Venture Capital Positively Disrupts Intergenerational Investing
[Cambridge Associates] Families of wealth face three key questions about intergenerational wealth planning: how best to invest to sustain future generations; how best to engage the next generation; and how best to ensure family unity endures. Often each question is addressed independently. We find that a conversation across generations about the impact of a meaningful venture capital (VC) allocation can help address all three questions in an integrated manner.
Venture capital offers the potential for attractive returns relative to public equity markets, often in a tax-advantaged manner, thus allowing the portfolio to generate more wealth to support current and future generations. Bringing the next generation into the conversation about the changing investing landscape also offers the opportunity for both generations to learn about the unique aspects of VC investing and the critical role it can play in the family’s portfolio.
As VC spurs continued innovation and industry disruption, families should consider the potential positive disruption the inclusion of VC can bring to their intergenerational investment plans. This paper provides some context for considering such an inclusion by discussing the investment potential and implications for interested investors.
Venture, the Source of Future Returns
Whether it be cloud computing, machine learning, or artificial intelligence, emerging technologies are transforming many industries. Venture capital investing offers exposure to evolving industries, often at the ground level, hedging the risks associated with mature companies ripe for disruption. To be sure, plenty of public equity and hedge fund managers are evaluating structural market changes, looking to buy winners and sell losers; the pure-play opportunity to capture this value, however, is via VC.
Venture capital has generated compelling returns relative to public markets, both in recent years and over long-term time periods (Figure 1). Looking ahead, we believe the environment will continue to support attractive returns. Technological advancements, strong entrepreneurial talent, availability of capital, and fund manager skill are creating intriguing investment opportunities across multiple dimensions.
While each family situation is unique, we advocate for families to consider allocating 40% or more to private investments. We also believe families should consider dedicating half of their private investment allocations to VC, provided these families have a long time horizon and the requisite liquidity provisions to meet their spending needs. Factoring in the potential tax advantages of VC investing—such as returns being taxed primarily as long-term capital gain; opportunities to discount interests for gift, estate, and inheritance tax purposes; and possible qualified small business stock tax treatment—a 20% allocation can nicely position a portfolio for future generations.
The Venture Investing Landscape Has Evolved
It is important for private investors to understand how the return and risk profiles of VC investing have changed, as today’s market is not the same as 20 years ago. Broad-based value creation across sectors, geographies, and funds means success is no longer limited to a handful of (often inaccessible) fund managers. Moreover, top returns are not confined to a few dozen companies. As Figure 3 shows, new and developing fund managers consistently rank as some of the best performers.
VC investors during the 2000 tech bubble experienced significantly varied results, with both big winners and big losers. Since then, the industry has evolved, and fund managers have learned valuable lessons that benefit today’s venture investors. What once was considered a bingo card approach to fund construction has been replaced with a more rigorous, risk-managed assembly of companies. VC funds are surrounding themselves with “incubator” forums and core communities of advisors, as well as setting aside capital for follow-on needs. These additional measures provide critical resources that enable start-up companies to find solid product market fit and to scale accordingly. This has had the dual effect of reducing return dispersion among managers and reducing the impairment and capital loss ratios of the underlying universe of companies. In the 1990s, the capital loss ratio was more than 50%. 1 This has dropped significantly to about 20%. Today, the time frame and capital required to determine viability is significantly lower than it was 20 years ago, allowing managers to trim the weeds and water the flowers more efficiently.
In light of the historically higher loss and impairment ratios, VC is often met with skepticism and deemed too risky. Given many start-up companies fail to return capital, it is reasonable to assume the risk of capital loss is high with VC investing. The data suggest that VC has matured and today exhibits a closer risk/return profile to global PE (buyouts and growth) than it did in the 1990s. Investing in venture funds, which each have 20–30 investments, reduces the risk from any single start-up. Diversifying across multiple funds helps to mitigate the downside probability of overall loss.
Still, the goal in VC investing is not simply to break even. While narrower than 20 years ago, the range of manager returns is still wide and significant (Figure 5). The modest, but real, dispersion among public global equity fund returns underscores the ongoing debate over passive versus active management. In VC investing, there is no “passive” approach, and manager selection is the key to capturing attractive returns.
Further Considerations for Inclusion
Given muted return expectations for public equities over the next ten years, increasing allocations to VC may prove to be beneficial. Consider the following math: A properly constructed VC portfolio will target a 300% return over the life of the fund (typically ten years). By comparison, to earn a 200% return on a public stock over ten years, the stock would need to have an annualized return of about 7%.
The importance of allocating to VC is further marked by what looks to be a clear and sustainable trend of private markets replacing public markets, as seen in Figure 6. Over the past 20 years the number of publicly traded US equities has nearly halved, from 8,090 to 4,336. This compares to 8,352 unrealized and partially realized VC-backed companies in 2019. While not all these companies will survive, or prosper, many will generate significant returns for investors. As these companies stay private longer, the greater returns are increasingly reaped by early VC investors.
Fears of too much money being raised in the VC space are consistently based on historical levels, rather than future potential. When put into context, the amount of money raised in VC represents a fraction of the market value of the industries being disrupted by many venture-backed companies, and a fraction of the total addressable markets of emerging business categories being created by VC. As shown in Figure 7, VC at $340 billion net asset value (NAV) is less than 0.5% of the $85 trillion in global equity valuation.
Publicity around the proliferation of overpriced “unicorns” (companies valued at more than $1 billion) as a sign of too much money in the space needs context. Once aptly named, unicorns are no longer rare and elusive. While several later stage venture-backed (pre- and post-IPO) unicorn companies are now visibly being repriced down, valuations for early-stage and growth sectors of venture have remained more reasonably balanced (Figure 8). For investors in the early and growth stages, increased funding options at later stages offer the opportunity for liquidity for early-round investors while allowing companies to remain private.
Venture Capital’s Convergence with Family Values
At the heart of VC is the investment in an entrepreneur. Whether his or her vision is transforming the consumer buying experience or addressing climate change, the goal is to make a difference while making a return on capital. Tapping into the perspectives, insights, and experiences of all generations will facilitate decision making on how best to incorporate VC into the family’s long-term investment strategy. Generations can combine their expertise, insights, and interests to identify unique and compelling areas for investment. One generation, for instance, may be at the forefront as consumers for many of the new technologies, bringing a level of insight that complements the other generation’s experience and wisdom.
As technological advances have been made, the ability to have profitable paths to sustainability is creating a vast array of areas for potential impact investing (Figure 9). This convergence of profit and impact affords a unique advantage for families. Separate from pure philanthropic conversations, discussions around VC fund investments can focus on opportunities that can profitably address these issues, ensuring longevity of the solutions. Many families are considering ways to have more impact with their wealth via VC investments that focus on sustainable change related to social and environmental challenges. By accessing specific opportunities aligned with individual interests, each family member’s distinct perspective, passion, and personal values can be incorporated in the family’s investment choices, making the family’s investment program more personally meaningful and impactful to all participants.
As technological advances are disrupting and transforming companies in every sector, the traditional investing landscape is also being disrupted. Venture capital is at the core of the transformation and has become a critical component of a long-term investment strategy. Institutional investors have understood this trend and have allocated accordingly. We encourage families to consider how their own intergenerational investing plans might best be positively disrupted by VC. With the potential for attractive returns and significant positive impact, VC presents a prime platform for cross-generational conversations about investing. ■
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