Asteroid warning! Traditional late-stage VC is a dinosaur

August 23, 2021

Venture capital (VC) still operates on small networks and personal connections that let a few investors into opportunities and funds, while most are left “unventured”.

There are three reasons why change is inevitable, especially in late-stage VC, where data-driven, systematic investment makes the traditional approach look like a dinosaur.

1. It’s wrong to lock most investors out of VC.

From 1928 through 2020, the average annual inflation-adjusted return of S&P 500 constituents including dividends was 8.5%. For many investors, that’s insufficient for their financial goals.

As the CFA Institute wrote in 2018, “With the global move toward self-funded retirement, it is not credible to allow an entire generation of retail investors to be left with only diversified public market exposure to generate retirement returns, while institutional investors crowd into innovative business models that offer potentially higher returns.”

In 2020, U.S. college and university endowments allocated 23% of their assets to private equity and venture capital, and half of U.S. multi-family offices were invested in venture capital.

All investors should have similar options. That includes not just individuals but institutions, such as single family offices and smaller endowments who don’t have consistent, reliable access to top performing VC funds.

2. Regulators recognize the need for more access to alternatives.

Regulators are slowly making alternative investments more accessible to a broader audience. In June 2020, the U.S. Department of Labor issued an Information Letter that allowed private equity to be added for the first time to target date, target risk, and balanced funds available through 401k plans.

The U.S. Securities and Exchange Commission (SEC) said the retirement plan changes would “provide long-term Main Street investors with a choice of professionally managed funds that more closely match the diversified public and private market asset allocation strategies pursued by many well-managed pension funds.”

In August 2020, the SEC also broadened the definition of “accredited investor,” allowing more individuals and organizations to invest in private markets. In the SEC’s view, investors “regardless of their financial sophistication, have been denied the opportunity to invest in our multifaceted and vast private markets.”

3. There isn’t one VC market. There are two.

Since last year, the search for returns in a low-yield environment has helped VC fundraising reach all-time highs. The argument for protecting investors from the entire VC space because of opacity or volatility makes less sense today than a couple of decades ago because of recent developments in the nature, size and activity in private markets.

Individuals without access to VC are pouring money into cryptocurrency and short duration stock options, which are objectively more volatile than a diversified fund of high-quality late-stage private innovation companies.

Meanwhile, initial public offerings (IPOs) continue to demonstrate the gap in opportunity between those with VC access and the unventured. A NASDAQ analysis shows that only a third of IPOs between 2010 and 2020 outperformed their relevant broad market index 6 months to three years after IPO. Robinhood is one recent IPO that was trading about 23% above its debut price on August 20. That sounds good if it lasts but investing 12 months pre-IPO would have produced annualized returns of 300%+.

Venture investing covers two distinct phases of company growth — early (angel through series A funding) and growth & late-stage (B round and above). In some ways, late-stage private companies are beginning to share more with public companies than with startups, and they now generate enough reliable data for investors to create data-driven, systematic investment models reminiscent of those that disrupted public markets only a few decades ago. Another important distinction is the outperformance of late-stage relative to early-stage companies. EQUIAM used Pitchbook data to calculate the mean net internal rate of return (IRR), a common performance metric for VC managers and investors. From 2002–2019, the IRR was 17.7% for late-stage US managers versus 15.5% for early-stage.

Do you think VC’s clubby investment circles are working just fine or is there a better way? Should the VC club just be more inclusive or bulldozed for a whole new approach? Join the debate about opening VC to a more diverse group of investors here or on LinkedIn.

Shachi Shah

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