Why Invest in Venture Capital?
Paul Bodnar
Director of Investments and Private Equity
In recent years, we have heard a lot of news about disruptive technology, the impact of automation, and the next group of emerging technology companies. We have also witnessed the buzz around cutting-edge ideas like cryptocurrencies and blockchain. Here in Cleveland, this spawned ideas like Blockland which plans to make the area a hub for blockchain technology. At CM Wealth Advisors, we believe that technology and innovative companies are key drivers of the future global economy and will continue to disrupt, often in unexpected areas. We want exposure for our clients, but we need to be thoughtful about how to invest into these trends. This is especially true in the current environment where a lot of capital has been raised, and parts of the market are expensive.
Why invest in venture capital?
Venture capital is investing in a business during its startup period or in the early stages of its growth. We have invested in venture since 2002 when we initiated our modern private equity program because research demonstrates that venture provides one of the best opportunities for investors to generate some of the highest long-term returns. Additionally, we believe we are in the middle of a multi-decade trend where new technology companies will continue to augment and disrupt parts of the economy. This creates the opportunity for a significant number of new businesses to emerge in everything from healthcare to finance. New companies will displace old ones at an increasing pace in our view. We need to invest in these opportunities through our private equity fund because venture funds are capturing a majority of the benefits from these investments.
This trend is not new, only 60 of the companies of the Fortune 500 list in 1955 were still in the Fortune 500 in 2017. Essentially, nine of every ten companies went away, merged, or shrunk in size. The pace of change has only accelerated in our view. It is critical for investors to gain exposure to the companies that will become part of the Fortune 500 in 2040.
In the 1990s and before, it was possible to invest in the next generation of companies through the public markets. This has changed. Now, the value accretion of emerging companies is largely going to investors in the private markets. Microsoft and Amazon had valuations of $773M and $438M at the time of their IPOs (Initial Public Offering), both of which have close to $1T valuations currently. For early investors in the IPOs of Microsoft and Amazon, this is over a 2 100x and 200x return, respectively. Compare this with Uber’s IPO valuation of $82.4B, Slack at $15.7B, and Pinterest at $10B. The opportunity to capture that upside through the public markets has decreased.
Critical changes in venture and starting a business
Venture went through a challenging time after the tech bubble in the late 1990’s. That era left a mark that took some time to work through. It was relatively expensive to start a business in 1999 and the path to profitability was long.
Improved profiles of more recent tech IPOs vs. the late 1990s
Since that time, a few changes led to an improved venture ecosystem. Changes in technology helped and new markets were created from the broad availability of highspeed internet, faster computing power, and the advent of the smart phone. A key change occurred to little fanfare in 2006 when Amazon Web Services was born. This spawned the age of cloud computing that greatly reduced the cost to start a company. It ended the days of building a server farm and making significant investments in hardware. The amount of capital a business consumes in the early years has dropped significantly. This has made new, niche software businesses viable. It has also made seed and early-stage investing more attractive, something we have targeted in our program and discuss further below.
Venture Exits: Venture companies are often acquired versus going through an IPO
Value from unicorns accruing to private not public markets
The bench of highly-valued companies in venture is deep and expanding and the profile is more attractive than a few decades ago. As of June 2019, there are 361 unicorns worth a total of $1,113B according to CB Insights versus 118 four years ago. A unicorn in venture is a private, venture-backed company valued at over $1 billion. All the value from investing in these businesses is going to investors in the private markets. Many of these businesses never go public and they are typically bought by strategic acquirers and, increasingly, private equity firms.
More value accrues to private investors with companies staying private longer
New applications and impact of venture is widening
We believe the recent trend of venture-backed businesses disrupting more traditional parts of the economy will continue. In the past, most venture-backed businesses were more focused on the obvious segments – computers, internet services, and software applications. This has shifted over the past decade with more venture-backed companies disrupting parts of the economy that were generally viewed as low-tech or ‘old line’ businesses. The recent IPOs of Beyond Meat and Uber are great examples of this shift. These companies are a food producer and a taxi service.
The potential disruption is broad. Technologies like blockchain, internet of things (IoT),
virtual/augmented reality, and artificial intelligence have wide-ranging potential applications. Artificial intelligence is already used to help businesses forecast sales and automate online support. It is expanding to ground-breaking applications in healthcare like radiology where it is used to identify tumors and broken bones with greater correct diagnoses than radiologists.
Our approach to investing in venture
Historically, successful investing into emerging technology is dominated by leading venture capital funds. These best-in-class funds demonstrated an ability to outperform peers year-after- year. A venture fund in the first quartile of performance among its peers has a 45.5% chance of its next fund finishing in the first quartile (see the following table). There are multiple reasons for this. These investors see the best deals backed by the strongest management teams, have the deepest networks to help build these companies, and understand trends in technology.
Our program has provided exposure to some of the best companies over the past decade. For example, in our older funds, we invested in funds that had exposure to Facebook through Accel Fund IX and Elevation Fund I, LinkedIn through Sequoia Fund XI, and Uber through First Round and Menlo.
Persistence of top-performing funds is strong in venture
CM Wealth Advisors’ private equity program focuses on identifying and investing in leading venture funds that have teams with proven track records. We have also targeted some additional themes: 1) funds must help create value at portfolio companies, not merely provide capital, 2) companies outside Silicon Valley will increasingly make up the next round of unicorns, 3) early stage investing is one of the most attractive current opportunities, and 4) venture will disrupt sectors we view as old-line businesses. When we commit to a venture fund, we expect it to return over a 20% net IRR and a 3x+ multiple on invested capital.
We are also very cognizant of the potential risks and always consider them when making new commitments to funds. The risks include valuations, the economic cycle, and availability of capital. Right now, we view valuations as unattractive in late stage venture and growth stage biotech. Additionally, there is a lot of capital willing to invest in inexperienced teams trying to raise funds. We focus on working with proven, top-quartile investors.
Early-stage and seed investing dollars have remained steady since 2014
Our approach: The early-stage opportunity
We believe early and seed-stage venture investing is one of the best opportunities in the market. At this stage the funds can establish meaningful ownership in companies at lower valuations. Changes in the startup environment have made it easier to start companies and has increased the opportunity set at this stage.
Our venture funds provide more than just capital. One of our recent early-stage VC commitments, Primary Venture Partners, focuses on creating value for portfolio companies. It is highly beneficial if a fund like Primary can add value by bringing customers onboard, help find the best talent to add to the team and make introductions to the right venture funds to invest in later rounds. Funds like Primary that use this approach can drive their companies to better outcomes versus those funds that just write a check. We have already seen this in the numbers. Primary has had over 85% of its investments raise follow-on capital, an early indication of success for companies. We believe this is among the highest success rates in early-stage venture funds.
The amount of money raised for late-stage venture/growth capital market concerns us
Our approach: Concerns on late-stage venture valuations
For some time, we have had concerns on parts of the venture market. For example,
there is too much capital raised to target investments in late-stage venture companies (see previous chart). We like companies at the point in their life when the business is generating revenue, growing rapidly, and often has line-of-sight to an exit to a strategic buyer or an IPO. However, the challenge is large. Late-stage growth funds are willing to pay very high prices just to get access to these companies. Softbank’s headline grabbing $100B Vision Fund is the most well-known of this type. Softbank, along with others, are inflating prices in these companies – the unicorns - valued at well over $1B. Generally, we see limited upside from investments at this stage but some significant downside risks due to the high valuations paid and some of the largest businesses consuming a lot of cash. This risk/return profile does not make sense in our view. Uber is a good example where the IPO price was below the last rounds valuation.
Our approach: Cities outside the Valley increasingly share in successes
While we will always have a place for the Silicon Valley funds in our portfolio, increasingly we have targeted funds that invest outside the Valley. It is both expensive to invest in companies in the Valley and to run them there. New York, Boston, Seattle, and Los Angeles are all very robust venture ecosystems with an increasing number of their own unicorns and more attractive pricing than in the Valley.
New cities are generating tech unicorns
Since we also believe that significant innovation will occur in sectors like insurance, financials, healthcare, media, and industrial applications, these cities often have better talent pools to target these areas. One of the most obvious is that New York’s large financial sector positions it to develop fintech businesses given the experience, talent, and customer proximity. We spend time assessing each funds target market since every city is not ripe for venture investing. It needs a critical mass of experienced tech entrepreneurs, a large enough talent pool to build the company, and venture funds interested in continuing to invest in these companies.