Publications

- May 1, 2022: Vol. 9, Number 5

Venture capital 2.0: A wider range of investors gaining access to VC, while many advisers sit on the sidelines

by Ziad Makkawi with Mike Consol

It might be premature to call advisers and investors “yield starved” at this stage, but the hunt has clearly begun for new portfolio assets to offset what many are prophesizing to be an end to the historic bull market on Wall Street. With equities curdling under the assault of a worldwide pandemic, rising inflation and interest rates, and warfare in Europe, some investors are moving up the risk spectrum.

Yet, in some asset classes, the risk spectrum isn’t as unpredictable and unmanageable as it once was, and that would include venture capital, according to Ziad Makkawi, founder and CEO of EQUIAM. Improved and more widely available technology and data models have made VC investment opportunities available to accredited (and even retail) investors. The problem: Many advisers are unaware of VC’s evolution and new accessibility, while others have been reticent to initiate the discussion with their clients.

You say advisers should start the conversation about VC investing, with distinctions about risk and reward.

Investors in venture capital are generally seeking something beyond public market growth; VC is where “hypergrowth” lives. As we all know, risk and reward are often two faces of the same coin. As a result, VC has been perceived as being on the high end of the risk spectrum, but over the past few years, the different risk profiles of seed/early-stage versus growth/late-stage have become better understood. This has attracted a record number of nontraditional VC investors, including individuals and family offices, who have traditionally had limited or no access to top-quartile VC managers.

A good place for advisers to start any conversation about these newly available VC opportunities is with two characteristics that impact the risk/reward equation for their clients — stage and style. Managers who invest in early-stage companies have a different risk profile from those that invest in the later stage. Many early-stage companies, after all, are literally no more than ideas, while late-stage companies tend to have revenue streams, established markets, and may be on the verge of an initial public offering. From 2002 to 2019, managers who focused on the late-stage market had a performance advantage. The mean net internal rate of return for that period was 17.7 percent for late-stage U.S. managers’ compared to 15.5 percent for early-stage.

Investment style is really about how a manager makes decisions. If you ask enough questions of a traditional venture capitalist, their decision making will ultimately be heavily influenced by intangibles or “gut feel” for the ecosystem and the founders. In the early-stage market, there is not much more to go on. The later-stage market is different. There’s a wealth of information on late-stage companies that allows investment decisions to be truly data-driven. We have high conviction that the data-powered model is superior because it allows for a wider funnel of deals, faster decision-making process and investing, and better diversification. Continuous performance monitoring is also important. Portfolio companies can be tracked to assess how they score over time, relative to other comparable companies, and whether a pre-IPO exit via secondary markets is warranted. That means investment and divestment decisions can be made based on a rigorous, systematic and quantitative process. The important point for advisers is to understand both styles (the systematic approach and the traditional one) in the context of growth and late-stage investing.

What are the opportunities in VC that are being overlooked by most advisers?

Early-stage investment strategies look the same as they did 70 years ago, where investment decisions are mostly art, not science. It’s good that advisers have more access to early-stage companies, especially for clients with a high tolerance for portfolio losses and illiquidity. But late-stage venture capital is where new products and platforms are changing the nature of what is available for clients.

This is not yet widely understood, but we can see it in the data. PitchBook reported record activity during 2021 among nontraditional VC players, sometimes called crossover investors. Fund-raising activity for first-time funds was also near a 10-year peak. A lot of the investment came from hedge funds and private equity, but individuals, family offices, corporations, and smaller endowments played a role too. We also see that the number of late-stage deals grew 47 percent in 2021, so the overall trend is clear. A wider range of investors than ever before is gaining access to venture capital, and many are focused on the late stage. This is one aspect of what we call VC 2.0.

How is the growing availability of private markets data a game changer?

The venture capital industry has been evolving rapidly over the past decade or so. We’re moving on from VC 1.0, or roughly the first 70 years of venture capital. The investment advantage in the old model relied heavily on a venture firm’s network and its ability to control information about issuers, which is why deals typically took place behind closed doors. VC 2.0 is a different world — more transparent and accessible and, therefore, more like a public market.

You argue that traditional VC firms no longer have the exclusive ability to see inside the hottest pre-IPO companies. Why is that the case?

In a public market, theoretically at least, participants all have access to the same information. The investing edge doesn’t come from the raw company information but how you use it. Managers can now analyze more than 10 million data points on the 120,000 venture-backed companies that have had at least a series B funding round. That includes the most sought-after pre-IPO companies. Because of the increase in nontraditional venture capital players, founders and entrepreneurs also have a broader lineup of potential investors than previously available.

Explain why recent SPAC deals and plans for a Nasdaq Private Market to become a standalone are two signs that secondary transaction volumes have reached a tipping point.

One important data source in this new world of VC is the secondary market. It has revealed prices for venture-backed companies between primary funding rounds. Historically, only primary round investors (i.e., traditional VC firms), had access to financials or valuations between rounds. Today, more of this information is becoming available through secondary market transactions and other data providers.

I would point to Forge Global’s debut listing on the New York Stock Exchange through a SPAC deal in March. Forge is a marketplace for direct private tech secondaries. It is building the ecosystem of this private capital market. In addition to being a marketplace, it also offers custody and data services that further fuel the growth of VC 2.0. With this listing, we literally saw the public and private markets coming together.

In the public markets, investors watch metrics such as price/earnings ratios. If P/E gets ahead of itself, they may start to think about trimming. We’re so used to the idea that it’s easy to forget this approach is revolutionary in VC. The traditional limited partner experience was to commit a chunk of capital to a VC fund and then wait for six to 10 years to see what happened. In that time, the general partners pick companies and stick with them, usually to the bitter end. Everyone hopes that a handful of winners will more than compensate for the bulk of the portfolio companies, which make no money or go to zero. Now VC funds can watch valuations in secondary markets like Forge, as well as other financial metrics for warning signs. If algorithms raise a red flag, VCs can investigate whether an exit is warranted. This kind of flexibility simply did not exist five years ago, and it ultimately means more choice of strategies and approaches for investors.

What kind of tech or other innovations are promising to make VC investment opportunities more egalitarian?

Funds, platforms and managers are finding new ways to use the newly available data on private companies to inform their investments and offer opportunities to different types of investors. Advisers and their clients will continue to see ways into companies that were beyond reach even five years ago. Big-name VC firms still control the primary funding rounds for sought-after companies, but accredited investors are seeing more high-profile names through secondary markets transactions.

Access is important and long overdue, but we also believe that data science and systematic, data-driven investing is critical. It removes a lot of the human bias from investing, and this should matter to investors because it also makes it possible to create risk-focused, relatively diversified portfolios with shorter fund lives than traditional VC funds. The risk focus can come from a wider investable universe that yields a more diversified portfolio, or a data-powered investment model, or both. The faster path to liquidity may be a function of faster deal sourcing, a late-stage focus, the ability to exit faster via secondaries, or all of the above.

Will market volatility and other factors increase the VC investing risk?

While we’re in a highly volatile environment, liquidity has not disappeared. Dry powder in venture capital is more than $500 billion, which means that there’s going to be issuance, but the market will become much more discerning. We also may see some rebound in initial public offerings this year at lower valuations for companies with strong fundamentals.

In general, advisers should be prepared for a bumpy 2022, and that spells risk and opportunity. Risk management will be extremely important. Companies that have strong revenue and growth to back up realistic valuations are less likely to be slowed by headwinds in the VC market. On the opportunity side, there are still great growth deals, and volatility may generate even more. We were getting concerned about rising valuations in December, and we started lowering our secondary market bids by as much as 50 percent. There wasn’t much immediate interest, but February and the Ukraine crisis changed attitudes.

It comes down to the adage, “know what you’re buying.” In venture capital this year, there are more options than ever before for advisers who want to find an appropriate, risk-focused strategy for their clients. In the end, the biggest risk of all may be not allocating to VC or other hypergrowth strategies, and missing the massive transformation that innovation and technology are ushering in.

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