Highland Capital and Tallwood Venture Capital represent two strategies of venture capital investing. Highland represents the traditional diversified portfolio strategy where many unrelated investments are made and little operational support is provided by the investor. Tallwood represents the focused portfolio strategy where fewer investments are made in a specific industry and investors are able to provide a greater amount of time and operational support to their firms. Neither of these firms is absolute in their strategic focus. Highland provides some support to some of its investments in the form of office space and access to other industry leaders. Highland also has focused teams in specific industries and cannot simply invest in any firm. While I will discuss a hybrid approach later in the paper, the number of focused sectors and number of investments in each sector results in a strategy that is indistinguishable from a diversified strategy.
Tallwood only has two executives in residence to assist partners in providing technical advise for its portfolio. Clearly, this is insufficient to provide constant support to their firms however this paper will discuss relative differences in strategies rather than absolute examples of either strategy. I will explain why this difference matters to investors, how it affects investment selection within the firm, and the type of firms that are most likely to receive funding from each strategy. Given the extremely high exits necessary to compensate for a large number of losers, a diversified strategy is interested in funding companies that have a low probability of success and a high-expected growth rate. A high probability of success would not allow for a large enough equity stake given a limited amount of equity and a low growth rate does not provide a sufficiently high exit valuation. Increasing an investor’s focus on an industry allows for investing in ideas that may have a smaller market potential but greater probability of success.
From the investor’s point of view, venture capital should provide superior risk adjusted returns with a liquidity premium when compared with public markets. Without this return, there is no incentive to invest. The problem lies with describing risk in statistical terms in order to get a precise quantitative answer rather than business terms that usually results in a more qualitative answer.
Investing in a venture capital firm requires a lockup period where the investor cannot withdraw the investment or may withdraw but at a severe penalty. This is to protect other investors in the fund from being forced to contribute more capital than planned or to sell illiquid investments at a discount. As compensation for being unable to quickly withdraw their investment, an investor requires a liquidity premium. Without this liquidity premium, investors would be better off buying assets such as stocks with the same returns and no penalty for selling early. Endowments that have too much of their portfolios allocated to illiquid assets may not be able to support their liquidity needs when a financial crisis causes the value of their stocks and bonds to fall. When the liquidity risk is not considered, venture capital returns may be overstated.
While venture capital may be an unappealing investment based on overestimated returns and underestimated risk, there may be opportunities to make a rational investment by choosing a successful fund manager. If an investor will need to accept a lockup period of up to 10 years, the initial manager selection is critical. There is a substantial risk that one of the partners may retire or leave the firm and support staff typically has a higher turnover so the selection process will need to focus on strategy rather than personality. Knowing this, the question then becomes what strategy produces above average returns in the venture capital industry?
Venture Capital Industry Concerns
According to Fred Wilson, venture firms need average exit multiples of three to meet the returns required by investors. The average industry exit multiple was 1.6 which is approximately a ten percent annual IRR. According to the article, another unnamed industry analyst estimated that venture capital would need to decrease by 50% in order to generate adequate risk adjusted returns before coming to the conclusion that the venture capital model doesn’t scale. This conclusion seems justified when we compare the expectation of a 10% return in 2010 with the expectation of a 25% to 35% return in 1998 and the realized return of 8.2% as of the third quarter of 2010 but does not take into account a strategy change in the venture capital industry.
Highland Capital represents the traditional diversified venture capital strategy. As Peter Bell noted in his presentation, the success of any investment is viewed as a random process and Highland’s partners are generalists that follow a top down approach to individual investments. The partner first determines an attractive industry; one that is in the growth period of the industry S-curve. High growth companies command higher valuations at exit and are easier to market to the public market or an acquirer. Since there is little disagreement in the industry on what the high growth industries will be, venture firms will tend to over invest in attractive industries.
According to Zider, a venture capital investment has an estimated 10% probability of success, which implies that the average venture capital firm has excess capital to allocate to investments. The exact proportion of the remaining 90% that is required to obtain the winning 10% cannot be determined with certainty without making some assumptions. In Highland Capital’s case, the assumption is that venture investors are not skilled in selecting investments. This assumption supports the diversification strategy also limiting the amount of time each partner can devote to an individual investment. A generalist who invests in a diversified portfolio has little incentive to choose the best firm in an attractive industry with time being a limited resource. This conclusion is based on the assumption of limited equity in quality firms seeking capital and limited time combined with excess funds with which to invest.
In Tallwood’s case, the firm has a focused portfolio strategy where the top down approach can only be applied in a limited manner. If investments are limited to the semiconductor industry and are smaller in number, Tallwood can pursue a bottom up investment strategy where more time is spent evaluating whether the particular investment is attractive as opposed to evaluating whether an industry is attractive. Time constraints become more relaxed relative to a diversified strategy since there are fewer investments to track. The focused portfolio strategy assumes that partners have some expertise in selecting investments and advising companies. Without this assumption, there would be no incentive to limit the number of investments or the industry in which to invest.
An alternative to the diversified and focused portfolio strategies is for a single venture capital firm to have multiple partners where each partner or team of partners is focused on a particular industry or technology. This hybrid strategy can mimic the results of either the diversified or focused portfolio depending on the number of investments made by each partner and the resources available for each partner or team to support their investments. A partner with few investments has an incentive to select best in class companies and provide operational support while a partner with many investments will provide little to no support and assume success is a random process. In the former example, the hybrid strategy will mimic a focused strategy while in the latter case; the strategy will be similar to a diversified strategy.
The assumptions I have made regarding diversified and focused portfolio strategies in the venture capital industry are supported by the work of Fisher Black and Robert Litterman in their model of portfolio optimization. The Black Litterman model was original applied to currencies but it can be applied to any investment. The main idea of this model is to optimize a portfolio not just on expected return but also on the deviation between market expected returns and the investor’s expected return. In essence, invest more money when the investor believes that he/she has an edge over the market.
The diversified strategy is diversified because partners believe that they do not have more skill at selecting investments than the market. Under the Black Litterman model, we would expect these firms to exhibit “herding” behavior investing in the same firms and industries and, as Peter Bell confirmed, this is what we observe in the industry. Focused funds believe that they have an edge over other investors and overweight those firms as described by the model. This results in fewer investments and more resources to support each investment.
Returning to the argument of the amount of excess capital necessary to secure a 10% success rate, the focused fund must assume that either they have a higher success rate than diversified funds or they have higher returns from their winners. Without one or both of these assumptions, there would be no incentive to remain limited to a focused strategy. If we assume that one or both of these possibilities are true, a focused firm has the opportunity to invest in firms where the expected return is lower than that required of a diversified fund. This occurs because of the secondary weighting of the difference between investor expectations and market expectations described by the Black Litterman model. The two components of expected return, possible returns weighted by probabilities of success, have some interesting implications regarding the type of investments that each strategy will prefer.
Impact on Funded Companies
In the case of Highland, a diversified portfolio results in many companies receiving funding with each project receiving little to no operational guidance. Given the extremely high exits necessary to compensate for a large number of losers, the type of ideas that get funding are those that have a low probability of success, a high growth rate, and a high expected return. Knowing that there is excess capital when measured against the limited amount of quality equity for the reasons discussed above, only a low probability of success will guarantee a sufficient equity stake to compensate for the large number of losers in the diversified portfolio. A high probability of success would not allow for a large enough equity stake and would not provide sufficient returns for the diversified investor.
Increasing an investor’s focus on an industry allows for investing in ideas that may have a smaller market potential but greater probability of success. This type of investing serves several important purposes. First, it is obviously an efficient allocation of capital that produces economic growth. Second, it provides a form of financing that is less expensive than the most speculative angel investing but more expensive than traditional debt financing. Usury laws prohibit charging an appropriate interest rate for the amount of risk that investors are exposed to even when investing in a company with a greater probability of success. This is because many firms that fit this description may not have sufficient physical assets to post as collateral. Firms with a focused strategy ensure that companies that may not change the world but may create substantial economic value receive funding.
Recent data from the National Venture Capital Association suggests that investors are on average pursuing a diversified strategy. Despite low and even negative returns the number of deals remains high while the amount invested decreases. This would suggest that venture capital investors are making numerous small investments rather than a small number of large investments. The most recent data also suggest that investors continue to choose the same sectors in which to invest. Cambridge Associates reports that 75% of its venture capital benchmark is composed of healthcare, IT, and software and that these sectors outperform other venture capital investments. This would seem to support the idea that most investors do not deviate from market expectations and under the Black Litterman model, would be best served by pursuing the diversified portfolio strategy.
If most venture firms are investing in similar companies and the returns of the industry are declining, an investor may still be able to obtain above average risk adjusted returns. One method is by choosing a venture capital manager that has sufficient expertise to beat the average venture capital return through a focused strategy. One problem with this alternative is that managers have an incentive to limit the number of investors in order to reduce the risk of missing a capital call. Investing with a focused fund of sufficient quality may not be possible for an individual investor. An alternative is to choose a venture capital manager that has a strong enough reputation and network to ensure that they are able to invest in the best firms in an attractive industry. Since the amount of equity with a high probability of success is limited and there is an excess supply of capital, it is critical that a venture firm that pursues a diversified strategy be able to invest in the best firms. Without this network and reputation, investors should not expect above average risk adjusted returns.
Cambridge Associates Private Equity and Venture Capital Funds Closed out First Half of 2010 with 5th Consecutive Quarter of Positive Returns November 2010
Ghalbouni, Joseph and Rouziès, Dominique The VC Shakeout. Harvard Business Review, Jul/Aug 2010, Vol. 88, Issue 7/8
Zider, Bob How Venture Capital Works. Harvard Business Review, Nov/Dec 1998