The venture industry took a breather last year as VC partnerships posted a 17.2% return to investors, compared with the 30% to 40% annual returns enjoyed since 1994, according to the Venture Economics Private Equity Performance database, which tracks 1,050 private equity partnerships. The results will be published in the the 1999 Investment Benchmarks Report.
With a slowdown in the IPO market since it admitted a record high of 276 venture-backed companies in 1996, venture partnerships have had to find alternate exits to generate proceeds to keep returns at stratospheric levels similar to those reached in the mid-1990s.
Given the increasing worldwide exposure to the Internet and the tremendous changes brought on by the Web, VCs certainly have capitalized on the high-tech revolution with a frenzy of technology investments. Hardly a week, let alone a day, goes by without some buzz about the latest venture-backed Internet or “dot-com” company hitting The Street. Such publicity has certainly increased the appetite for more venture investing, but it remains to be seen how this IT craze will affect long-term private equity performance.
One way to begin to explore the potential effect is to look at how the public and private markets are intertwined, and the impact this has on private equity performance.
By examining overall returns of the venture industry, the following observations can be made:
* L.P. commitments are at record levels.
The venture capital industry is still raising unprecedented amounts of capital, with nearly $25 billion raised in 1998 alone – the equivalent of the total amount of capital raised by the industry in the era marking the take-off of personal computers between 1980 and 1987.
* Investments are at record levels.
The venture industry invested almost $17 billion in 1998, which again equals the money invested in the heady technology years between 1980 and 1985. The common complaint continues to be “too much money, too few deals,” but the industry nevertheless invests more every year.
* Average investment size is at a record level.
The current average investment is about $6 million per company, compared with some $3 million per company in 1992.
* Valuations are at record levels.
Average valuations of venture-backed companies at the time of investment is around $30 million, compared with $20 million in 1992.
Clouding the horizon, however, IPOs and performance appear to be slowing down a bit.
Public Markets Are Increasingly Important to Performance
The venture industry and the public markets have become inextricably linked, and while it is true that mergers and acquisitions of venture-backed companies continue to increase as an exit mechanism, the public market continues to have an effect on venture returns.
The public market impact is not only related to direct exit opportunities, but also to the valuation comparables that the public market provides for technology and other venture-backed companies.
Correlation Is High
Figure 1 shows the quarterly returns of venture partnerships and compares them with the Nasdaq market returns of the same period. One need not be a sophisticated statistician to deduce a demonstrable correlation between the two, especially in the last few years. The obvious difference, however, is that venture returns appear to be less volatile. This might be misleading because the conservative valuation policies used by most venture firms dampen quarterly returns.
In fact, Figure 1 indicates the correlation with small stocks is quite high for some sectors of the venture market. In the past four years the correlation for all venture funds with small stocks has been 59.7%, compared with 31% for the previous 20 years. By no small coincidence, the venture industry posted a quarterly loss of 3.5% last fall in the third quarter of 1998, the largest quarterly downturn since 1990. This coincided with a 10% loss in the Nasdaq market and is highly coincidental with the record dearth of IPOs in the same quarter. Both the public and private market rebounded by the fourth quarter of 1998, however.
Examining two points in Figure 1 is not statistically valid, but Figure 2 reflects correlating statistics for each sector of the private equity industry over the course of two time periods – the most recent four years and the last 20 years. These quarterly statistics are taken from the 1998 Investment Benchmarks Reports published by Venture Economics. It is evident that the correlation between public and private markets has increased dramatically in the recent past, as compared with the 20-year history of the venture market.
The connection is not universal, as there is clearly more diversification in the balanced/diversified funds and later-stage funds than there are for early-stage and seed funds. What this portends for the investor is the generic fund does not provide as much diversification from public market stock as it did several years ago. While total diversification is impossible, the investor has to be knowledgeable about which funds to invest in if diversification is a key objective.
Returns Strong in Some Areas
The venture industry continues to yield fairly strong returns in some areas. Figure 3 provides last year’s net returns to limited partners for various time horizons. While balanced funds have lagged their siblings, early-, seed- and later-stage funds continue to perform at consistently high rates of return, outperforming buyout funds. However, there is a trade-off because there is less correlation between buyout funds and the public market.
Because there is a difference in correlation between buyout and venture funds, institutions have been smart to invest in both sectors to diversify their portfolios. Figure 4 shows a negative correlation, at least through the 1980s and 1990s, between venture and buyout funds. This makes both an attractive part of the modern alternative asset portfolio. Figure 4 also illustrates the slowdown in recent years of returns to both venture and buyouts – a bigger slowdown in buyout returns and a more moderate slowdown in venture returns.
Because there appears to be an increasingly important link between public and private market returns, it is necessary to examine the public market aspects of performance as they relate to venture capital.
Post-Venture IPO Performance Is More Important
Venture Economics and Warburg Pincus Counsellors in 1996 launched a new index of venture-backed stocks called the Post Venture Capital Index (PVCI) to supplant the older Venture Capital 100 index. PVCI tracks all venture stock performance on a market-cap weighted basis, and venture-backed companies are added to the index when they go public. Companies are kept in the index for 10 years or until they no longer trade, which ever comes first. The index tracks all venture-backed companies going public since 1970 but has a starting date of January 1986.
While more than 3,000 venture-backed companies have gone public since 1970, the index, which switched from monthly to daily calculations in August 1998, lists about 1,200 companies.
Figure 5 tracks the index since its inception and compares its performance to the Nasdaq and the S&P 500. Venture-backed stocks have been clear winners compared with other stocks, as the PVCI has consistently dominated the other indices since 1992. However, the extreme volatility of venture-backed stocks has been evident in recent years as the risk of venture-backed companies has shifted from the private markets to the public markets.
Figure 6 compares performance of venture-backed stocks with the other major market indices for various time periods, and, except for the last five years, venture-backed stocks have dominated other indices. Venture-backed stocks posted a 57% return in 1998, compared with 38.5% for Nasdaq and 21.2% for the S&P 500.
This performance is a major reason that many firms, including Warburg Pincus, have launched post-distribution services for their institutional clients so the public market return can augment the private market return. While this index is market-cap weighted, Venture Economics will add an unweighted index series later this summer.
Shifting of Risk to Public Markets
No doubt the public market has had a profound influence on private market performance, and, given the public appetite for new Internet companies, there is increased concern among industry pundits that the risk associated with venture investing has shifted from the private to public markets. As a result, this leads to the archetype modern IPO candidate that has some revenue, an Internet business model and no profits. This same company 10 years ago would have been nurtured a few more years in the venture womb before going public. What remains to be seen is whether the shift of risk to public markets makes the public hungry enough to live with the volatility inherent in venture capital.
Figure 7 shows the dramatic decline in the number of companies that are profitable when taken public. Until 1996, about 50% to 80% of venture-backed and nonventure-backed offerings were profitable at IPO date. Starting in 1996, the number of profitable venture-backed IPOs took a nose dive until only 30% to 50% were profitable at IPO.
To be certain, venture-backed IPOs more likely will be composed of technology companies and, as a result, be part of the archetype technology IPO sector. What is not clear is when the companies will become profitable, and ultimately, if not enough do, what effect that will have on private market returns.
Figure 2. Correlation Statistics (%) of Private Equity Returns with NASDAQ Returns
Fund Type 1995-1998 1978-1998
Seed Stage 13.2 13.2
Early Stage 40.0 31.3
Balanced Venture 60.9 49.5
Later Stage Venture 45.2 40.2
All Venture 59.7 41.4
All Buyouts -4.9 -0.8
All Private Equity 35.0 30.5
Source: Investment Benchmarks
Figure 3: Private Equity Performance
Net Returns to limited partners for period ending 12/31/1998
Sample 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr
Early/Seed Stage 25.7 37.7 33.7 19.7 16.8
Balanced Venture 10.8 23.6 24.2 16.1 14.0
Later Stage Venture 26.5 27.3 29.8 23.9 18.2
All Venture 17.2 27.9 27.4 17.7 15.1
All Buyouts 10.9 19.2 17.2 16.4 19.6
Mezzanine 11.7 10.4 10.4 10.2 10.8
All Private Equity 12.8 22.0 20.5 16.9 17.1
Figure 6: Performance of Venture-Backed Stocks*
vs Major Market Indices (as of 4/30/99)
Index YTD 1Yr 3Yr 5Yr 10 Yr
PVCI* 26.2 57.4 27.4 27.5 22.0
S&P500 8.6 21.2 27.4 24.2 15.7
NASDAQ 16.0 38.5 32.2 28.2 19.5
Dow 17.5 22.6 24.5 24.0 16.1
* Warburg Pincus/Venture Economics Post Venture Capital Index