VC is another way to invest in small, high-growth companies
Taking a chance on venture capital investments could seem daunting to some, but it is worth considering as a viable alternative to small- and micro-cap stock allocations.
Taking a chance on venture capital investments could seem daunting to some, but it is worth considering as a viable alternative to small- and micro-cap stock allocations.
Although some of the nuances of private VC investing will require extra legwork and a different level of due diligence, the trade-off can be better performance and risk management.
The benefits of a VC allocation in a portfolio are obvious when evaluated through two efficient-frontier models using core indexes, with the objective being to achieve the highest return with the lowest level of risk.
In the first model — based on the historical returns of the S&P 500, the Barclays Aggregate Bond Index, the Wilshire REIT Index and the Wilshire Micro Cap Index — the portfolio allocation gradually tilts toward a concentration in small-cap stocks and produces an annual return of 11.2%.
In the second model — which adds the Cambridge Associates LLC U.S. Venture Capital Index to the four other index options — the portfolio allocation ultimately favors venture capital as the primary allocation. Its 14% return outperforms the first model by almost 3 percentage points.
The quantitative modeling of both portfolios, which was based on historical performance from 1981 through June 2009, illustrates the impact and importance of exposure to small, high-growth companies.
But it also illustrates how well venture capital can serve as a proxy for publicly traded small- and micro-cap stocks.
This is important, because the smaller company asset class “ain’t what it used to be,” according to William Banks, co-founder and a partner at Huntington Allen LLC.
As the head of a broker-dealer focused on raising assets for VC funds, he clearly has a dog in the fight. But Mr. Banks does raise some valid points for why investors might want to look beyond, or at least take a more cautious approach to, traditional smaller-company investments.
Increased regulatory requirements that came out of the Sarbanes-Oxley Act of 2002 “created an environment where the most innovative companies, with strong VC backing, promise and growing revenue, are being held up on the private sidelines until they are more mature,” he said.
The continuing effects of Sarbanes-Oxley, combined with fewer opportunities for initial public offerings, effectively has resulted in a less robust class of publicly traded small- and micro-cap stocks.
For example, as much as 40% of some small- and micro-cap indexes are now represented by the financial services, durables, consumer staples and utilities sectors, none of which is an area typically associated with high-growth small-caps.
“To a great extent, micro-cap has been diluted by mature companies whose businesses are flat or in decline,” Mr. Banks said.
Of course, venture capital as an alternative to public companies is not without its challenges.
Most VC funds are structured as private partnerships that limit the number of investors, include investor net-worth requirements, charge performance fees and impose investment lockup periods of at least six years.
At least one company is making an effort to reach a broader investor audience by marketing a VC fund that has been registered under the Investment Advisers Act of 1940.
Hatteras Capital Investment Management LLC, which has $1.7 billion under management, is cutting a new trail with the Hatteras VC Co-Investment Fund II LLC.
The fund, which has attracted $5 million so far, is set up to take in $100 million before its scheduled closing in June.
A key element of the fund’s “40 Act structure is its ability to have an unlimited number of investors, allowing the fund’s management to set minimums at $25,000. By contrast, most funds have minimums in the $1 million range.
Another feature unique among VC funds is the Hatteras fund’s fee structure, which includes a 2% asset-based management fee, but not the industry standard 20% performance fee.
Representatives from Hatteras said that they are prohibited from commenting on the fund during the offering period, but sources familiar with the fund said that it is focused primarily on the financial adviser channel.
New investments in VC funds fell to $18 billion last year, well below the historical average of $30 billion per year, according to the National Venture Capital Association,
But according to NVCA spokes-man John Taylor, last year’s slowdown doesn’t necessarily reflect a weaker investment climate for venture capital.
“When it comes to the size of the venture capital market, you can’t assume bigger is better,” he said. “Some people believe a $12 billion to $15 billion industry is the right size.”
Mr. Taylor added that with fewer opportunities available to companies pursing the IPO route, the VC market looks even stronger.
“The better VC funds are equipped with Rolodexes full of people that they can bring in to help manage these companies and get them ready to go public,” he said. “And the quality of the companies coming along now is very good.”
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
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