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Why should I complement my portfolio with venture capital investment?

By 29 July 2021 No Comments

Historically the Venture Capital asset class has been viewed as the riskier and more illiquid asset class. Venture Capital consists in direct or indirect investments (via a Venture Capital fund) in companies with high growth potential, also known as Startups. The usual and simple case scenario consists in an investor making an investment in a company in exchange for equity, which will use these proceedings to grow the business. Later, the investor will sell their stake at a higher valuation and earn capital gains in the process.

Venture Capital in Spain: How has the pandemic affected VC investments?

The Venture Capital industry in Spain represents 0.049% of GDP, which is slightly above the European average of 0.04%. Additionally, the industry has shown an accelerating positive trend in the past years. In 2019 alone, € 721.9 million were invested in Spanish companies by both national and international Venture Capital firms – a 42.8% increase from 2018 – allowing for the ecosystem to develop and mature. 

As shown above, the year 2019 was marked a record year for Venture Capital investments in Spanish startups. When comparing the sum of investments made the previous year with the volume reached in 2018, we can get an idea of the growing importance of Venture Capital in Spain. This becomes increasingly more evident when we take into account that Venture Capitalists agree to take on high-risk investments with the aim to buy into small, highly innovative companies with high growth potential that will lead to high returns in the short-term. However, due to inflation and interest rates hovering close to 0, such as the EURIBOR, (benchmark of other interest rates) investors are now looking for alternative sources of passive income, such as VC. 

In 2019, a total of 79 Spanish Venture Capital funds and 68 international funds invested in Spain. International funds are demonstrating a growing appetite for the increasingly attractive Spanish market year on year. This year, foreign investment reached a volume of €443.2M (+70% compared to 2018).

why complement my portfolio with venture capital
Table 1 – Venture Capital Investment in Spain (in millions of €)
Source: Startupeable

Undoubtedly, 2019 was a year of many records. Despite the global pandemic, the sector has maintained its dynamic and the record number of investments recorded in 2019 was even surpassed in 2020, with 590 investments as opposed to 431 in 2019. When it comes to the number of deals closed, the Venture Capital sector has been the biggest driver in terms of volume and number of investments, with €750M in 590 investments undertaken in 2020. A new all-time high in late-stage venture investments (151 in 2020 vs 113 in 2019) has proved the maturity of Venture Capital. When it comes to Venture Capital internationally, new records have been set too, with investment volume reaching €459M in 141 investments, an increase of 44 investments when compared to 2019.

The following table shows that Venture Capital profitability in the long run has exceeded that obtained by two commonly benchmarked equity indexes on a global level and, consequently, other asset classes such as real estate or fixed income. As such, it is fair to say that the incorporation of Venture Capital in a diversified portfolio increases its expected return. It also should be considered that, historically, Venture Capital investments in early-stage companies typically deliver higher returns, with over 8% capital gains increase since 1969, when compared to investments in later stages.

why complement my portfolio with venture capital
Table 2 – Average 10-year Return
Source: “US Venture Capital Index and Selected Benchmark Statistics” Cambridge Associates

Venture Capital in Europe

Despite the slowdown in fundraising that Startups have experienced due to the pandemic, which particularly affected them in Q1 and the beginning of Q2, European Startups overall raised $40 billion in 2020. This constitutes a decline of only 4% when compared to the $41.8 billion raised in 2019 and is an encouraging sign for Venture Capitalists as it represents the second highest amount raised for European Startups over the last few years. Looking back to 2018, when Startups raised only €28.7 billion, we can say with confidence that Venture Capital investments have gained substantially in significance in Europe. In the graph below, we can see the evolution of deal counts and their value in Europe over the last decade.

why complement my portfolio with venture capital
Table 3 – Evolution of deal counts in Europe and their value in Europe (in billions of €)
Source: Sifted

Venture Capital in Germany

2019 was also a record year for Germany, with funds raised amounting to $5.7 billion and 49% year-on-year growth. 23% of the capital raised was allocated to the Fintech sector and related businesses, while 20% were destined to B2B software related companies. This earned Germany second place in Europe in terms of capital allocation and has allowed the country to maintain its global industrial leadership position by representing 26% of total funds raised ($1.3 billion). Finally, Venture Capital remains one of the main sources for fundraising in Germany and represents some of the highest levels worldwide with 58%.

In 2020, the German government successfully accelerated initiatives aimed at increasing liquidity and supporting fundraising activity for Startups in the German market to maintain the increasing upward trend of Startup investment seen over the past 5 years and safeguard a well-balanced and diversified ecosystem. The strategy has paid off with innovative German Startups taking advantage of the unprecedented demand for digital business models and mobile solutions. Investors have responded positively to this trend and fund-raising activities in Germany have nearly rebounded to 2019 levels in the second half of 2020.

why complement my portfolio with venture capital
Table 4 – Evolution of deal counts and their value in Germany (in billions of €)
Source: PitchBook

It is worth noting that Germany demonstrates a growing tendency to invest in growth-stage Startups. An example is HV Capital, which is based in Munich and focuses exclusively on early-stage investments. The firm has also launched a €535 million vehicle that not only focuses on growth-stage Startups, but also on Seed rounds. To further support Startups, the German government also announced a €10 billion aid initiative for late-stage Startups to expand and grow their businesses.

why complement my portfolio with venture capital
Table 5 – Distribution of investments in German Venture Capital (in billions of €)
Source: PitchBook

Conclusion

In addition to offering higher expected returns in the long term, Venture Capital has a low correlation with most asset classes. More specifically, it shows a zero correlation and even a somewhat negative one with equity and high yield bonds, while holding a moderate correlation with real estate or private equity investments. Given this lack of correlation, Venture Capital increases diversification and reduces the associated risk when incorporated in an investment portfolio.

Nevertheless, Venture Capital investments entail other risks, such as:

  • illiquidity risk, given that the investments are locked in for a considerable period of time (usually 5-10 years), and even though the secondary market is getting more dynamic by the day, publicly traded securities still have more liquidity;
  • product risk, its market timing, and the adoption by the market;
  • the risk inherent to the management team to be able to execute the strategy;
  • exit risk, among others.

As such, it can be concluded that investments in Venture Capital not only have the potential to increase the returns of a portfolio by including this asset class, but also decreases portfolio risk. In fact, the pandemic has boosted Venture Capital as an asset class. Whenever an investor has no experience nor contacts in the sector, it is recommended to rely on professional investors. Additionally, there are several alternatives to traditional Venture Capital funds, such as crowdfunding platforms and investment Clubs, like Faraday Venture Partners.

By Dennis Kirpensteijn – Managing Director Germany & Fernando Taub – Analyst