Venture capital is becoming more popular with investors but picking the right firms might not be easy, finds Joseph Mariathasan
At a glance
• Venture capital evokes powerful emotions among investors.
• Some argue that venture capital offers poor returns.
• The rush of mobile phone apps could represent a bubble in the making.
• Technology tools have given more power to entrepreneurs.
Venture capital (VC) evokes powerful emotions, both positive and negative, from investors as well as the press and governments seeking to create Silicon-Valley type hotspots in their economies. With the rush of mobile phone apps, many without any clear plan for generating revenues, some have argued that there is another technology bubble in the making. The epitome of this was the app Fling, which burnt through $21m (€20m) before going bankrupt.
For investors, venture is certainly a problematic opportunity. “VC is an idiotic asset class,” says Nick Lewin, founding partner at Crown Predator. “You need to fund the right fund managers and the right vintages which can be impossible to pick. Great funds and great vintages may get a 20-25% IRR but six out of 10 deals get zero. One or two deals do very well but you are stuck in them for 10 years.” As he adds, for every unicorn (a VC company that grows to a greater than $1bn valuation), there are a 1,000 orphans. He sees VC as having low returns and argues that VC returns are based on exits – “they do well when Nasdaq is doing well”. The fee structure in venture can also be controversial.
Andrew Brown, senior consultant at Willis Towers Watson, argues that venture can look less attractive than private equity generally. For buy-outs, fees are on committed capital through the investment phase of three to five years, and then on actual invested capital. In VC, Brown finds that fees on funds by well established firms generally in the US can be on committed capital throughout which makes it considerably more expensive: “If a PE and VC firm create the same amount of alpha and each have the same standard two-and-20 fee structure, the PE manager takes away 60% of the alpha. With the same alpha assumptions, the VC manager will take 80% or 90% of the alpha. You need to make some heroic assumptions on alpha creation for VC to look attractive.”
In Europe, with newer funds, as Matthieu Baret, Partner at Idinvest Partners says, VC fees generally usually follow the same structure as PE. However, as Jim Strang, head of Europe at Hamilton Lane points out, for most institutional investors that may be less relevant as venture is only a very small part of their portfolios. A challenge for many investors is accessing top quality venture managers in sufficient scale to make sense from a portfolio construction perspective, as the nature of the type of firms seeking venture capital is that they do not require a lot of it.
Yet, despite the naysayers, interest in venture is increasing, albeit from a low base. VC also has to overcome misinformation prevalent in the press – initial public offerings (IPOs), for example, get the most press coverage but account for a small fraction of all exits, says Joe Schorge, CEO of Isomer Capital.
In the past 15 years a relatively stable amount of money has been flowing into early stage venture, says Adveq CEO Sven Lidén. At the same time, early stage venture is becoming valuable more quickly, so returns come quicker he adds. Lidén admits that for 10 years, it took a long time to get your money back in venture and returns were lower so venture did not sound like a fantastic investment. He argues, however, that we are now back to a more normal environment with venture giving better returns than the buyout industry resulting in more people looking at it again.
There is certainly a different perspective in the US compared with Europe. Schorge says Europe still suffers from a confusion between venture and growth capital. The idea of venture, as he explains, is to put in a small amount of money to build and test a product. Investors should not commit large sums until there is some evidence of product-market fit. “Start-up companies are experiments. When Google was new, there were already over 15 search engines. Many people doubted that yet another market entry could be useful.”
This can be seen in the plethora of new mobile phone apps which, for many investors, seem to represent the triumph of hope over reality. But as Matthieu Baret, Partner at Idinvest Partners explains, there are many different levels of mobile apps, with some, such as job searches, providing a clear real service. With new business-to-consumer ideas coming, though, it can often be unclear how they will be monetised. Investors, however, can wait to let them create good traction. Many will stay at a few million downloads. “If an app grows at 100% a month and has one or two million users already worldwide, then it is a good sign that the app is becoming global. But we haven’t seen that many like that,” says Baret.
Schorge sees a big difference here between US and European attitudes and argues that companies like Twitter would never get funded in Europe rather than the US. “Twitter, for a very long time, was looking for a sustainable revenue model. It was not making money.”
Schorge notes such models tend not to be funded in Europe where investors want to see revenues before they invest. However, for businesses which require scale, there are models where you need to build the audience before you can monetise them. “LinkedIn is a very valuable network. Until you had many people using it, it had no value and you certainly could not charge people to use it.” Moreover, as Baret points out, companies do not have to base their business model on advertisements.
Perhaps it truly is time to take venture more seriously given what is happening in the world around us. “We see opportunities everywhere,” says Schorge. As he argues, a fundamental trend today is the ubiquitous availability of technology tools and the readily available access to deep technology. That puts a lot of power into the hands of entrepreneurs which was not available even a decade ago. In traditional sectors such as healthcare and education, as well as new technologies such as artificial intelligence, we are just at the beginning of what may be possible.
As Schorge points out, computers are becoming better at analysing images and other complex data sets than humans, because, for example, they can quickly look at 50,000 X-rays and learn to look for patterns and indications like a doctor would. Government and education, banking and insurance are all sectors where we can expect to see important developments in the use of new technology that will transform the way they operate.
Venture capital, particularly in Europe, may look more attractive than it has ever been for a decade or more. For investors, it may only represent a flutter, given the limited requirements for capital. The question may still be, though, where best to place the bets.
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