During economic downturns and times of market volatility like we are currently experiencing, investors inevitably look for safe havens and tried-and-true investment strategies to protect and grow their assets. However, the options available during the current downturn have been limited. Even the traditional 60/40 equities/fixed income allocation has failed to protect investors. Stocks and bonds have essentially moved in tandem, to the downside. However, within the private markets, investing in venture capital has provided an outsized return opportunity for investors. In fact, some of the best performing venture capital “vintages” have come during or immediately following periods of economic distress (e.g., 2008-2012).
We recently connected with Jordan Stein, Director of Cresset Private Capital, to further explore how and why venture capital is providing investors with significant opportunities in this unsettled market environment. Below is what he had to share:
Jordan, why are you bullish on venture capital in this market? What is the appeal for investors now?
Stein: Good question. But before we talk about the current market, let’s zoom out and look at venture capital performance historically. Over the last two-plus decades, venture capital has delivered the highest long-term returns versus every other major asset class. That said, it also has the widest dispersion of outcomes, and much of that out performance is driven by the top performers. The gap between top-quartile, median-, and bottom-quartile returns is wider than any other investment class. However, venture capital also has the highest “persistence” of any asset class. Persistence refers to the likelihood that a fund will be in the top quartile if the manager’s previous fund was a top-quartile fund. For venture capital, there is a roughly 45% chance that if a previous fund was a top-quartile fund, then the next fund will be a top-quartile fund, and a nearly 70% likelihood that the next fund after a top-quartile fund will beat the median. This is due to a multitude of factors but comes down to the fact that the best venture capital firms have unparalleled access to the best new founders and companies, win competitive rounds to invest into them, and can often add significant value in helping those businesses scale. As a result, if you are going to invest in venture capital, it’s important that you do so with the best managers.
Now, let’s talk about venture capital investing today. Historically, great vintages, marked by when a venture capital fund starts investing, have followed recessionary environments. This was present after the dot-com bust, but was even more significant after the Great Recession in 2007. Warren Buffett once said, “Be greedy when others are fearful.” The current market environment presents this opportunity to investors. There are a few themes driving this: 1) valuations and terms are more attractive to investors, 2) startups are competing for fewer dollars, so the quality of companies that receive funding tends to be higher, 3) when the labor market becomes challenged, startups have the opportunity to hire excellent engineers and executives that have been laid off, 4) companies are more focused on capital efficiency, which can persist after a recession has ended and create a stronger business, and 5) big shocks to the economy often create unique opportunities for new business ideas to flourish. Innovation is not tied to market cycles. Category-defining companies are founded across all market cycles. Uber, Square, WhatsApp, Airbnb, PayPal, and many others were started during recessionary environments.
How does the current venture capital environment compare with previous market downturns, including the dot-com bubble burst in 2000 and the Great Recession beginning in 2007?
Stein: It’s still early and unclear how deep this downturn will ultimately go. It’s unlikely that we will see the type of bounce back from the brief Covid downturn in 2020, as this one is more fundamentally predicated on fiscal and monetary policy, coupled with a combination of geopolitical issues, supply chain disruptions, inflation, and other macro factors. That said, I believe it’s more similar to 2008 than 2001 for a few reasons:
The 2000 crash was driven by a variety of factors. A massive number of companies sprung up to take advantage of the internet, many of which didn’t have a product or business model. There was “tech exuberance,” and investments were made into unproven business models, many without a viable product. Lessons were learned (by some), and this type of undisciplined investing has declined. In other words, while valuations have been inflated, a much higher percentage of businesses that have raised capital actually have viable products or a clearer path to viability. Venture-backed businesses are structurally stronger than they were during the 2001 crisis. 2008 was driven by more exogenous macro factors that weren’t as specific to the technology sector. People around the world were concerned about banking institutions failing, the housing market collapsing, etc. That said, every “black swan” event or recession is unique, so it can be hard to predict where we ultimately end up.
What is it about venture capital investing that provides protection from the day-to-day market volatility that the public markets are experiencing? Why is that appealing?
Stein: Venture capital investors deploy capital at the earliest stages of a company’s life cycle. Generally speaking, early-stage ranges from pre-seed investments, before a company has a real product or revenue, all the way through series B, at which point there is some revenue and product market fit has been proven to some degree. Investing after this point and prior to a liquidity event is known as late-stage venture or growth equity. Depending on the entry point, capital can be locked up for 5-15 years before a return is realized. Because those investments are not tied to the day-to-day fluctuations of the public stock market, venture capital investors are not exposed to those market gyrations, and the angst that can produce. Additionally, early-stage valuations are often low, and less impacted by market downturns. The average seed-round valuation has been ~$15 million, and a good outcome is north of $1 billion 10-12 years later. In other words, the eventual outcome isn’t correlated to current market conditions. One more thing to note, it usually takes 2-3 years for a venture capital fund to fully deploy, so a 2022 vintage fund will be investing in underlying companies into 2023, 2024, and even 2025, with reserves to follow after that.
Let’s talk valuations of early-stage companies. Are they falling as quickly as some publicly traded companies? Why or why not? What does that mean for investors?
Stein: From a valuation perspective, the further away from the public markets a company is, the lower the impact of all market dynamics will be. Seed and pre-seed valuations will be less impacted by the macro environment than late-stage venture or growth equity. We are starting to see valuations fall in growth equity, but it hasn’t quite trickled down to the earliest stages. There’s typically a lag between private market valuations and public markets that can be up to a year or more. In part, this is because private companies don’t receive changes in valuation nearly as often as public companies. Private companies are generally valued when capital is raised (which can be six months to multiple years), though there are sometimes adjustments made based on how competitors are being valued. It’s still relatively early in this downturn, so we expect to see valuations continue downward over the near to medium term, depending on how bad things get. That said, we have noticed a difference in momentum. The number of deals that are getting done at all stages has decreased precipitously in 2022, a trend that will likely continue into 2023.
Who should consider investing in a venture capital fund? What, if any, downsides or limitations should they be aware of?
Stein: It’s important to understand how investing in venture capital fits into a larger financial plan. While the asset class has outperformed over the last few decades, investors need to know that their capital will likely be tied up for significantly longer than a public market investment, or even an investment into a buyout fund. If an investor needs investments to produce liquidity in the near to medium term, venture capital will not accomplish that goal. However, if there is capital that can be set aside for longer-term objectives, venture can be a great choice to maximize returns. The most sophisticated, largest investors (endowments, pensions, etc.) have been increasing their allocations to top-tier venture capital firms, which has largely been rewarded with outperformance.
How does one get started in investing in venture capital? Finding the best fund managers matters a great deal, correct?
Stein: Given the wide dispersion in outcomes, it’s important to invest in top-tier funds. Unfortunately, most investors are unable to find or access these funds. The best venture capital firms are seeking LPs who can provide significant amounts of capital, consistently, over a long period of time. They are also looking for LPs who can reliably invest in subsequent funds and hopefully provide some value add via customer and founder introductions, as well as operational support/guidance. In addition, investment minimums can often be high ($5, $10, even $25 million). These factors can create significant barriers to entry for your average investor.
There are thousands of venture capital funds, and it can be difficult to differentiate which ones are truly top tier. That is why endowments, pensions, fund of funds, large single-family offices, and sovereign wealth funds have teams of people who are focused on sourcing and due diligence. At Cresset, we’ve taken a similar approach. In 2022 alone, our team has spoken with more than 400 managers to find the best opportunities for our clients and investors. If you are able to invest with firms that have the right level of expertise and resources, your chances of succeeding in venture investing grow exponentially.