Friday letter: Stop trying to time the market

LPs, repeat after me:

I will not try to time the market.

I will not try to time the market.

I will not try to time the market.

Sorry we had to do that, but it is for your own good. I’ve seen you get out of the VC market when it’s down and rush back in when it’s up. Venture should be an integral part of your portfolio and you should be consistent about investing in the space.

As you’re no doubt aware, we are in an up cycle, and everyone wants in. Venture capital funds worldwide raised a record $131.3 billion in 2021, a 46 percent jump from the $89.9 billion they collected the previous year, according to exclusive research by Venture Capital Journal.

Not so fast

Given how well the market is now doing, it is easy to forget that the outlook wasn’t so rosy not too long ago. I was looking back at a panel I moderated in 2018 and one of the big questions at the time was about a headline from a Q4 2017 report by PitchBook and the National Venture Capital Association: “Exits continue to slide, leaving industry in crunch.” The report stated, “VC-backed exits declined for the third consecutive year in 2017, reaching the lowest total since 2011.”

It would be understandable if that headline gave you pause when thinking about your allocation to VC. But it would not have been a wise move to make a change. Fast forward about four years and the headline in the Q3 2021 version of that report was: “Exit value surpasses $500 billion for the first time ever.”

New research from PitchBook shows that IRRs for venture funds are at an all-time high. “VC returns continue to display the benefits of the robust VC exit market over the last few years,” states the most recent Global Funds Performance Report. “The rolling one year IRR for VC rose to 65.5 percent as of Q2 2021, notching the fifth consecutive quarter of sequential IRR increases.”

Very impressive, indeed. However, those IRRs alone shouldn’t prompt LPs to suddenly increase their VC exposure or jump into the space for the first time, just as a negative headline shouldn’t prompt them to bail. Sadly, it appears that some LPs are taking an inconsistent approach to the space. I’m basing that on my review of the last few years of Probitas Partners’ annual survey of institutional investors. In particular, I focused on the sectors that LPs said were of greatest interest.

What I found was that interest in VC by institutional investors has gone up and down like a yo-yo. LPs ranked venture capital fourth in the 2020 Probitas report, with 51 percent of LPs saying it was a key sector of interest. The following year, investors ranked VC in ninth place, with just 30 percent of LPs describing VC as a key sector in the 2021 report. In Probitas’s most recent survey, the attitude toward VC went from lukewarm to white hot: LPs ranked it third, with 54 percent of respondents saying it is a primary sector of interest in the 2022 report.

Some experts say now is not the time to get into VC. Hunter Lewis, CEO of Hunter Lewis LLC and a co-founder and former CEO of Cambridge Associates, writes in the Wall Street Journal:

“This isn’t the moment to begin investing in these [venture and private equity] funds. Why? There is a tsunami of money pouring in from institutional investors because of recent sizzling returns, deal quality is lower, and funds are paying much higher prices for the deals. Additional red flags include still sky-high fees for investors and returns that are calculated by fund managers. Add to that some funds’ ersatz claims that their operations have a low correlation with public markets, when the opposite is true…”

Those are certainly valid points, but I would ask if not now, then when? Do you wait for the next downturn? That means you’re trying to time the market.

Don’t wait, with the caveat that you should have a thorough understanding of venture capital and realistic expectations. I am by no means suggesting you carve out a $100 million allocation and write checks to any old manager. But if you take a thoughtful approach and spend the necessary time to find good managers, you will be fine, judging by historical returns. A good manager is worth paying premium fees and will figure out a way to make money even when assets are overpriced. Assume you’re going to lose money (on paper) in the short term, but focus on the long game.

Think of your VC allocation like your personal 401(k) plan: commit to investing a set amount each year, then forget about it. Don’t get distracted by headlines.