Venture capital funds are mostly just wasting their time and your money

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A good investment strategy is to only buy stocks that go up. Most stocks don’t go up though, at least not consistently, so an easier strategy is to buy lots of stocks and hope some will go up by more than most go down. It’s an application of power law, where just a handful of portfolio investments will generate nearly all of the returns.

A popular way to finesse this strategy to buy venture capital funds, because they’re arguably the purest expression of moonshot investing. Payoffs from private assets are much higher reward at lower probability than from public markets, generally speaking, so the power law concept has been very deeply embedded in the VC world.

The perhaps obvious catch is that power law applies just as much to funds as stocks. Just a handful of VCs generate nearly all of the sector returns.

Morgan Stanley equity strategists Edward Stanley and Matias Øvrum have run the numbers for the past 20 years of crossover investing and found that the average VC fund doesn’t reliably outperform the average stock.

Any investor lucky enough to pick a top-performing VC was awarded with an internal rate of return “off the scale” relative to all other strategies, Morgan Stanley says. Mostly, though, the few big winners were funds that either backed tech giants pre float or caught 2021’s Spac boom, as illustrated by this slightly absurd chart:

Remove 2021 from the analysis and the top-tier gains would be more than 50 per cent lower, Morgan Stanley says. For the rest of the fund universe, even with the mid-pandemic exits included, the medium-term median returns have been no better than mediocre:

Fans of hindsight and survivorship bias will note that US big tech still beat the top quartile of VC funds over 20 years, which is interesting but probably irrelevant to anyone who can’t time travel.

A potentially more actionable finding is that, even over 20 years, a reasonable number of stocks outperformed the median VC fund:

The chances of identifying these buy-and-hold winners ahead of time doesn’t look great — 3,626 long-term outperformers globally still only represents 4 per cent of the total — but your odds of finding them might be substantially improved by filtering by measures like growth and momentum. That’s not really possible in private markets.

And thanks to power law distribution of winners and losers, the worst VCs are impressively efficient at destroying wealth.

For the sector as a whole, 50 per cent of deals go bad . . . 

. . . so for managers whose hit rate is average or worse, all those failed gambles combine with the perpetual taxation of management and performance fees to compound negative IRR:

One big advantage private assets have over publicly traded ones is that with the former, managers can cheat a bit. VCs tend to only report marks on their portfolio once a quarter, and there’s a whole toolbox of financing structures that can delay marking to market. Having no daily price fix might reduce volatility, which could help improve the risk-adjusted return. That’s worth something, right?

Morgan Stanley’s testing of that theory against Refinitiv’s Thomson Reuters Venture Capital Index isn’t conclusive. The VC index did well for the three years to 2021 but has since underperformed nearly everything. Its Sharpe ratio is a third lower than the Nasdaq (and Apple), which suggests asset illiquidity has been more a curse than a benefit:

(Key for the above chart: Rule of 40 stocks have a combined growth rate plus ebitda or cash margin of 40 per cent or more; unicorn hunters are public companies flush with cash that they use for tech-ish acquisitions; multi-unicorn hunters are the same but are serially acquisitive.)

In conclusion, says Morgan Stanley, the smartest thing to do was to buy Apple in 2003 along with maybe a couple of others listed below. The next-smartest thing to do was to buy a high quality and/or lucky VC fund then sit tight for 18 years awaiting an exit bubble. The worst thing to do was to buy any VC fund that turned out to be neither high quality nor lucky:

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Stanley and Øvrum’s advice to clients is that they should be choosing good quality private funds, though they concede that locating one might prove a challenge: according to Dealroom, the number of active venture/growth investors has increased fourfold in a decade to 40,000.

The alternative was to just buy Apple. It has beaten the median VC performance even on a volatility adjusted basis over the one-, three-, five-, 10-, 15- and 20-year views — though as the disclaimer always says, past performance is no guarantee of future results. Apple’s now a $3tn crowded long in a top-heavy market whose biggest winners have probably outgrown power law dynamics, which means the note’s main lesson (to be applied however you wish) is to make sure you only buy the stuff that will go up.

Further reading:
— Most stocks are bad for your wealth (FTAV)
— What exactly is problem with stock index concentration? (FTAV)