The writer is founder of Sifted, a media site for European start-ups
Most of us have had the occasional crisis of confidence about our career choices and hanker after becoming a ski bum or a Buddhist monk. Even so, I was struck by a recent conversation with a seemingly successful venture capital investor, who wailed that the impressive headline returns generated by his fund had undershot the Nasdaq Stock Market over the past decade. Why work so hard scouring the world for breakout investments when you could earn more money by buying an index-tracking fund and sitting on a beach?
As my FT colleague Patrick McGee has calculated, Apple’s stock market value has on average increased by more than $700m a day for the past 10 years. Even the best VC investors cannot generate wealth at such scale. In tacit recognition of that reality, the legendary Silicon Valley VC firm Sequoia has now declared that its investments will no longer have “expiration dates”. This will enable Sequoia to break with traditional VC practice and remain invested in tech companies long after they have floated following an initial public offering.
Many successful start-ups — such as Apple — compound their strategic advantage over decades, accumulating much of their value post-IPO, Roelof Botha, a Sequoia partner, wrote recently.
Ironically, just as VC investors have grown increasingly envious of the latter-stage returns available in public markets, institutional investors have been further warming to the attractions of earlier-stage private markets. According to a report by the data firm Preqin published this week, institutional investors continued to pour money into VC funds and direct private market deals in 2021, attracted by a surge in more recent returns. Preqin’s Venture Capital Index showed a 37.2 per cent annual return, outperforming most other asset classes. Over the past five years, VC funds have increased their assets under management from $547bn to $1.7tn.
However, as we are always told, past performance is no guarantee of future results. Given the oceans of cheap capital in the world, most asset managers have found it hard to lose money in the past few years. But markets are growing increasingly squally as higher inflation and the prospect of further interest rate rises disrupt the investment calculus. Already this year, we have seen a great rotation out of publicly listed “speculative tech” stocks into value companies. Ark Invest, the high profile fund run by Cathie Wood, has been particularly badly hit. “Spec-tech is getting wrecked,” as one investor said.
It seems only a matter of time before falls in public market tech valuations infect private markets, too. The recent inflow of money into the sector has pushed valuations into unsustainable nosebleed territory. Rising interest rates will also make life harder for the VC industry. Institutional investors become more risk averse and less willing to allocate money to VC funds in higher interest rate environments. The higher cost of capital also damps the rate of new business formation and makes it tougher for young companies to expand.
“I think there will be a correction. It’s inevitable,” says Josh Lerner, a professor at Harvard Business School who has researched the VC sector. He notes that a lot of the “craziness” that accompanied the dotcom crash at the turn of the century has parallels today. “When we look at the movie from 1999 to 2000 that did not end well, especially for the ‘tourist’ investors who crossed over into arenas that they did not know a lot about.”
Although methodologies are contentious, there is growing evidence that, net of fees, VC returns have been lower this century than those made on similarly risky assets in public markets. But the sector’s overall returns mask a wide divergence in performance between the best and worst such funds. We are perhaps at that stage in the cycle when smart judgment will again assert itself over dumb luck. It will become all the more important to pick winners rather than surf the market.
Moreover, the argument for investing in VC funds is that long-term technological trends will outweigh short-term market gyrations. As Prof Lerner says, there has been a fundamental change in the way innovation is pursued in many economies. VC-backed start-ups, rather than big corporations, have most often proved the best innovation engines when it comes to exploiting new technologies and creating new industries.
My VC acquaintance has good reason to stay off the beach.