Horse racing could be considered the not-so-distant relative of venture capital. Though containing some differences, both enterprises share the common requisite of experience, evaluation, and prudence. Nearly 550,000 businesses are started each month in the United States. Early-stage venture capitalists seek out the businesses with the most disruptive ideas and the highest growth potential, and as VCs become increasingly adept in doing so, the US Venture Capital Index has generally outperformed the S&P 500.
For much of the 20th century, however, this area of investment was offered exclusively to ultra high-net-worth individuals and their families. Fortunately, with recent policy movements in the venture capital space, such as the JOBS Act, some funds now offer this area of investment to individuals for a relatively low buy-in. With more investors and funds than ever, what should investors look for in a venture capital fund?
#1. Diversification – Aside from high reward potential, one of the main reasons investors flock to venture capital is diversification. In the world of horseracing, this would be like hedging your bet; backing up a wager with a less risky one. This would look like picking a horse to win, but also betting that the horse will place. This strategy mimics the risk mitigation of portfolio diversification. If your horse falls short in the photo finish, you’ll still cash your “place” bet. While many individual investors will have their portfolio separated into stocks, bonds, and money markets, venture capital provides a new asset class. Venture capital investing can also be used to mitigate risk, as the US Venture Capital Index generally performs inversely to the S&P 500.
#2. Industry – Horse races vary in length, so knowing what horse is best suited for certain races is imperative. Similarly, many venture capital funds are focused on a specific industry, such as healthcare, manufacturing, or technology. While each industry performs well at different times, technology has consistently delivered returns above the IRR of the US Venture Capital Index.
# 3. Stage – Just as VCs commonly invest in syndicates, most horses are owned in partnerships to lower individual costs and risk. Partners that join later, especially as the horse becomes more successful, will expect to see less in return. Companies require financing at several different stages, including seed, early stage, growth, expansion, and later stage. While returns can be realized by investing in the right company at any stage, early and growth stage investments have generally performed better.
#4. Strategy – Regardless of their discipline, every successful person or group has a strategy. Every trainer has their own method for guiding horses to success, every investor has his or her own investment strategy, and so does every venture capital fund. A venture fund’s strategy dictates the type of investment it looks to make, be it in a cash-flow-positive business, a rapidly-expanding business, a path-breaking and disruptive business, or one that exhibits some of all three.
#5. Management – Is it the horse or the jockey that wins the race? No doubt that the jockey serves a vital purpose, but the race winner is ultimately determined by the horse. Of course, this really means the trainer and all those who pay for the horse’s expenses. Making an investment is like giving your horse to a trainer. You expect results in return for the money you spent. In venture capital, your trainers are usually a team of the most senior members of a firm. The general partners of a VC fund are responsible for vetting and executing investments that will earn a successful exit for all investors in the fund. Other facets to consider when evaluating a management team are the managers’ educations, industry experiences, and visions.
: Source: Small Business Association
: Source: Cambridge Associates LLC, Dow Jones Indices, Standard & Poor’s, and Thomson Reuters Datastream. The Cambridge Associates LLC U.S Venture Capital Index is an end-to- end calculation based on data compiled from 1,420 U.S. venture capital funds, including fully liquidated partnership, formed between 1981 and 2012.
: Pooled gross IRR by company initial investment year. Based on data complied from 1,401 US venture capital funds, including fully liquidated partnerships, formed between 1981 and 2011. Returns are net of fees, expenses and carried interest. Vintage year funds formed since 2010 are too young to have produced meaningful returns. Analysis and comparison of partnership returns to benchmark statistics may be irrelevant. Benchmarks with NA (not applicable) have an insufficient number of funds in the vintage year sample to produce a meaningful return.* Source: March 31, 2013
Cambridge Associates LLC
U.S. Venture Capital Index® and Selected Benchmark Statistics