The importance of venture capital in portfolios
Today, venture capital investment stands at the intersection of several key trends in the global economic ecosystem. In particular, this includes the emergence of technologies central to the fourth industrial revolution, such as artificial intelligence, the internet of things and quantum computing, as well as digital transformation and the continued rapid adoption of technology. And while the COVID-19 pandemic sped up digitization of the economy, the sustained utilization and application of technology is here to stay. In addition, venture capital, or VC, has provided investors with attractive historical returns, with U.S. venture capital pooled returns delivering a 17.2% return for the trailing 10-year period to Dec. 31, 2020.¹
From an investor’s standpoint, this has fostered a strong interest in being able to access investment opportunities in private companies that are driving the most promising technological advances under development today and in the future. In this blog post, we'll discuss the basics of venture capital investments, the rationale for exposure to venture capital funding in a total portfolio and key considerations for success when investing in venture capital firms.
What is venture capital?
Venture capital is the financing for start-up, early-stage emerging private companies with high potential for growth where, given the stage of their lifecycle, access to financing sources such as stock offerings or debt issues is unavailable. Venture-backed companies typically operate in the technology and healthcare sectors, where there is the potential to disrupt industries with life-changing products and services.
The VC financing cycle involves different stages from seed to late stage, where each stage is typically characterized by certain milestones, which are either operational and/or financial. Through this process, private equity financing has the potential to take companies from the earliest stages of their life to where they can be generating millions or even billions of dollars in revenue. These different stages are outlined below:
- Seed – The first capital financing round after incorporation of the company, which typically funds the development of new products or services
- Series A – The first significant financing round, in which one or more venture capital firms become involved in a fast-growing company that was previously financed by founders, seed venture capitalists and/or angel investors
- Series B & C – Financing that is provided to assist in scaling the company’s operations, including manufacturing, new products, marketing, sales and customer service
- Late stage – Private equity financing provided once the business generates meaningful revenues. This can include capital for significant expansion, mergers and acquisitions or entering new markets, for example.
The case for VC
Within the total portfolio context, we believe there is a compelling case for exposure to VC. In addition to exposure to key technological trends and innovation, along with the potential for attractive absolute returns, there are also some additional structural market dynamics that may be attractive for investors.
First, consider that companies are staying private for longer. In previous decades, venture-backed companies tended to go public earlier in their lifecycle. For example, Amazon went public in 1997 when it was three years old. At the time of Google’s IPO (initial public offering) in 2004, it was six years old.²
Today, however, the market dynamics are quite different as companies rely more and more on private markets for their growth and are electing to stay private for longer periods of time. For example, Uber and Airbnb, two of the 10 largest-ever technology IPOs, were 10 and 12 years old, respectively, before going public—long after they had disrupted the industries in which they operate.³ Moreover, while private companies valued at over $1 billion (also known as unicorns) were virtually non-existent a decade ago, today there are approximately 1,000 companies with billion-dollar valuations across a range of sectors, including internet software and security, hardware, artificial intelligence, fintech, healthcare and e-commerce. In aggregate, these companies are worth approximately $3.3 trillion.⁴
Given that companies are staying private longer and their valuations are much higher than has been the case historically, the implication for investors is that by not participating in VC, they risk forgoing exposure to high-growth companies, disruptive technology and the potential for high returns. The bottom line: from our vantage point, gaining exposure to venture-backed companies prior to their IPOs is more important than it has ever been.
What are the diversification benefits of venture capital?
We also believe that VC contributes to improved portfolio diversification. Through time, the success of a high-growth company will be idiosyncratic in nature and less dependent on the general direction of macroeconomic factors, such as GDP (gross domestic product) growth, fiscal and monetary policy, interest rates or inflation. This is why we believe venture capital plays an important role in the long-term strategic asset allocation of a portfolio.
Secrets for success: Key considerations for institutional investors
While we believe the opportunity cost to investors of not participating in VC is large, there are important implementation considerations that investors need to be mindful of to ensure their desired investment outcomes are achieved. For example, there is a wide dispersion of returns across the universe of venture capital managers, and having the necessary relationships to access these top-tier firms whose returns have typically been found to be persistent is critical to success. In addition, having the depth of resources to be able to identify and access top-tier funds around the world—including the United States, Europe and Asia—is also key.
Exposure to venture-backed companies is critical
On balance, we believe gaining exposure to venture-backed companies as part of a total portfolio is a critical way for investors to participate in high-growth companies as they commercialize and scale their operations. Overall, VC can provide investors with several important benefits, including exposure to structural trends across technology and the opportunity to benefit from the substantial value creation that is occurring in private markets.
Ultimately, it’s not surprising that as investors seek to address the challenges of generating returns and improving diversification, they’re increasingly turning to venture capital to potentially improve their investment outcomes by partnering with firms that have the requisite depth of resources, strong manager selection skills and demonstrated access to top-tier funds.
¹ Cambridge Associates, “Are the Strong Recent US Venture Capital Returns Bankable?”, July 2021, https://www.cambridgeassociates.com/answers/are-the-strong-recent-us-venture-capital-returns-bankable/
² Hamilton Lane, “The Myth of Peak Venture” July 2019, https://www.hamiltonlane.com/en-US/Insight/9667e821-9b4a-428b-9306-1d7c5a145d74/The-Myth-of-Peak-Venture
³ Hamilton Lane, “Broader Horizons: The Case for Private Markets Investing” April 2021
⁴ CB Insights,”1,000 Unicorns: Global Billion-Dollar Private Companies Hit A Four Digit Milestone” February 2022