Venture-capital trusts – buy at your peril

High-profile venture-capital successes tempt ordinary investors, but be careful, says Max King.

912_MW_P20_Funds
Everyone's looking for the next eBay

In 1997, venture-capital company Benchmark invested $6.7m in a small online auction company called eBay. By the spring of 1999 that stake was worth $5bn. In 2000, SoftBank, a Japanese company founded by Masayoshi Son in 1981, invested $20m in a fledgling Chinese venture called Alibaba. When Alibaba went public in 2005, that stake was worth $5bn.

Dreams of the Midas touch

Every investor dreams of backing a start-up that becomes, if not an international giant, then at least a household name. While investors are warned that venture capital (VC) is highly risky, with most start-ups ending in failure, the lure of massive returns from the occasional success is almost irresistible. Unless you have excellent connections, this usually means opting for a venture-capital trust (VCT).

To those tempted, a research paper by Blake Patterson of Harvard for Verdad Advisers provides a sobering warning. "Silicon Valley buzzes with stories of fortunes made by early investments in companies that went on to disrupt entire industries," he says. "Investors from all around the world compete to deploy capital with those few venture capitalists who have shown the Midas touch. But are these stories representative of the broader industry?"

Patterson's analysis of published returns, compiled by consultants Cambridge Associates, says not. While average returns were decent, they were lower than for the S&P 500, the Russell 2000 index and Nasdaq over three, five, ten and 15 years, according to the data. Only in the tech bubble prior to 2000 and in the 2007-2009 period when equity markets crashed did US VC outperform. The data does not cover the UK, Europe or elsewhere, but it is beyond belief to imagine that returns there were not lower.

What makes the data and therefore the prospects worse is that success was highly concentrated. Investors lost money, often their entire stake, with 65% of the businesses they plumped for between 2004-2013. In 25% of cases, investors made between one and five times their money; in 6%, five to ten times; and in only 4% more than ten times. "This means that a small number of [VC] firms have put up truly spectacular returns while the majority have had mediocre outcomes at best."

The lottery effect

Accessing these funds is not easy. "Picking the best [VC] fund is nearly as challenging as identifying great start-ups", while "the very best-performing funds have generally been small", meaning that it is extremely hard for investors who are not closely connected to the principals (key investors) to know about, let alone be allowed to invest in, these funds. So the odds of choosing the right funds the big winners that generate the majority of returns are very low.

But if VC returns are so persistently disappointing, why do investors keep putting money in? The answer lies in the so-called "lottery effect". When hopes and dreams of extraordinary gains are for sale, people overpay. These hopes and dreams are encouraged by "confirmation bias" we hear about the spectacular successes, but not about the overwhelmingly larger number of losses.

This explains why investing in start-ups and VCTs attracts such favourable treatment from the government. Without the tax breaks, far fewer people would commit their money to what is seen as a socially desirable form of investment.

In the UK, this improves the odds, especially for higher-rate taxpayers, but since success tends to breed further success, it makes sense to focus on the VCTs with the best performance record. Those who choose to invest directly, rather than through a trust, need to be very persistent, very well connected and very lucky.

Recommended

Think Tesla is a bubble? This might be the best way to bet on it bursting
Oil

Think Tesla is a bubble? This might be the best way to bet on it bursting

The huge rise in Tesla’s share price means that, by market value, it’s now the sixth-largest company in the US and and the world’s biggest car-maker. …
25 Jan 2021
Three clean energy stocks for your portfolio
Share tips

Three clean energy stocks for your portfolio

Professional investor Christian Roessing of the Pictet Clean Energy Fund highlights of his three favourite stocks at the forefront of the clean energy…
25 Jan 2021
The MoneyWeek Podcast: let's talk about bubbles
Stockmarkets

The MoneyWeek Podcast: let's talk about bubbles

Merryn and John talk about the many obvious signs of a bubble in certain assets, including tech stocks, TikTok, and stock-trading 12-year olds. It's c…
22 Jan 2021
Eternal growth: how to invest in the future of the drinks industry
Share tips

Eternal growth: how to invest in the future of the drinks industry

Humans have been dabbling in tasty beverages for millennia. Jonathan Compton assesses the key trends in the sector and recommends seven hard- and soft…
22 Jan 2021

Most Popular

Why we won’t see a house-price crash in 2021
House prices

Why we won’t see a house-price crash in 2021

Lockdown sent house prices berserk as cooped up home-workers fled for bigger properties in the country. And while they won’t rise quite as much this y…
18 Jan 2021
Inflation is the easiest way out of this – just don’t expect politicians to admit it
Inflation

Inflation is the easiest way out of this – just don’t expect politicians to admit it

The UK government borrowed £34.1bn in December, a record amount for that month. Britain's debt pile now amounts to 100% of GDP. How are we going to pa…
22 Jan 2021
When will the US stockmarket bubble burst?
US stockmarkets

When will the US stockmarket bubble burst?

With US stocks more expensive than before the Wall Street crash of 1929, there are growing signs of “mania”. But what will push markets over the edge?
22 Jan 2021