Illiquidity premiums and relative returns between venture and public market funds
This piece contains a number of speculative inferences and assumptions. Readers should apply their own critical judgement and common sense to digest this opinion.
I was reading an article in the AFR last week regarding the maturity of OneVentures’ maiden Fund (OneVentures’ Innovation Fund I) which they launched in 2010. OneVentures is one of the larger Australian venture funds, primarily investing in later stage technology, health equity and providing growth credit.
What caught my attention was the claim that it’s first Fund returned 4x it’s initial capital to it’s investors, a compound annual return of ~10.4% over 14 years, implying this is a net or post-fee return.
The fund raised $40 million with half the money coming from the government under the ‘Innovation Investment Fund’ program which structurally was similar to a mezzanine note; ie. had a fixed return linked to the long-term bond rate, plus a 10% share in ‘excess’ profits above the return of principal and interest.
The Fund’s investment mandate differs from the firm’s current incarnation; investing solely in early stage VC (pre-seed to startup) versus the current mandate which is focused on supporting later stage companies.
This change in mandate is likely due to:
the weight of greater capital that it has been successful in raising over the years;
the lower risk of investing in later stage companies
greater scalability of effort ie. it takes an equal effort to assess opportunities irrespective of size
greater maturity and competition within the Australian VC space
The overall size and composition of the Fund and disclosed portfolio exits strongly reminded me of small cap funds that invest in public listed markets; albeit with 50% leverage.
Another thing that interested me was the timing of the Fund’s inception in 2010. The era encompassing the year 2010, was a highly fertile environment for active managers to capture alpha.
This was driven by a few factors:
cheap valuations as a consequence of the GFC
a slow recovery in market confidence and liquidity
uncertainty in respect to residual systematic and idiosyncratic risks
This period of time was the genesis of a number of Australian boutique fund managers, who achieved strong returns over the following years and who have consequently built enduring businesses. This fortuitous timing, successfully ‘riding the cycle’, was a key factor for success outside of their own individual investment skills; and in many ways this is a commonality with the local gamut of venture capital firms.
My curiosity was piqued.
How did the leveraged, illiquid 10.4% CAGR return over 14 years invested in unlisted microcaps (VC Fund) compare to a cohort of top quartile, public market, long-only funds which had the (investor) benefit of liquidity (daily or monthly liquidity via open-end structure) but did not have the (manager) benefit of cheap leverage and a fixed term, closed end structure.
The results astounded me.
Two out of the seven large cap cohort outperformed the VC Fund and an incredible six out of seven outperformed in the small cap cohort. Amazingly, the funds examined were mostly run by larger funds management firms with only 3 out of the 14 issued by firms with less than AUD$1 billion AUM presently, albeit most firms were likely smaller in 2010.
However, the fact that MOIC (money on invested capital) metrics for the public equity funds were overall superior to the VC fund was intriguing. This effectively means that the public equity funds were able to surpass the VC fund’s return, despite the greater weight of money inflowing via an open-ended structure - at odds with general rule that greater weights of funds results in diminishing returns.
Some learnings from my analysis were:
Leverage can obfuscate risk-adjusted returns in certain closed end vehicles.
Investors should capture an illiquidity premium when making long-term investment decisions.
Size does not appear to be an insurmountable impediment for exceptional investment teams within public markets.
Timing does appear significant both at the market and manager level. ‘Buying the dip’ when top quartile public funds experience draw downs, appears to work in aggregate over time taking a portfolio approach.
Small differences in net performance magnify over long time periods. Investment performance drives this rather than differences in fee structure.
It will be intriguing to track this dynamic as more local venture funds begin to mature in the years ahead. I’m especially interested in the crystalised returns of various ‘vintages’ by year and their correlation with public markets.
Some caveats when digesting this:
Only the single VC Fund was selected, and that being a maiden or first-time fund. It’s likely that OneVentures have refined and improved their investment process over time; given their reputation as one of the best local VCs.
Greater data across multiple VC Funds and firms is required to make a more substantiative case. Specifically, no claim has been made as whether the VC fund selected for analysis is top-quartile in its sector. We are also hamstrung by the fact that there is significant dispersion in returns between VC Fund vintages, even within the same firm.
Market beta does appear to be evident even within the unlisted investment space driven by a range of factors, commonalities and groupthink. These comments appear to confirm the degree of correlation between fund vintages run by different VC managers.
Disclaimer: The information contained within this website and article is not financial advice and reflects the opinion of its author in a strictly personal capacity.