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?"
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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.
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Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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