Venture Capital Q&A: Ziad Makkawi, EQUIAM
The venture capital market is generally associated with early-stage investing; thousands of funds exist to identify the next unicorn that will deliver exceptional returns. But venture capital has its own after-stage, a part of the market where portfolio companies generate income, but they are not large enough to be considered a target for a buyout venture. AlphaWeek’s Greg Winterton sat down with Ziad Makkawi, Founder and CEO of VC EQUIAM, to learn more about this final stage of VC.
GW: Ziad, first of all tell us about what EQUIAM considers later stage venture capital, and why it should still be considered venture capital, not private equity/buyout.
ZM: EQUIAM is focused on growth as well as development-stage private technology companies. Companies that have a proven business model, rapidly growing revenues and healthy balance sheets. Our universe excludes any company that has had less than 3 funding rounds and has a market value of less than $250 million. These criteria position us firmly in the field of venture capital, but with a sufficiently wide range of targets which, combined with our systematic, offers a strong competitive advantage. At the broader end of the market capitalization spectrum, companies that have become profitable or have a clear path to profitability, the line with private equity is increasingly blurred. I would say the correlation and analogy is even stronger with publicly traded stocks as opposed to private equity. A private tech company that is a Decacorn (market cap over $10 billion) with an active secondary market for its stock should behave and be treated more like a public stock – and we do.
Our thesis has always been that the line between public and private markets is blurring, the same can be said about the line between VC and PE with larger, established managers in each segment starting to step on the cutting edge feet. For the most part, I would say the biggest differentiator is where the target companies are in their revenue and EBITDA lifecycle. Nearly 85% of the companies in our shortlist of 1,000 eligible companies still have negative EBITDA but have much faster growth trajectories compared to private equity firms. Private equity and in particular buyout strategies rely on exploiting the cash flows of target companies, which is generally inaccessible to them in the venture capital universe and which will become increasingly expensive in this environment of higher interest rates.
GW: EQUIAM takes a quasi-systematic, hedge fund-like approach to venture capital investing. Tell us more about how and why.
ZM: So far, our funds have been long-only funds and will remain so for the foreseeable future. Our strategy is to ingest over 60 million data points, filter the VC supported universe (120,000 companies), apply a variety of other proprietary filters to arrive at a universe of 10,000 companies. These are subject to further analysis via our 90+ metrics and sub-metrics. Each company is rated and ranked against all other companies using a proprietary algorithm that examines the spectrums of valuation, momentum, business health, growth, sentiment , among others. The result is a list of the top 30-50 companies in the universe that we will include in building our portfolio. Our access has been primarily through direct secondary markets; however, we are also increasingly able to access primary market issuers. I cannot overestimate the benefit of comfortably navigating both secondary and primary markets, and the additional flexibility that the secondary market allows, especially on exit flexibility. Our systematic approach generates both buy and sell signals and enables a more agile portfolio management strategy.
Although private derivatives markets remain embryonic, we have the flexibility to hedge our portfolio in different but highly correlated markets. This flexibility has been built in to protect against large macroeconomic shocks or company-specific shocks. EQUIAM seeks to stay at the forefront of innovation and investment technology in an industry that hasn’t really evolved much in the past 70 years. In this regard, we have also begun to use and are exploring the use of options strategies in private markets. We see great arbitrage opportunities here, as a systematic data-driven approach opens up analytical and data asymmetries. We believe private market derivatives will move rapidly in tandem with liquidity and we are already seeing crossover investors, including hedge funds, bringing their skills to this asset class.
GW: You’ve decided to go the 506c route, which allows for “general solicitation”. What motivated this decision?
ZM: Yes, Rule 506(c) allows general solicitation but requires managers to perform additional verification of investor eligibility. We have chosen to rely on the Rule 506(c) exemption because it allows for broader communications about our fund offerings. We wanted to reach people who have been shut out from investing in one of the most exciting asset classes, private tech companies that are changing the world.
GW: What is the allocation argument for later stage venture capital? Why should investors allocate to it? Is it a replacement for an early stage or growth equity exposure, or a complement?
ZM: The era of US Fed monetary policy feeding cheap money is over for the foreseeable future and a tightening of the belt is inevitable. In the environment, many riskier or marginal businesses that could have received funding will see their cash flow dry up. Later-stage companies are more likely to have understood the market fit of the products, bridged the chasm to wider adoption and revenue traction, and have a path to profitability.
There is often published data to show that early-stage funds and companies perform better than early-stage funds. What is missing are two key factors: return dispersion and risk (Sharpe ratio). Early-stage venture capital returns are more skewed than people realize: nearly 50% of seed funds fail to earn a positive return and 65% of investment rounds return less than 1.0x the capital. Unless you can get into the best funds and invest in a seed-stage Facebook, you’re unlikely to see blockbuster returns. Later-stage investments have much lower failure rates, less than 25% of investments return less than 1x. When it comes to the PE/buyback space, there is tremendous uncertainty and risk associated with this strategy in a rising interest rate environment.
Access to a diversified portfolio of growth companies systematically organized and managed to deliver outperformance, combined with a shorter fund life and a shorter path to liquidity seems like a no-brainer to me.
GW: Finally, Ziad, there’s a lot of talk right now about the difficulty of accurately valuing start-ups affecting deal flow, but there’s still a mountain of dry powder that needs to be put to work by VCs. next year or two. It is as if the irresistible force meets the motionless object; what will be the impact on the venture capital market at a later stage?
ZM: We believe that growth and late-stage markets are much easier to value than early-stage markets, where entry-level valuations are better compared to an option premium. In the case of growth and late stage, public market compositions are very relevant, especially in market dislocations and confusion, as we are currently experiencing. The probability of survival and positive returns in the early stage is generally much lower than in the late stage, in the current environment this delta will be much higher. When you start comparing seed/early stage to growth/late stage, many investors mistakenly ignore the risk component of this equation. There is an innate tendency to want to discover the next Amazon, or Facebook, or more recently Uber; Airbnb; Bandaged; Palatinate etc. Our analysis of the long-term risk/reward difference between early and late-stage venture capital clearly indicates, as mentioned earlier, that growth/late-stage portfolios have a higher risk/reward profile than earlier stages.
The ‘dry powder’ argument is one that most managers sitting on cash or looking to raise capital like to bring up to back up their argument! It’s also unclear how much of this dry powder is reserved for restocks and follow-on investments versus new opportunities.
Recent numbers put that number around $290 billion for VC. Nearly $130 billion of this sum is invested in venture capital funds with a generalist approach over the entire life cycle (with a majority reserved for late-stage funds) and $70 billion for early stage only and $50 billion for late stage funds only. It is unclear how much of dry powder is reserved for renewals and follow-on investments versus new opportunities.
Sure, it’s better to have that powder dry than not, but I think that’s a marginal argument for investing in VC. The real argument is that trillions of dollars have been pulled from the markets and are on the sidelines, not to mention the trillions more that international investors will pump into the United States as the global macroeconomic and geopolitical situation deteriorates in Europe, China , and emerging markets. Many will look to lock in relatively cheap entry valuations, by historical standards. Investors fleeing to “immediate cash” find a place to hide, but an inflationary environment will sooner or later push investors up the risk curve. We believe that there is a very large imbalance between the $s looking for yield and high returns and the quality companies that can deliver that in the private tech space, which means that manager selection becomes critical. The ability to see trees in fog may be more important, and certainly safer in this environment, than seeing the forest! The innovation super-cycle will continue to move forward, creating both the “winners” of tomorrow, as well as the “hotspots” and the “almost hits”. Going forward, investing success will depend less on who you know in the VC space and more on how well you analyze large amounts of data. This will find the companies most likely to be game changers and then proactively seek them out.
Ziad Makkawi is founder and CEO of EQUIAM