Should advisors continue to allocate capital to late-stage VC-backed companies despite recent setbacks at several high-profile companies in the category?
We believe the answer is yes if you have a two- to four-year investment horizon and the expertise and insight to navigate the asset class.
It appears that investing in late-stage VC-backed companies has provided better returns overall than waiting for the Initial Public Offering, as the data in the chart below illustrates.
We examined all 479 IPOs of U.S. VC-backed private companies that executed an IPO between January 2010 and May 2020. We then charted the change in price at both six months and 12 months after the IPO. As per the charts below, investors who bought into VC-backed companies as late as their last private financing rounds saw a median price increase of 91% and 90% over the six and 12-month periods following their IPO date, respectively, with average returns even higher.
By comparison, those who invested in the initial public offering or after the start of public trading experienced much lower price changes or even losses. These past results indicate that investing in high-quality, late-stage VC-backed companies before they leave the private marketplace have produced sizeable changes in price. Of course, past results do not indicate future performance.
Note: Factors that are unusual outliers have greater influence on Average results than they do on Median results.
Over the last decade, more than $6 trillion has flowed into the private market 1 driven largely by institutional investors – pensions, insurance companies, foundations, endowments, family offices – with increased skepticism around the high efficiency of traditional public markets.
Venture capital is perhaps the smallest segment of the private market compared to other segments such as buyout stage assets, real estate, and infrastructure, but in 2019 there was over $100 billion in VC-related investments 2. Furthermore, VC-related exits (an IPO, merger or acquisition) in 2019 generated more than $200 billion in proceeds to investors 3, marking the ninth straight year in which investor inflows from exits have exceeded outflows into new investments.
Venture capital offers a different risk/reward profile compared to other private market segments, meaning that there is potentially greater risk associated with these assets that may generate higher returns. There is also remarkable variance within the asset class. For example, early-stage VC-backed investments often involve emerging businesses still in the conceptual phase of their development. With this higher risk comes the potential for significantly higher returns, often in the 5x+ range (five times or more on the original investment) as seen in the past.
In contrast, late-stage VC-backed investments typically involve high-growth businesses with well-defined operating models that may have a clearer path to liquidity via M&A or IPO. Looking at funding and exit data in CrunchBase for companies with two or more funding rounds in 2008 through May 2018, investments in late-stage VC businesses have generated risk-adjusted returns in the 3x+ range (three times or more on the original investment) 4. Of course, we cannot predict the future, but past performance gives us reason for continued optimism.
Whether accessed through primary or secondary investment strategies, holding periods for late-stage VC assets tend to be relatively short compared to other private market strategies. That being said, we believe that this asset class still requires a longer-term view of at least two- to four-years before meaningful results have the potential to be realized. Investors with a shorter time horizon would be wise to limit their exposure.
For those with a higher risk tolerance, VC investing can be rewarding, but a key question all investors should ask is: “What about liquidity?”
Over the past two decades, the secondary market for private asset transactions has grown significantly, providing increased liquidity to the market. Reports for 2019 cite volume of approximately $85+ billion 5. In 2018, there was $80 billion 5 in reported secondary transaction volume—up from $58 billion the prior year 5. A subset of this secondary transaction volume includes the buying and selling of securities in late-stage VC-backed companies, which in recent years has grown to thousands of secondary transactions annually in hundreds of these late-stage VC-backed companies in the U.S. alone.
The secondary market helps to provide much of the needed liquidity for the general partners (GPs) of funds, the limited partners (LPs) who invest in these funds, and the shareholders in the funds’ underlying portfolio companies. Secondary investors are often able to take advantage of dislocations and information asymmetry, which may allow them to purchase private assets at significant discounts to their fair market or intrinsic values. Purchasing at a discount does not guarantee the ability to sell at a gain.
The risk/reward profile for secondary transactions also varies depending on the underlying asset stage and transaction types. For late-stage VC secondary assets, investors will typically seek returns in the 3x range 6.
To understand the potential opportunity, it is important to acknowledge there has been frothiness in the valuations of late-stage VC and growth-oriented companies over the past several years. Overheated valuations have been driven by a variety of factors:
Prior to recent COVID-19 pandemic, the volatility in private and public valuations at some of the highly publicized decacorns (company valued at at-least $10 billion) like WeWork, Uber, and Lyft, among others, was part of a necessary market correction in our view. As we’ve observed, the COVID-19 pandemic has created additional volatility for private and public companies alike. Depending on where one sits in the capital stack, a market correction may or may not have a significant impact on valuation and performance of these investments. In addition, sophisticated investors in this asset class have been negotiating for special terms that include seeking some downside protection into new financing rounds, which we expect will continue in the COVID-19 pandemic environment. Examples of these downside protective provisions may include a guaranteed minimum preferred return, discounted conversion metrics if an IPO occurs below a certain defined valuation, anti-dilution coverage to preserve an investor’s ownership interest, etc. Nevertheless, these investments continue to be subject to risk of loss.
As the market corrects during periods of increased volatility and uncertainty, it can create an attractive buying opportunity for experienced investors to either enter or increase their exposure to the late-stage VC asset class. Like public market behavior, private market investors may exhibit a desire for increased liquidity during these periods, perhaps even more so, which can lead to a supply/demand imbalance. However, the ability to achieve such liquidity is more challenging when the underlying assets held are illiquid, which can result in transactions being consummated at higher discounts. Similarly, new private financings completed during these periods may come with lower valuations and more investor-friendly terms, as noted above.
While the appetite for hypergrowth in highly capital-intensive businesses with no accessible path to potential profitability in sight had already waned prior to the COVID-19 pandemic, there continues to be a deep pipeline of highly anticipated IPOs. In our experience, only a subset of these companies will become publicly listed and perform well, but we believe there continues to be strong public market demand for high-growth companies in large total addressable markets that offer near-term paths to profitability. To some extent, direct listings may increase in frequency once there is better visibility around the macro-environment. Also, it is important to remember that the vast majority of VC-related exits has historically involved M&A, not IPOs.
That said, we entered 2020 following a year in which both M&A and IPO volume fell to the lowest levels we have seen in several years and we would point out again, that this is prior to the COVID-19 pandemic. As the world now comes to grips with the pandemic, macroeconomic concerns, and an unpredictable U.S. presidential election cycle, it is reasonable to assume that downward pressures on valuations may continue and liquidity prospects may become more challenging for late-stage VC-backed companies. However, we continue to believe that companies with differentiated business models, strong operating metrics, healthy balance sheets, experienced management teams, and seasoned boards will ultimately reward their investors, even if it takes a bit longer than expected.
There is no question that the late-stage VC asset class comes with a higher risk/higher return profile when compared to conventional public equity and fixed-income strategies, as well as certain private market strategies. However, solid data and analysis indicate that investors with longer-term time horizons would be well served to explore how this asset class may complement their current portfolio allocation models.
Christian Munafo is Chief Investment Officer of Liberty Street Advisors, Inc.