Venture capital funds offer a number of investor benefits, but they also carry a commensurate level of risk.
Venture capital funds, which present a way for investors to stake a claim in privately held companies, have long been recognized for their potential to create significant returns. However, they also come with high minimums and long lock-ups, or illiquid periods. Their investors have been thought of as members of an “exclusive club” reserved for the super wealthy, endowments, and other institutions. This is now changing, due to the demand for alternatives from the mass affluent, product innovations and legislative changes, as well as investor and adviser education.
Public investment in private companies started to gain significant momentum around 2010, as more early venture investors and employees sought liquidity for their shares.
Additionally, companies started to stay private longer. Historically, technology companies went public after being in business for five-to-eight years on average. Today the average is 11 years. Given that companies are staying private longer, more of their value creation is occurring while they are private. Apple went public in 1980 with revenue of $117 million and a growth rate of 145%. Today, a private company with that level of revenue and revenue growth rate would be considered a later-stage venture and would likely stay private a few years longer in order to maximize value for its shareholders.
EARLY STAGE VS. LATE STAGE
“Early-stage” and “late-stage” are two categories used in describing private companies. Early-stage companies focus on securing capital, product development and exploring markets in which to sell their product. These companies are in their inception phase. They typically have little or no revenue, a high uncertainty regarding their product and business model and a high cash-burn rate. While investments in early-stage companies typically offer higher return multiples to the investor, the failure rates can be as high as 50%.
Late-stage companies are different. They likely have a proven business model with a stable product offering and significant revenue. Their revenue is usually growing at a rapid rate of 100% or more each year. Some late-stage companies may already be household names — think of Airbnb, Jawbone, Uber and Pinterest. Investors expect to realize their gains through an IPO or an acquisition within two-to-four years.
BENEFITS AND RISKS
Venture funds offer a number of investor benefits, but they also carry a commensurate level of risk.
The first primary benefit, which is rather obvious, is the potential for strong returns. Private companies are often managed for aggressive growth, with management teams focused on generating and growing revenue as rapidly as possible in order to achieve a successful exit, most often through an IPO or an acquisition.
Another investor benefit can be investor portfolio diversification. As suggested by modern portfolio theory, simply adding any new asset class to a portfolio can reduce the overall risk of that portfolio. Additionally, venture capital and private companies have historically had a low degree of correlation to the broader markets; they are not traded on an open exchange, and are therefore less subject to the day-to day volatility associated with the public markets. Both of these factors can help reduce the volatility of an investor's portfolio.
It is essential to remember that professional management in this space is of paramount importance. There is no substitute for experience and knowledge when it comes to investing in private securities. Most mainstream investors do not have exposure to private companies. Research and financial information is limited and deals are frequently consummated through close business relationships. This opaqueness suggests that mainstream investors would not likely know which companies present the best opportunities for rapid growth or industry disruption, and at which prices private stock should be traded.
GAINING ACCESS
As the benefits of investing in private companies have become more widely known, interest from advisers and investors in the asset class has grown. Some investors are looking to nontraditional product structures, such as the interval fund, to gain access.
The interval fund is different from an open-end mutual fund. Investors can be purchase shares daily, but they can only sell or redeem them on specific, stated dates — hence the “interval” component of the fund. Interval funds are governed by the Investment Company Act of 1940 and, therefore, have a high level of reporting and disclosure requirements imposed by the SEC. These funds offer greater liquidity and transparency than their traditional counterparts — venture capital funds — but should not be considered a fully liquid alternative investment.
Interval funds were designed to provide the average investor access to non-liquid investments like real estate, oil and gas assets, private debt and now also private stock. They give the mass affluent — investors with savings goals such as college and retirement — access to an asset class that they may not otherwise have had.
Private company investing is no longer reserved for an exclusive club. Everyday retail investors can now further diversify their portfolio by adding a new asset class, and gain exposure to some of the most interesting and innovative companies that are driving our economy and changing they way we live our lives.
Sven Weber is the president of SharesPost Investment Management, the investment adviser to the SharesPost 100 Fund.
