Barry Downes, Chief Investment Officer of Sure Ventures, makes the case for boosting portfolio diversification – and growth potential – by investing in venture capital strategies
There is a lot of bad news for investors out there right now. One only has to open any newspaper such as the Financial Times, or a publication such as Forbes to find headlines such as “The bad stuff that the stock market is worried about is about to happen” or “All the risks besieging European bonds are spilling over into 2019” from Bloomberg, or “Brexit could cause ‘serious damage’ for foreign investment into the UK new study says” from CNBC or “Apple’s stocks downgrade rattles global stock markets” from the Guardian or “The case why 2019 will be a bad news for the markets and 2020 will be even worse” from CNN Business.
It appears that everywhere one looks in the market at the moment there are pent up risks that could materialise any day and it’s difficult to see where future returns will come from
It appears that everywhere one looks in the market at the moment there are pent up risks that could materialise any day and it’s difficult to see where future returns will come from. However, despite this, experienced investors know that there are always opportunities to be found, even in potentially bad times, and diversification is an important strategy to protect returns. This article will focus on one such diversification strategy, which is allocating assets to the Venture Capital asset class, as a mechanism for diversification and potentially improving the performance of a portfolio.
Lifting the lid
Firstly, let’s examine the asset class in general, and then let’s look at a specific fund, Sure Ventures PLC, to see how diversification and potential returns can be achieved. Venture Capital is a subset of the Private Equity (PE) asset class and Venture Capital (VC) funds are specifically focused on investing in high growth companies such as the software sector. A typical VC fund will invest in a portfolio of 20 – 30 companies in a particular sector and/or at a particular stage of development, with a view to realising significant returns over the medium term by selling the portfolio companies (either via a trade sale or public listing).
The Wall St. Journal recently published an analysis from Prequin that asked the question “Does Private Equity really beat the stock market?” and the results are shown in Chart 1 below: To compare the returns, Prequin constructed an index that allowed it to analyse PE returns versus the S&P 500 index. It found that from 2005 to 2017 Private equity significantly outperformed the S&P as shown in Chart 1.
Source: Forbes Forbes also examined VC returns and published a very detailed analysis by Correlation Ventures of nearly 8,000 Venture Capital deals which is shown in Chart 2: The analysis examined realized returns on a deal-by-deal basis using “apples to apples” cash investments in either venture-backed deals or public indices. Chart 2 captures overall U.S. Venture Capital performance (blue line) relative to this theoretical S&P500 investor (dashed line).
Their analysis approximates the methodology of “Public Market Equivalent” (PME) analyses. One difference is that most PME analyses include the “mark-to-market” paper valuations of unrealized, illiquid private companies; whereas Correlation’s analysis focuses only on realized returns and “exits” – acquisitions, IPOs, and shutdowns. Over the period analysed, cash on cash returns for VC have been significantly higher than the S&P 500 in many years, peaking at a 2.8x multiple versus 1.2x in 2012.
But how do the absolute returns of VC compare to other asset classes over the long run? Cambridge Associates analysed this over a 5 to 25-year period and the results are presented in Figure 1:
Venture Capital can produce outsized returns over both the medium term and long run when compared to other asset classes
As can been seen from Figure 1, Venture Capital can produce outsized returns over both the medium term and long run when compared to other asset classes. For example, over a 25-year period top quartile returns for VC were 57%, compared to 10% for Large-cap equity and 8% for high-yield bonds. Of particular interest to asset allocators, Cambridge Associates also analysed the VC asset class’ correlation to other asset classes and this is shown Figure 2: The results show little correlation with Large-Cap equity (-0.06) and High-Yield bonds (-0.13), and as a result, it can be concluded that VC as an asset class can be used both to diversify risk in a portfolio and also as a source of Alpha.
Getting access to VC within Client Portfolios
Given this, asset allocators might ask themselves what are the options for allocating assets to VC and what is involved? Most VC funds are closed-end private GP/ LP structures that require an investor to sign-up to a 10 to 12 year lock-up on capital, which is then called as investments in companies are made. There are fewer VC funds that are publicly listed and can be invested in via a placement or bought in the open market.
These are closed-end public funds which are bought up front but as a result do have some measure of liquidity – being able to trade by appointment or being sold directly in the market. Such funds may provide more flexibility for asset allocators than the traditional private 10 to 12 year fund. An example of one such VC fund is Sure Ventures PLC, which is listed on the Specialised Financial Segment (SFS) of the main board of the London Stock Exchange (LSE).
The sure solution
Sure Ventures PLC is a fund that invests only in software companies. In particular, it focuses on three key areas of emerging growth in software, namely Artificial Intelligence (AI), Augmented Reality and Virtual Reality (AR/VR), and the Internet of Things (IoT).
Sure Ventures PLC provides access to this exciting sector to public market investors. It typically aims to be their first institutional investor and its companies normally have previously received prior funding from “friends and family”, Accelerator and/or Angel investment. In Silicon Valley this stage would be termed “Seed” whereas in the UK it is often referred to as “Series A”. At this stage individual portfolio companies typically have a management team in place, have brought their product into the market and have initial sales, i.e. market validation. Thus, the fund is taking minimal product and market validation risk, rather its focus is on taking execution risk – i.e. scaling up the company, over a number of investment rounds. The goal being to provide capital and know-how to help the company grow to the point of an exit for a large return. The benefit of the strategy is that Sure Ventures PLC can purchase its initial investments in these companies when they are still at attractive valuations of between £2m and £6m on average. As these companies progress over time, they can become very large and their value substantially increase. Later, the Fund aims to exit them through a trade sale or following an IPO. Of course, within the VC model individual companies can fail, but others are expected to produce substantial returns and an overall target of 30% internal rate of return (IRR) is set across the portfolio.
The current Sure Ventures PLC portfolio consists of 10 companies and it expects that number to reach 25 to 30 over the next two years. Two of its holdings have already gone to IPO.
Investment trust structures
It is important to clarify that Sure Ventures is an investment trust which invests in this sector, rather than a Venture Capital Trust (VCT) by definition. VCTs carry tax breaks for a five year hold period and have certain constraints too. The investment trust structure is also tax efficient but in a different way. It provides more flexibility. With a VCT or EIS fund all the investments must be made into qualifying UK companies. An investment trust strategy allows for investing outside the UK. This is important for the strategy of Sure Ventures as it is looking for the best and brightest companies in three technology sectors chiefly across the UK and EU, but potentially even further afield.
About Barry Downes
Barry Downes is CIO of Sure Ventures PLC, Managing Partner of Sure Valley Ventures and also Chairman of TSSG (previous CEO), a leading technology Research Institute, Incubator and Accelerator which has raised over €90 million to date. Previously, he was Founder of FeedHenry, which was acquired in 2014 for $82M by RedHat Inc. and also a Partner in SVG Global Inc. a leading Silicon Valley accelerator, VC and technology consulting firm. Barry was a co-founder of Phoenix Technology Group a high-growth Fintech company and Software Development Manager at Infinium Inc. in Hyannis, Massachusetts. Barry holds an MBA from Smurfit Business School UCD, a BSc in Applied Computing from WIT and has executive education qualifications from Haas School of Business at the University of California Berkeley (in VC) and also Harvard Law School. Barry was recently named one of the top Irish software superstars by Silicon Republic and he won the Enterprise Ireland ICT Commercialisation Award in 2007 and the Irish Software Association (ISA).