Why incorporate Venture Capital in your portfolio?

The sustained growth of Venture Capital investment by private and institutional investors and large corporations has been increasing since 2008. After the financial crisis of 2007-08, an environment of stability, low interest rates and cheap financing was established, while at the same time the ecosystems of technological and innovative entrepreneurship were emerging globally. There were more and more success stories of entrepreneurs who were very quickly able to create a lot of value... and provide huge returns for their early-stage investors. Thus, a whole industry of fund managers specialising in this new asset class has developed in Europe and Spain in just 15 years.

Although macroeconomic conditions have changed, with strong geopolitical uncertainty, high inflation and interest rate hikes, the main arguments in favour of investing a portion of the portfolio wisely in Venture Capital remain undiminished. Let's talk about why:

Portfolio diversification

Venture Capital funds acquire stakes in unlisted startups at an early stage, and their valuations do not depend on market perception but on actual transactions and their growth and evolution as a company. Therefore, the correlation with other traditional assets such as equities, bonds or real estate is negligible. Some Startups will, of course, be affected by exogenous shocks affecting the markets, but a good investment manager diversifies the portfolio of Startups invested in taking this into account, and the small size and track record of Startups allows them to pivot their business models much faster than large corporations in the face of unforeseen events.

Thus, incorporating Venture Capital in a diversified portfolio by 5-10%, depending on the investor profile, can reduce the overall risk of the portfolio.

Countercyclical nature

Venture Capital investments are, above all, long-term investments. You have to be patient: you invest between the second and fifth year of a company's life in the hope of being able to sell your stake 6 to 10 years after the first investment. This is usually the time it takes for a company (the ones that are doing well and fast) to grow from a small turnover (less than 50-100k per month) to over several tens of millions and with large EBITDAs. For this reason, most Venture Capital funds typically have a duration of 7-10 years, in which they usually go through several economic cycles.

A good investment manager will try to take advantage of down cycles to invest cheaply and up cycles to sell companies at the best price. When investing, cycles actually have less impact (except for those who invest in more advanced stages of the Startup's life) as they are still very small companies and the bet is on their capacity for rapid value creation and not on investing cheaply with respect to the current market price. In future divestment, cycles in turn are more relevant, as the acquirers of the Startup depend on their own financial situation and their ability and cost to finance the operations, especially for larger transactions. Here, the good investment manager will know how to communicate to founders and investors in a highly successful company the wisdom of waiting for an upward cycle before initiating a sale process.

Maximising expected return

Entrepreneurship is the human activity that will continue to generate the most wealth in our society. This human capacity and ambition, together with learning, innovation, tools, methodologies, a lot of technology and capital, sometimes results in companies that reach a considerable business size and high valuations in a very short space of time. Of course, many conditions have to be met, but sometimes it is possible to multiply the initial investments in some successful startups by more than 50X or 100X. Most Venture Capital funds aim to deliver returns to their investors in the range of 20-25% (IRR).

Venture Capital is positioned as the Real Economy investment asset class with the highest expected long-term returns. Its low correlation with other assets in a diversified portfolio expands our "efficiency frontier" according to Markowitz's Modern Portfolio Theory. In other words, by incorporating this asset class into our overall investment portfolio, we achieve a higher expected return with an equal or lower level of risk... which adds value to our portfolio.

Entrepreneurship spirit affinity

Beyond all the theories and technical aspects that we must take into account as investors, let us remember that we are investing in recently created Startups, with great challenges ahead. When we invest in Venture Capital, we invest in founders who are brave and convinced of their contribution to their clients and to society, excited about overcoming these challenges and proving their worth as a company and as founders. This enthusiasm is contagious, and a good investment manager will do his or her best to facilitate meetings between founders and investors, some of whom may be able to lend a helping hand in the early stages. In fact, many Venture Capital investors have a successful entrepreneurial profile.

Today it is possible to choose Venture Capital funds based on different themes, such as specific sectors (Fintech, Healthtech, Agrotech, etc.), environmental impact, social impact, or the promotion of female entrepreneurship, among others. This allows investors to support the type of activity/behaviour they wish to promote, but this should not be confused with donations. A good investment manager will, however, seek to minimise the limitations in his investment policy, as they could reduce his expected return by not being able to invest in very attractive projects that do not respect it.

Conclusion

All in all, Venture Capital is an asset that, after its recent arrival in Europe and in Spain, is here to stay. Little by little, legislation is adapting to this reality and allowing smaller investors to access this type of asset through professional managers, which could be a decisive factor in the incorporation of Venture Capital in the portfolio of the small investor. Good news for everyone, as apart from its profitability/risk profile, it is an asset class that boosts the creation of value and wealth in our society.

Media sources: Funds People (opinion editorial written by Gonzalo Tradacete Gallart, CFA, member of the Alternatives Comité of the CFA Society as part of the vision of a fund as seen from the vantage of a CFA professional) (Spanish only!)