Venture capital’s reckoning looms closer

The writer is founder and chief investment officer of Verdad Advisers

After about a decade of significant outperformance culminating in a Covid boom, technology investors faced a sharp reversal this year. By the end of June, Nasdaq was down 29.5 per cent and the Goldman Sachs Unprofitable Tech index was down 52 per cent.

Yet one corner of the tech market was strangely unaffected. The US Venture Capital index compiled by Cambridge Associates was down only 12.5 per cent through the end of June (the last available data).

This gap between private markets and public markets is the largest since the bursting of the dotcom bubble more than two decades ago.

Few would argue that these venture capital marks are accurate in aggregate in any meaningful way — though probably most venture capitalists believe their own portfolio valuations to be right. They reflect an accountant’s appraisal of value, rather than the market’s capricious judgment — and thus tend to be significantly less volatile.

Academics have found that venture capital returns tend to lag behind public markets; the venture capital index looks roughly like an average of the last five quarters of the public market benchmark.

There aren’t many investors in VC funds complaining. Both they and the fund managers seem quite happy with the smoothed marks. It’s the volatility of public markets that seems outlandish and excessive, not the smoothness of the VC valuations. Yet perhaps this is not the costless ploy that it appears on the surface.

Consider an institutional investor looking to add growth/tech exposure at the start of 2020. They could choose between allocating to Cathie Wood’s Ark Innovation exchange traded fund or to a VC fund. The ETF was on a great run, beating both the Nasdaq and VC indices by about 15 per cent annually over the previous three years.

But, other than the State of Wisconsin Investment Board, endowments, foundations and pensions do not appear on the list of top 100 investors in the ETF, according to Capital IQ. In fact, scepticism about Ark was so widespread that Tuttle Capital launched an ETF (SARK) explicitly designed for investors who wanted to short Ark.

But despite the doubts about Ark, which had handily outperformed the venture index during the bull market, institutional investors dumped money into VC funds. In 2021 and 2022, investors allocated an unprecedented $270bn to US VC, according to Preqin. Back in 2014-17 there was only $30bn-40bn of VC capital raised per year.

Hating Ark and loving venture capital seems intellectually inconsistent. The underlying companies are similar.

The valuations of innovative companies should be comparable across both the private and public markets. And Ark was dramatically outperforming venture in the good years. But it presented a problem that venture does not: true mark-to-market volatility on small and unprofitable companies’ equity.

While most institutional VC managers acknowledge the smoothing effect and make internal adjustments, we think the reported marks are what truly drives decision making.

Just think: if an institution told you they had 15 per cent of their portfolio in Ark, you might question the degree of the bet. But many institutions have well over that allocation to venture capital.

The average buyout and VC allocations for a university with a $1bn endowment were 16.6 per cent and 13.4 per cent, respectively, at the end of June last year, according to data from the US National Association of College and University Business Officers. Some investment consultants recommend that clients should take private allocations (which also include private real estate and other private assets) higher than 40 per cent, arguing that institutions with higher allocations to privates do better in market downturns.

Institutions have fallen in love with private markets, lured by promises of higher returns and lower volatility. Allocations to VC have soared along with allocations to private equity, private real estate and private credit.

But perhaps these investors have been lulled into complacency, paying an illiquidity premium for the “phoney happiness” of private marks. By doing so — instead of receiving a premium as economic theory suggests — there is bound to be a drag on returns.

As research from Harvard economist Andrei Shleifer has shown, there are three ingredients to a financial crisis: consensus optimism, leverage and illiquidity. And private markets exhibit all three characteristics. Illiquidity may be fine on the way up, but, as investors in the Blackstone Real Estate Income Trust are discovering, it’s not ideal when market conditions change. Blackstone limited withdrawals from its $125bn real estate investment fund last month following a surge in redemption requests.

And after the dotcom bubble bursting, it took all the way until the end of 2014 for the VC index to regain the high water mark it set in early 2000. If the current listed equity market downturn persists, marks will eventually converge nearer to reality, leaving institutions nursing very real and illiquid losses.