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When capital prefers venture over public markets

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Market movements in the technology sector — particularly in SaaS tech companies — are causing a stir among investors. It’s always a challenge to estimate valuation ranges for publicly traded companies such as LinkedIn, Salesforce and Workday because these calculations require assumptions of growth. Twitter is another beast. Some people get obsessed about enterprise value; others focus on the gross margins or multiples of R&D spendings of these companies in an effort to come up with a reasonable explanation of what’s happening.

Investors are trying to draw parallels between these publicly traded companies and private venture-funded companies, but a number of differences exist between these two types of investment opportunities (or “asset classes,” as we refer to them in fund lingo). Let’s review some major differences between investing in stocks versus venture capital.

Publicly Traded Companies Private Venture- Funded Companies
Investment horizon Open 3 to 7 years
Deal flow Always Sequential
Access to deals Open Difficult
Leverage Yes No
Recycle Yes Limited
Derivatives Yes No
Hedging Yes No
Correlation (return) Yes No
Return distribution Normal Lognormal
Impact of investment Limited Significant
Value movements Fluid Stepwise

 

When we invest in private companies, the capital we infuse makes a big difference for the company — or at least it should. After a seed round, a startup becomes a bona fide company. After Series A, it becomes a contender. In public markets, with the exception of activism, equity trades make no difference for the company’s activities and margins.

So if a market correction does take place and the stock plummets, the investor loses value significantly — and that’s value the company did not earn operationally to begin with. In venture investing, every dollar invested should make the company better.

So if I were to put my money to use, why would I invest in stocks just to be at the mercy of Mr. Market? Private equity and sovereign wealth funds agree with this notion (that’s why we saw more unicorns last year).

Within the confines of a fund, we want to keep the invest-to-exit period as short as possible.

In public markets, you can buy and sell equities and their derivatives at any time. In the venture capital world, we don’t have that luxury. We buy into a company at some point, and we must exit at another point. The exit generates either a profit or a partial or full loss. But within the confines of a fund, we want to keep the invest-to-exit period as short as possible, regardless of whether we profit or not. If we profit, we boost our IRR.

If we lose, we cut our losses quickly and move on. We don’t hold long positions in portfolio companies due to our fund mandates. And because the deals inside a venture capital fund are finite, a fund itself must be finite — and it is.

Deals in venture come sequentially and often in bursts, and a deal today will not be available tomorrow (unlike the public markets where one can buy and sell any security, any time). Deal flow and access to deals are vital for VC firms.

So, at any point, the challenge in venture capital is to choose the most favorable deal in the current set of deals in the pipeline, which will soon change. And choose we must. We’re constantly running out of time inside the fund, because we have a set investment period. Therefore, another problem emerges: How many deals should we invest in, and how big should the checks be?

One shortcut is to invest in as many of them as possible, which would create high visibility in the marketplace, but the check sizes will be small, and the returns probably won’t move the needle. Another solution is to invest in x number of companies per partner, which is even more arbitrary. It’s actually a difficult stochastic problem, and understanding return distributions, the nature of the deal flow, the overall size of the fund and the investment horizon are some of the parameters that would go into solving it.

If we invest in stocks, we can buy derivatives contracts to hedge our bets. Those are like insurance for which we pay a premium, and we are covered if the market moves against the direction of our bet. We can do this on both the long and short side. We can’t really do it for our VC bets, other than, perhaps, shorting the Russell 2000 index. So if you make a bet, you’re stuck with it.

Capital is moving in all sorts of directions right now.

In VC, there’s no leverage — but that’s a good thing. We invest only if we have capital in the fund. Therefore, our losses are capped at the investment level. One wrong bet in a leveraged scenario in the public markets can wipe out a fund several times over. Public market stocks are correlated to one another because of the existence of their historic returns. We don’t have this situation in VC, so Markowitz won’t apply, which makes portfolio formation much more complex.

Meanwhile, the path to liquidation has changed for VC. Before, the path to liquidity was to go public or sell to a larger company. Now, it is via private sales to sovereign wealth funds (SWF) or private equity. Institutional funds have built tremendous amounts of capital that are sitting on the sidelines. There has been a surge in the number of “family office” establishments (mainly in the last two years).

Capital is being funneled to a number of new investment vehicles that have a high level of thirst for advanced, and often exotic, investment products. The most recent sale of Lyft shares to Prince Al-Waleed Bin Talal is just one example. (The value of Prince Bin Talal’s 34.9 million Twitter shares has shrunk by about $500 million since last October, when he upped his long position). Capital is moving around investment vehicles in different ways than before; right now, it is liking venture capital.

VC-funded firms are founded on the premise that they will disrupt existing markets.

Is venture capital immune to macroeconomic events such as fluctuations in GDP, inflation or unemployment rates? Of course not. A sizeable decline at the institutional level will necessitate portfolio rebalancing. When that happens, the influx of capital into the venture capital industry typically declines, thereby causing investment activity to drop.

However, VC-funded firms are founded on the premise that they will disrupt existing markets by introducing innovative products and services, which depends less on capital and more on talent. So a correction should actually lift venture returns in the long run, particularly if it hits certain sub-verticals like SaaS. It would then be easier for newcomers to recruit talent away from incumbents.

These corrective declines in the stock market work to the benefit of venture-funded firms and the VC industry, as long as they are not catastrophic. Capital is moving in all sorts of directions right now (other than the stock market). Let’s just hope that more of it finds its way into venture capital.

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