Venture capital and its growing importance in portfolios

Today, venture capital sits at the intersection of several key trends in the global economic ecosystem. This notably includes the emergence of technologies essential to the fourth industrial revolution, such as artificial intelligence, the Internet and quantum computing, as well as digital transformation and the rapid and continuous adoption of technology. And while the COVID-19 pandemic has accelerated the digitalization of the economy, the sustained use and application of technology is here to stay. In addition, venture capital has provided investors with attractive historical returns, with aggregate US venture returns offering a return of 17.2% for the ten-year period ending December 31, 2020. [1]

From an investor perspective, this has sparked strong interest in being able to access investment opportunities in companies that are driving the most promising technological advancements being developed today and in the future. Here, we’ll discuss the basics of venture capital, the rationale for venture capital exposure in a total portfolio, and key considerations for success when investing in venture capital.

What is venture capital?

Venture capital is the financing of start-ups, emerging private companies with high growth potential where, given the stage of their life cycle, access to sources of financing such as equity offerings or debt issues is not available. Venture-backed companies typically operate in the technology and healthcare sectors, where there is potential to disrupt industries with life-changing products and services.

The venture capital funding cycle includes different stages, from seed to late stage, where each stage is usually characterized by certain stages, which are either operational and/or financial. Through this process, venture capital has the potential to take companies from the early stages of their life to those where they can generate millions or even billions of dollars in revenue. These different steps are described below:

Plant– The first round of financing after the incorporation of the company, which generally finances the development of new products or services

A-Series – The first significant funding round, in which one or more venture capitalists get involved in a fast-growing company that was previously funded by founders, seed venture capitalists and/or angel investors

B and C series– Funding provided to help scale company operations including manufacturing, new products, marketing, sales and customer service

Advanced stage– Funding provided once the business generates significant revenue. This may include capital for major expansion, mergers and acquisitions or entering new markets, for example.

The case of venture capital

In the context of the total portfolio, we believe there are compelling arguments in favor of exposure to venture capital. Along with exposure to key technology and innovation trends, as well as the potential for attractive absolute returns, there are also additional structural market dynamics that may be attractive to investors.

First, consider that companies stay private longer. In previous decades, venture-backed companies tended to go public earlier in their life cycle. For example, Amazon went public in 1997 when it was three years old. At the time of Google’s IPO (IPO) in 2004, he was six years old. [2]

Today, however, the market dynamics are quite different as companies increasingly rely on private markets for growth and choose to stay private for longer periods of time. For example, Uber and Airbnb, two of the ten biggest tech IPOs ever, were 10 and 12 years old, respectively, before IPOs — long after disrupting the industries in which they operate. [3]. Moreover, while private companies valued at more than a billion dollars (also called unicorns) were practically non-existent ten years ago, today there are approximately 1,000 companies valued at billions of dollars in various sectors, including software and internet security, hardware, artificial intelligence, fintech, healthcare and e-commerce. In total, these companies are worth around $3.3 trillion [4].

Given that companies remain private longer and their valuations are much higher than before, the implication for investors is that by not participating in venture capital, they risk giving up exposure to companies at high growth, disruptive technologies and high growth potential. Return. Bottom line: From our perspective, it’s more important than ever to get exposure to venture-backed companies ahead of their IPO.

What are the benefits of venture capital diversification?

We also believe that venture capital contributes to better portfolio diversification. Over time, the success of a high-growth business will be idiosyncratic in nature and less dependent on the general direction of macroeconomic factors, such as GDP (gross domestic product) growth, fiscal and monetary policy, interest rates interest or inflation. This is why we believe that venture capital plays an important role in the long-term strategic asset allocation of a portfolio.

Secrets to Success: Key Considerations

While we believe the opportunity cost to investors of not participating in venture capital is significant, there are important implementation considerations that investors should take into account to ensure that investment results desired are achieved. For example, there is a wide dispersion of returns in the universe of venture capital managers – and having the connections to access those top companies whose returns have generally proven to be persistent is critical to success. In addition, it is also essential to have sufficient resources to identify and access top-tier funds around the world, including the United States, Europe and Asia.

Exposure to VC-backed companies is key

Overall, we believe that exposure to venture-backed companies as part of a total portfolio is an essential way for investors to participate in high-growth companies as they commercialize and expand their operations. Overall, venture capital can offer investors several important advantages, including exposure to structural trends across technology and the opportunity to benefit from the substantial value creation that occurs in private markets.

Ultimately, it’s no surprise that as investors seek to meet the challenges of generating returns and improving diversification, they are increasingly turning to venture capital to potentially improve their investment results by partnering with companies that have the necessary resources, strong manager selection skills and demonstrated access to blue-chip funds.

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

[1] Cambridge Associates, “Are the Strong Recent US Venture Capital Returns Bankable? », July 2021, https://www.cambridgeassociates.com/answers/are-the-strong-recent-us-venture-capital-returns-bankable/

[2] Hamilton Lane, “The Myth of Peak Venture,” July 2019, www.hamiltonlane.com/en-US/Insight/9667e821-9b4a-428b-9306-1d7c5a145d74/The-Myth-of-Peak-Venture

[3] Hamilton Lane, “Broader Horizons: The Case for Private Markets Investing” April 2021

[4] CB Insights, “1,000 Unicorns: Global Billion-Dollar Private Companies Reach Four-Digit Milestone,” February 2022

https://www.cbinsights.com/research/1000-unicorns-list/

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