Friday Letter: Time to re-enter venture?

Conditions are looking more favourable for venture investing than they have for some time. But that doesn’t mean LPs should do it

Far be it from us to wish the rest of the year away. But now October is fast approaching, with the leaves falling and the nights drawing in, it's hard to escape the feeling that we're entering the final stretch of 2014. At which point, investors' thoughts inevitably start to turn towards the challenges that await next year.

We're currently talking to limited partners around the globe for our annual Perspective survey, where we ask them what they're worrying about ahead of 2015 (if you'd like to participate and haven't done so already, just click HERE – there are just four very simple questions and we'd love to hear your thoughts).

As you'd expect, one of the topics that comes up most frequently is asset allocation: how, if at all, are LPs planning to change where they put their money next year? Which is why a new paper to be published today by Australian fund manager Barwon Investment Partners, on the case for and against venture capital, is timely.

Now everyone knows that venture has had a pretty mixed track record over the years. The Kauffman Foundation famously published a report in 2012 showing that just 20 of the 100 VC funds it had backed in its history had made more than 3 percent above public market returns for the same period, while the average fund actually lost money. Equally, it’s been well established that success in venture investing depends to a huge extent on getting into the relatively small number of high-performing funds, since the dispersion of returns between the best and the worst is greater than in almost any other asset class.

But according to Barwon, the current market has several features in common with previous periods of good venture performance – which might give some investors cause to take another look.

The first precondition is a wave of disruptive technology. Where we had semiconductors and personal computers in the 1980s, the internet in the 1990s, and social media in the 200s, today’s wave is all about cloud computing, genomics and energy storage, Barwon suggests.

Another is a sufficient – but not excessive – supply of capital. According to the US National Venture Capital Association’s most recent handbook, the amount of venture capital under management has shrunk by almost a quarter in the last decade. On the other hand, there seems to be a broader range of institutions willing to play in the market for early-stage or pre-IPO financing, from mutual funds to early-stage private equity – as the list of winners from last week’s mega-IPO of Alibaba made clear. That may be linked to the fact that big technology companies like Alibaba are staying private for longer and going public at much bigger valuations than their equivalents in previous decades – which means more upside for private investors.

Something else that Alibaba proved was that the IPO market is functioning well and very receptive to venture-backed companies, especially in the technology space; according to Barwon, the first quarter of this year was the strongest for venture-backed IPOs since 2000. Coupled with the huge amounts of cash currently sloshing around corporate balance sheets, that adds up to another important precondition for successful venture investing: a favourable exit market.

So there are reasons to be positive. But the big problem continues to be access: it’s almost impossible for new investors to get into the big-name VC funds these days (especially if you’re a US public pension, because the GPs don’t like their disclosure requirements). It’s particularly difficult for groups like Barwon who like to access private equity through listed structures; there are some listed vehicles with a venture allocation (notably London-listed HarbourVest), but the options are limited. And if you can't get into the best funds, the ones most likely to produce those billion-dollar-plus ‘unicorns’, it’s a very different game.