High yields, decorrelation, tax advantages and support to real economy
In search of alpha types, the road leads to venture capital. Particularly suited to pension and institutional funds, the start-up business can be a booster of portfolio performance. This can be also true for private bankers and family offices, provided they have a medium-term perspective, not less than 3 to 5 years to see the first returns on investment. VC is virtuous for portfolios and, potentially, also for real economy, given the high-impacting nature of this kind of investment. Not to mention that AIFMD, the European Alternative Investment Fund Managers Directive, is moving towards an opening to retail. Currently in Italy there are no suitable products for small investors, contrary to the UK and USA, where there are some experiments for the public in collaboration with private equity funds. But the path has been marked out.
“Returns,” says Andrea Di Camillo, managing partner of P101, “will increasingly come from long-term value creation rather than short-term activity on more liquid markets.” At the core of venture capital lays the creation of business value, and only as a result of this, financial value is created – not the other way round. How does this work exactly? We’ll try to explain it starting from the rather technical definition provided by AIFI (the Italian Private Equity, Venture Capital and Private Debt Association): firstly, VC brings “share capital or subscription of convertible shares to unlisted companies that have a high potential for the development of new products or services, technology, market ideas.” Participation is temporary, minoritarian, and aimed at accelerating the company’s value creation in order to achieve high capital gain.
How high? This is a very debated topic and difficult to sum up in a number, because, at least in Italy, track record is too thin to build statistics on. The good thing about this is that, because of its very embryonic state, the Italian market represents a great opportunity. The value of the Italian industrial and digital transformation can be captured by intercepting the companies that are making innovation and being funded by VC.
But let’s go back to the creation of business value: venture capital funds invest their investors’ money, i.e. the money of the so-called limited partners, in young companies that have a big growth potential. VC funds partner with these companies and help them throughout the various transformations that start-ups have to deal with from the early phase to when they become well-established. In short, VC funds provide new business owners not only with financial resources, but also with relations, know-how and a network of experts, help start-ups design their business growth strategy and, ultimately, have a role in the development of society as a whole.
VC funds are high-risk instruments with potentially high returns that can exceed 20% per year. A golden rule of venture capital is power law: in short, in a basket of companies there must be one – or some – whose expected performance is higher than that of all the others. Something like Uber or Facebook or, to make an Italian example, Yoox – i.e. a unicorn that alone does the work of the whole team. Yoox, which is one of the few Italian cases with international allure, was founded with 25 million euros investment and today, after merging with the French Net-a-porter group, it has a stock market capitalization of 2.5 billion euros.
Of course, this is not always the case. The 20% potential return is not universally true, but it is a useful approximation to understand the real potential of venture capital as an asset class. There is no database, not even outside Italy, of realized yield for VC investment. However, the pioneers Reshma Sohoni and Carlos Eduardo Espinal of Seedcamp have made a case in point. They have recently invested 500 million euros in 230 start-ups. Their first fund, Fund 1, launched in 2007 and intended for rounds up to $200,000, was about $3 million in size and funded 22 start-ups. In October 2016, Fund 1 has returned over 1.5x thanks to a number of exits, including the unicorn Stupeflix that gave Seedcamp a 60x return. Seedcamp says it envisions reaching a 8x-10x return on money invested considering that 8 other companies are still growing.
A more precise number – and still close to 20% – is provided by Preqin. According to their research, in 2015 venture capital funds invested $136 billion globally, of which $73 billion were disinvested, covered 9,241 transactions, raised $47 billion and a yearly IRR of 20,5%. Preqin has also calculated that, in 2015, VC achieved the best performance compared to all other private equity strategies, with a net IRR of 18.2% versus 18.1% of buyout funds. 2016 IRR is just 9%, but that of 2014 is 40% and that of 2013 is almost 60%. Again, according to Aifi and Kpmg Corporate Finance survey published in early July, the gross IRR of transactions was 14.5% in 2016, slightly down on the previous year (17.8%), but still positive and in line with the positive returns of recent years.
It is worth mentioning that returns are high because the investment has a high level of risk, even though it is diversified – so it needs to be accessed through professional operators who analyse and select the best opportunities on the market. “Venture Capital Funds – as Di Camillo explains – are structured in such a way as to break down portfolio risk: at P101 we see thousands of companies every year and we choose the best ones. An informal investor, who acts in a non-consistent way, cannot have such a wide basis for comparison. Co-investing makes it possible to leverage the selection of a professional investor and also to enter, partially but directly, into the company. And if the company needs more funds, it is already in contact with a venture capitalist who can meet future needs and has better access to the investors community.”
There are various advantages, starting from taxation: from 2017, in Italy, venture capitalists can write off 30% of their investments (only investments up to 1 million euros) on their taxes (before, it was 19%). It should also be stated that VC investment is entirely uncorrelated to traditional markets, in a world where decorrelation between traditional asset classes no longer exists.
According to an analysis by Stanford Graduate School of Business, in the US, the value of vc-backed companies amounts to about 20% of total stock market capitalization. The research also points out that if we look at companies that were founded after 1979 – the year in which venture capital was born – the picture changes, drastically: 574 out of 1330 companies are VC-backed, that is, 57% of them. These companies invest 82% in research & development, which explains their role of innovators and their ability to transform entire industries. These companies are young, have grown rapidly, and in the last twenty years they have helped the growth of local economy and employment. In Italy, the value of VC-backed companies is close to 2%: there’s a huge space for growth.
The latest numbers released by Aifi give an idea of the scope of this phenomenon in Italy. In 2016, private equity and venture capital, together, reported a record high of 8.2 billion euros (+ 77%). Foreign operators are back on track, investing 69% of this figure. The number of operations decreased from 342 to 322, and the first 17 operations alone accounted for 74% of the total value. Disinvestments amounted to 3.6 billion euros, 26% higher than the 2.9 billion of the previous year. However, looking a little deeper into the Aifi numbers, we can notice that 5.7 billion euros of that record number consist in buyout operations, and early stage rounds represent a thin slice of just over 104 million euros. Then the good news is somehow half-good: companies are more and more often on the radar of alternative funders, but new ideas are still struggling to find venture capitalists.