run here the last few years, and there are a lot of legs to this.

Snow: Erick, as an IR professional who speaks to many investors, were you aware of a waning enthusiasm among LPs for venture capital during the doldrums years? Was this a conversation you had?

Erick Bronner, The Riverside Company: There are a couple of ways to look at it. First of all, investors commit capital to try to generate alpha, especially in the private equity space. In general, they don’t put themselves in a position of trying to market time. So, you take a view on the venture capital space and then you invested in it. I did hear people say that a number of formerly venture capital funds somehow became growth equity funds because the words “venture capital” for a period of time weren’t particularly helpful in raising capital. And, as the performance of venture capital has gone back to historical norms, that growth capital crowd has become a venture capital fund again. There was also a sense, from the limited partner community, that the returns in venture capital were at a few firms versus other parts of private equity where the returns were more broadly spread and that also seems to be changing, where the number of managers showing up with very good performance is outside what I would call “the top 10” to a broader set. Now, if you can take that knowledge and if you’ve been in the space for a while, your ability to select managers is broader. Certainly, as an investor, you want to diversify that portfolio and have exposure to what would have to be one of the most dynamic areas of our economy.

Auerbach: One thing worth mentioning, though, is the doldrums have been incredibly beneficial and it’s been conflated with a reduced cost to actually be a start-up. So, capital vacated to venture capital. The classic venture capital, like classic Coke, new Coke—capital vacated the classic venture capital space, in fact, commitments in 2001 to VC were $110 billion. The last six years of commitments to the U.S. venture capital asset class total $106 billion. So, there’s no way we’re going back yet to 2001, but because so much capital vacated people were able to be more choosy with how they deployed their capital. The cost to actually start a technology company keeps coming down, right? So, you don’t need as much money to create something that could be incredibly innovative. You’re doing it with fewer dollars and, because capital had vacated the space, it was more beneficial to those that remained. That’s resulted in a lot of the performance we’re watching come through now.

Clark: I think the industry has been right sized. One of the issues is, “How do I get access now that the industry’s been right sized? How do I get access to the top-tier managers?” But it’s interesting, because when you go back to the early 2000s (and that’s the reason it took so long to really digest), this decade plus downturn in venture. There was so much capital raised, but when you look at the interesting companies that were started and built and you go to the mid-2000s, people were still saying, “What’s happening? I’m not seeing returns.” You started to see some interesting companies in our VCs portfolios and these are companies that were now generating $25 or $50 million-plus of revenues and growing at a 2x clip, year over year. You knew that when the markets, which are huge in the returns as well, you got to have access to an exit environment and that’s a stronger IPO environment and a stronger M&A environment, but a lot of companies were being built in the early 2000s that were well positioned for a nice exit. I think you’re seeing that in the last few years, and it’s not just about Facebook or Twitter—you’re seeing a broader set of companies having some very attractive exits.

Snow: I’d like to talk about the exit market in a bit, but first a question for Andrea about Cambridge Associate’s data. We’re looking at the several different ways of measuring venture capital performance from one year to 30-year, and it’s all remarkable. The 20-year performance for venture capital is 31.71% on average.

Boxed Item:

U.S. Venture CapitalAnnualized Returns14.5%10.5%18.66%31.71%
S&P 500 Index20.88%8.04%6.10%9.02%

Source: Cambridge Associates 

It’s hard to get that just about anywhere else in the world, but from the average participant’s point of view in the market, is that going to be the experience of the average institutional investor in venture capital? Or is this so heavily-weighted toward the top firms that most people are not in and will never get in?

Auerbach: Lots of interesting questions in there, David. The information that we publish on is an index. It’s not replicable in nature. You can’t buy this index and bank in it, right? It’s the collective performance of every venture capital firm we monitor. So, this is an example of what the market has yielded and, as we all know, a number of highly successful exits can crystallize and pull up that performance for most. Should investors avail themselves of the asset class if they can’t get into a certain subsector? One other piece of information we’ve worked on is that if you look in the top decile, the top-10 venture capital managers of the last 10 vintage years, there’s always a handful of new comers. Folks who were on Funds 1, 2 or 3 are not on Funds 5, 6 or 7, and if you had committed to their first fund, you would have benefited and been in that winner’s circle for that vintage year. So, there are opportunities for investors to deploy capital in those off, less on-the-runs, known strategies and still benefit from the success in the market. There’s one other thought on this, which is a lot of the performance you’re watching is due to public equity capital market exuberance and lift. Twenty-three percent of the venture capital index we track, 23% of the companies in that index, are publicly traded. So, you’re getting one-for-one direct lift from what’s happening in valuations on the equity on the public equity markets; you’re seeing it come right through in the index.

Bronner: Another point that Andrea made that’s very important is the sense that venture’s going through a generational transition where a lot of the folks who founded these top-10 firms are either retiring, taking a step back or trying to cut up new California. You have this second layer of professionals, some of which will inevitably spin out, where you have an opportunity to get folks who are highly qualified, are embedded in the sectors and are Fund 1 or 2, where there are real chances to even outperform the index. And her point that every time you look at the top 10, there are names you wouldn’t have expected to be in there, that there is a lot of opportunity. The key is not trying to market time, but thoughtfully looking at these managers. What’s their background? What’s their expertise in the sector? Do you think they have a better expertise than others? That’s really the analysis you need to do. If you do that, I think you’ll be richly rewarded.

Clark: But, when you look at the most successful companies that have been built the last five to 10 years and you look at who really had a piece of those companies and who led the Series A and Bs and so forth, it is a lot of the franchise names. So, it is an issue if you’re a huge institutional investor. How do I make this a real asset class in my portfolio? Because I can’t just come in and say I want $50 million of Sequoia. That’s not going to happen.

Auerbach: One interesting thing about venture capital as an investment strategy is that the height requirement works in reverse. You can be too big to go on the ride, right? It can be; it won’t be a meaningful driver of the returns in your portfolio as an institutional investor above a certain size. So, it really benefits, perhaps, the smaller institutional investor because you can make a broader or small commitment that will have a material impact on the performance of your overall program. And it is an issue for larger institutional investors, because they just can’t get enough of the exposure they want.

Snow: I want to move to a topic that John mentioned and this can be our final topic: the current market for exits in venture capital and that drives a lot of the recent success of the asset class. You made a very good point, that these companies that are now well-known were legitimate revenue-generating, growing companies that are now hugely profitable and successful. Or at least the ones we have heard of are successful. That’s not a bubble, is it? It seems like every time venture capital has a success run, people start talking about a bubble because of the bad memories of 2001. But to what extent are we in an unsustainable environment for future exits?

Clark: There are certainly areas of concern, and a lot of people try to make the comparison to the late 90’s. People look at late-stage valuations; certainly you look at the really hot deals and how valuations have skyrocketed. But when you talk about a tech bubble, again, there’s a giant engine that’s been built over the last 10 years and when you look at the pillars that are really going to drive returns, you’re not relying on just one area. It’s not about mobile. It’s not just about internet and the consumer. It’s a lot of great things in enterprise and infrastructure and storage and these are all needed innovations to continue to drive technology and innovation. Then, you look at the globalization; people have had concerns about China and exits, but just the size of that economy. And you look at the penetration of the internet and applications for mobile. Or, you look at a flip card in India and those kinds of things. There’s just tremendous opportunity. Yes, there are concerns when you look at some of the valuations, but when you really dig deep and you look at concerns about a tech bubble and the public markets and so forth, you take out bio tech and it doesn’t look at bad as it did in the late 90’s. There’s still room to grow, and what you need is a breadth of companies. It’s not just one or two. And you’re seeing a lot of those in our underlying VC portfolios.

Auerbach: And there were 81 venture-backed IPOs in 2013, which is the most since the global financial crisis. That’s up from 51 in 2012. So, we’re going up and to the right and it’ll be interesting to see what happens this year, 2014, when the bell rings at the end of the year. It feels like the trend is, there’s a lot of retail and equity capital market interest in these kinds of companies. Whether or not there’s a complete disconnect of valuation from reality, that’s continuing in certain pockets of innovation that we’re watching happen. Does it feel like there’s a bubble brewing? Yes.

Clark: Obviously, there’s a lot of cash on the sidelines for M&A activity. You’ve seen some crazy valuations with recent transactions as well. But, because you have such a large portfolio of companies to really drive continued performance, you have to have a continued exit environment that’s attractive whether it’s public markets or M&A. If that pulls back, it’s obviously going to have a negative impact on our returns.

Bronner: It also feels to me that—different from the prior bubble—globalization’s had a meaningful impact on venture; there were a couple of concentrations of technology expertise, whereas today, at least as I see it, there are lots of places around the world where you see real pockets of capability. And the capital markets they can tap into aren’t confined to one particular region. That’s also playing into the broader benefit of performance.

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