Fine Tuning Venture Capital Allocation Through The Cycle

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Attractive returns, increased familiarity, and a recent focus on growth and innovation have led to a significant increase in Family Offices’ allocation to Venture Capital over the past 5 years. Despite the hype and excitement, this has been an arduous journey due to the challenging nature of the asset class and the limited resources that most mid-size family offices can allocate to it. Getting it right requires steadfast vintage diversification planned for many years in advance and a rigorous, time-intensive manager selection process. We spend a lot of time with our clients on these issues and would love to share our thoughts with you if you are interested.

Attractive but challenging asset class

Over the long term, Venture Capital has delivered materially higher returns than other equity-like asset classes. As shown in Chart 1 below, over 10, 20, and 30 years, Venture Capital has delivered a premium over public equities of respectively, 11.7%, 4.2%, and 17.2%.

Chart 1: Trailing Pooled IRR for Private Equity / Venture Capital Indices - Premium Over Public Market Equivalent

Looking forward, we believe that Venture Capital could deliver a premium of 5.5% against DM public equities and 2% against private equity over the next decade[1],[2] – the highest of any asset class we track. Venture Capital also offers a very different risk-reward profile compared with buyouts, making it an increasingly important building block in long-term diversified portfolios. Mid-size family offices, especially in Asia, are now routinely investing in the asset class either directly or indirectly.

However, Venture Capital is a challenging asset class to invest in. To start, Venture capital returns display significant volatility across vintages even compared with other illiquid strategies like Private Equity and Private Debt. Chart 2 shows how this has been the case over the past 20 years. This is all the more important to account for that innovation is uncorrelated with macroeconomic cycles.

Chart 2: Average IRR by vintage across Private Equity, Venture Capital, and Private Debt Funds

Finally, the difference between top- and bottom-quartile managers is much larger in Venture Capital than in other asset classes we track, including Private Equity. Chart 3 shows how stark this difference can be. Partly as a result, while we talk about Venture Capital as an asset class, it is inaccessible as a market (as a "beta”): it requires a manager-by-manager approach in addition to careful portfolio construction, and building a portfolio of exposures is thus challenging.

Chart 3: IRR for Top and Bottom Quartiles by Asset Class (Private Equity and Venture Capital)

Given these challenges, a ‘simple’ rule of thumb to maximise returns would be to invest consistently year after year and to skew allocation to managers in the top two quartiles.

This much, most sophisticated investors understand. Execution is however easier said than done, particularly for most mid-sized family offices – as a rule of thumb, this would include those below US$2B in assets. Identification of top strategies would be the first hurdle, and gaining access is the second, but understanding the nuances of portfolio construction is also key. Anecdotally, we observe sub-optimal allocation at two levels:

• Sub-optimal vintage diversification – While innovation may be uncorrelated to macroeconomic cycles, venture capital fundraising tends not to be. The hot venture market of the last 5 years has led many people to significantly boost their venture allocations, be it due to genuine excitement about the changing world or simply FOMO. In our discussion with many Family Offices, we see less vintage diversification than optimal with a concentration around the top of cycle. While all understand that the current vintages, at the bottom of an equities cycle, may turn out to be relatively more attractive, they now lack the allocation capacity and sometimes liquidity to allocate to these vintages.
• Second, we sometime see disappointing returns driven by allocation to new managers or those outside of the 1st and 2nd quartiles. Managers who have performed consistently in the top two quartiles are typically closed to new or smaller LPs. In turn, identifying new outperforming managers in Venture Capital requires a lot of resources to understand and analyse a very fragmented market. By definition, there is a high risk of adverse selection for smaller LPs.

Building a best practice Venture Capital programme

As with all facets of investing, having a strong governance framework is key to decision making. This is magnified in the venture space where the dispersion of outcomes is greater both within and across vintages. Our investment approach for Venture Capital aims to reconcile this high long-term potential with the real challenges of investing in the asset class by:

• Maintaining a consistent commitment pace. This means running and updating forward-looking commitment models that account for longer-term allocation targets, expected capital call and distribution schedules, the growth of other asset classes, as well as available liquidity.
• Invest in building long-term relationships with managers with a proven ability to source and attract the most talented founders, as we believe these attributes are associated with performance persistence. Building these relationships and conducting in-depth due diligence requires significant investment in resources in specific geographies – mostly around innovation centres.

We find that, while they have already invested significantly in Venture Capital over the past decade, few Asian family offices have built the tools and resources to fully commit to the asset class and to fully leverage its attractive characteristics in building their portfolios.

One final thought is that many of the factors that make venture attractive, such as access to innovation, are not unique to this asset class. Innovative biotech businesses continue to list earlier in their life cycle, allowing for the returns of innovation to be accessed in the public market space where both active position sizing/rebalancing and the use of short positions can be used to enhance risk-adjusted returns. Similarly, many technology and software businesses are looking to debt markets to help fund their growth, and private lenders who understand the products well can make mid-teen returns while having strong downside protection from their senior ranking in the capital structure[1]. Having a multi-asset approach allows for maximising risk-adjusted returns across different parts of an economic cycle.

[1] Source: Partners Capital Insights 2023.

[2] Hypothetical return expectations are based on simulations with forward looking assumptions, which have inherent limitations. Such forecasts are not a reliable indicator of future performance.

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