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Venture capital and its growing importance in portfolios

Russell Investments’ alternative investments client portfolio manager Darren Spencer discusses why venture capital should be a focus for all serious investors.
Russell Investments’ alternative Investments client portfolio manager. Darren Spencer

Today, venture capital stands at the intersection of several key trends in the global economic ecosystem. In particular, this includes the emergence of technologies central to the fourth industrial revolution, such as artificial intelligence, the internet and quantum computing, as well as digital transformation and the continued rapid adoption of technology. And while the COVID-19 pandemic sped up digitisation of the economy, the sustained utilisation and application of technology is here to stay. In addition, venture capital has provided investors with attractive historical returns, with US venture capital pooled returns delivering a 17.2% return for the trailing ten-year period to December 31, 2020. [1]

From an investor’s standpoint, this has fostered a strong interest in being able to access investment opportunities in companies that are driving the most promising technological advances under development today and in the future. Here we'll discuss the basics of venture capital, the rationale for exposure to venture capital in a total portfolio and key considerations for success when investing in venture capital.

What is venture capital?

Venture capital is the financing for start-up, early-stage emerging private companies with high potential for growth where, given the stage of their lifecycle, access to financing sources such as stock offerings or debt issues is unavailable. Venture-backed companies typically operate in the technology and healthcare sectors, where there is the potential to disrupt industries with life-changing products and services.

The venture capital financing cycle involves different stages from seed to late stage, where each stage is typically characterised by certain milestones, which are either operational and/or financial. Through this process, venture capital has the potential to take companies from the earliest stages of their life to where they can be generating millions or even billions of dollars in revenue. These different stages are outlined below:

Seed– The first financing round after incorporation of the company, which typically funds the development of new products or services

Series A – The first significant financing round, in which one or more venture capitalists become involved in a fast-growing company that was previously financed by founders, seed venture capitalists and/or angel investors

Series B & C– Financing that is provided to assist in scaling the company’s operations, including manufacturing, new products, marketing, sales and customer service

Late stage– Financing provided once the business generates meaningful revenues. This can include capital for significant expansion, mergers and acquisitions or entering new markets, for example.
 

The case for venture capital

Within the total portfolio context, we believe there is a compelling case for exposure to venture capital. In addition to exposure to key technological trends and innovation, along with the potential for attractive absolute returns, there are also some additional structural market dynamics that may be attractive for investors.

First, consider that companies are staying private for longer. In previous decades, venture-backed companies tended to go public earlier in their lifecycle. For example, Amazon went public in 1997 when it was three years old. At the time of Google’s IPO (initial public offering) in 2004, it was six years old. [2]

Today, however, the market dynamics are quite different as companies rely more and more on private markets for their growth and are electing to stay private for longer periods of time. For example, Uber and Airbnb, two of the ten largest-ever technology IPOs, were 10 and 12 years old, respectively, before going public - long after they had disrupted the industries in which they operate [3]. Moreover, while private companies valued at more than $1 billion (also known as unicorns) were virtually non-existent a decade ago, today there are approximately 1,000 companies with billion-dollar valuations across a range of sectors, including internet software and security, hardware, artificial intelligence, fintech, healthcare and e-commerce. In aggregate, these companies are worth approximately $3.3 trillion [4].

Given that companies are staying private longer and their valuations are much higher than has been the case historically, the implication for investors is that by not participating in venture capital, they risk forgoing exposure to high-growth companies, disruptive technology and the potential for high returns. The bottom line: From our vantage point, gaining exposure to venture-backed companies prior to their IPOs is more important than it has ever been.

 

What are the diversification benefits of venture capital?

We also believe that venture capital contributes to improved portfolio diversification. Through time, the success of a high-growth company will be idiosyncratic in nature and less dependent on the general direction of macroeconomic factors, such as GDP (gross domestic product) growth, fiscal and monetary policy, interest rates or inflation. This is why we believe venture capital plays an important role in the long-term strategic asset allocation of a portfolio.

Secrets for success: Key considerations

While we believe the opportunity cost to investors of not participating in venture capital is large, there are important implementation considerations that investors need to be mindful of to ensure their desired investment outcomes are achieved. For example, there is a wide dispersion of returns across the universe of venture capital managers - and having the necessary relationships to access these top-tier firms whose returns have typically been found to be persistent is critical to success. In addition, having the depth of resources to be able to identify and access top-tier funds around the world - including the United States, Europe and Asia - is also key.
 

Exposure to venture-backed companies is critical

On balance, we believe gaining exposure to venture-backed companies as part of a total portfolio is a critical way for investors to participate in high-growth companies as they commercialise and scale their operations. Overall, venture capital can provide investors with several important benefits, including exposure to structural trends across technology and the opportunity to benefit from the substantial value creation that is occurring in private markets.

Ultimately, it’s not surprising that as investors seek to address the challenges of generating returns and improving diversification, they’re increasingly turning to venture capital to potentially improve their investment outcomes by partnering with firms that have the requisite depth of resources, strong manager selection skills and demonstrated access to top-tier funds.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

[1] Cambridge Associates, “Are the Strong Recent US Venture Capital Returns Bankable?”, July 2021, https://www.cambridgeassociates.com/answers/are-the-strong-recent-us-venture-capital-returns-bankable/

[2] Hamilton Lane, “The Myth of Peak Venture” July 2019, www.hamiltonlane.com/en-US/Insight/9667e821-9b4a-428b-9306-1d7c5a145d74/The-Myth-of-Peak-Venture

[3] Hamilton Lane, “Broader Horizons: The Case for Private Markets Investing” April 2021

[4] CB Insights,”1,000 Unicorns: Global Billion-Dollar Private Companies Hit A Four Digit Milestone” February 2022

https://www.cbinsights.com/research/1000-unicorns-list/


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