Why should I complement my portfolio with venture capital investment?

Venture capital consists in the lending of financial resources to start-up companies for a limited period of time. It is expected that these financial resources lead to increased growth thanks to its proposed innovative value, in exchange for shares in the company. This capital contribution undertaken by investors is frequently complemented with strategic support in operational, commercial and HR issues etc. The objective of venture capital resides in promoting the growth and expansion of companies in order to increase their value and profitability. All with the end goal to sell these shares at a higher price, achieving a capital gain in the process.

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Venture capital in Spain

The Venture capital sector in Spain  accounts for 0.043% of GDP, thereby coming in slightly above the European average of 0.039%. Moreover, over the past years the sector has shown increasingly dynamic trends. In 2017 alone, Spanish companies received € 537 million in investment from national as well as international venture capital firms (+24% more compared to 2016) contributing to the continued development and maturity of the national ecosystem.

In order to determine the effect that the inclusion of venture capital investment might have on a diversified portfolio, it is necessary to analyse the historic movements of this type of asset, in absolute and relative terms. Since this asset class is highly heterogeneous, we’ll approximate the impact of venture capital using the results obtained from the “Cambridge Associates LLC US Venture Capital” index, which includes information on 1,794 venture capital funds between 1981 and 2017.

The subsequent table confirms that the profitability of venture capital investments in the long-term have comfortably exceeded those obtained by two of the most consulted equity indexes on a global level, and consequently other asset classes such as fixed income and real estate investment. Given this, we can stand by our argument that the inclusion of venture capital within the “asset allocation” of a diversified investment portfolio indeed increases said profitability. It needs to be pointed out that historically venture capital investment in early stage companies has typically been more lucrative, exceeding 8% in annual capital gain increases since 1969, compared to investment in later stages.

[Source: “US Venture Capital Index and Selected Benchmark Statistics” Cambridge Associates]

Venture capital investment, other than offering superior returns in the long run, exhibits a low correlation with the most common asset classes. This means that venture capital contributes to increased diversification and reduced associated risk in the case of an investment portfolio. More specifically, it demonstrates a zero correlation and even, a somewhat negative one, in relation to equity and high yield bonds and maintains a moderate correlation with Private Equity and real estate investment.

[Source: “The case for venture capital” Invesco]

It’s important to highlight that venture capital shows positive asymmetry, thereby leading to a lower number of investments that generate the bulk of returns obtained. This is different to other asset classes whose return distributions mirror largely a normal one. This mentioned positive asymmetry reinforces the necessity to diversify the part of the portfolio that is allocated to venture capital.

However, investment in venture capital also entails other risks too, such as:

  • their illiquidity, given that the funds in question enforce “lock-up periods” on their investors and direct investments usually do not dispose of frequent liquidity windows either,
  • the inherent risk of the product itself, its “market timing” and its adoption in the market
  • the risk created through its management team and its execution
  • its exit risk, among others.

We therefore conclude that investment in venture capital has the potential to increase returns as part of a diversified investment portfolio, at the same time decreasing its risks. However, since this asset class is exposed to such disparate returns, it is advisable that should you not have any experience or contacts within the sector, to rely on professional investors. Additionally, many of the venture capital funds mentioned, also offer other alternatives, such as crowdfunding platforms and investment clubs, such as Faraday.

Wishing you happy holidays!

Diego Sánchez Arboleya, CFA

Investment Manager