Investors in public equity markets will immediately recognize the Morningstar Style Box as the leading asset management framework for asset selection and allocation. The framework, introduced by Morningstar in 1992, quickly became the lingua franca for investors seeking to normalize and understand their equity strategies across an increasingly complex landscape of mutual funds and exchanged-traded funds (ETFs).
Institutional public equity money managers leveraged the model to develop and hone strategies that focused on one or more sectors in the Style Box. Today, for example, it’s not unusual to find hundreds of mutual funds or ETFs that focus on small value stocks.
Individual investors sought the Style Box not only to direct their investments in asset classes they thought would outperform the market (value stocks until recently, for example, outperformed the market for the last seven years), but also to test their managers’ investments against their advertised strategies. Investors in Fidelity’s Low Priced Stock Fund, a $40 billion mutual fund marketed by Fidelity as a mid-cap blend fund, learn via the Style Box that the majority of the fund’s investments are actually mid-cap value stocks. This revelation may not matter to most passive investors, but those who sought to implement a well thought out asset management strategy will be surprised by the news. This information requires the investor to rebalance their portfolio to accommodate the real vs. advertised strategies of their fund managers.
With such an accepted framework, you would think a huge and growing asset class such as private equity would have something similar. But surprisingly, it doesn’t.
Hole in the universe
The lack of a formalized framework for manager and fund asset allocation for PE investors stands out as a spectacular gap in the alternative asset universe, which today claims more managers and funds than the public market had in 1992. With hundreds of PE managers and almost (it seems) as many consultants advising buyers in alternative assets, and hundreds of billions of dollars in assets to be allocated, one would expect a well documented framework for PE and VC selection.
Certainly some buckets or categories do exist, although they are nowhere nearly as standardized as the Morningstar matrix. Most institutional investors can quickly outline their buyout allocation vs. their venture allocation. A few investors will define their Emerging Manager vs. their Established Manager investment allocations. And some will define their international and domestic allocations. But most investors have a hard time agreeing on definitions for some of these categories.
Emerging Managers are defined by some as those raising their first or second institutional funds. Others define Emerging Managers as members of ethnic minority or regional investment groups. With international funds, most LPs would agree that an Israeli-focused venture fund is different from a Latin American buyout fund, which is different from a China-focused venture fund. But how do they account for the different risks and allocations? Not easily, and almost certainly not with consistency.
The lack of a formalized framework for manager and fund asset allocation for PE investors stands out as a spectacular gap in the alternative asset universe.”
Size doesn’t matter
One commonly accepted Style Box-like categorization applies to the size of the fund itself. Most often, $250 million is cited by LPs as the dividing line between small and large funds. Occasionally, an institutional investor will seek funds above or below this line in a structured attempt to create a Style Box. This line is more often a result of the investor’s insatiable (or limited) bite size than a sophisticated attempt at asset allocation.
A state pension fund with $50 billion in assets might have statutory limits on percentage ownership of a given fund, and practical limits to the staff’s ability to deploy capital. Investors such as these are forced to “divide” their universe into large and small funds, if only to direct small fund managers away from their over-solicited inbox. A $25 million bite size, limited by law to less than 10% ownership of a fund, inherently creates a universe divided between those raising $250 million or more.
But this makes no sense. Bite-size considerations aside, fund size should have absolutely no bearing on the institution’s asset allocation, just like mutual fund size is not part of the Morningstar Style Box. Size doesn’t matter.
The only size consideration for a private equity framework (as for a public one) is the capital requirement of the underlying companies of the fund. A “small” $150 million fund whose strategy is to make passive investments in Series C or D rounds (formerly known as mezzanine or pre-IPO strategies) is a large capitalization investment strategy. A Venture Style Box, should one exist, would place such a fund squarely in the Large-Cap area, regardless of the size of such fund.
Emerging Manager, fund size and international appear to be the only attempts at categorization or asset allocation in Private Equity and especially venture. And no attempt has been made to blend any of these to better understand the risk/reward tradeoffs of any given allocation strategy. Rarely has any institutional investor or consultant we know gone beyond this simplistic asset allocation in the PE or VC space.
Performance metrics do exist, but performance is meaningless without measurement of risk. Quartile-by-quartile performance benchmarks provided by Cambridge, State Street and others are meaningless without a benchmark for risk.
Fund size should have absolutely no bearing on the institution’s asset allocation, just like mutual fund size is not part of the Morningstar Style Box.”
For venture funds in particular, no attempt to date has been made to focus on the X axis of the Style Box (Value vs. Growth). This is quite surprising, since it is a good way to address the question of risk in a venture manager style box. Some might argue that venture investments cannot be categorized in ways similar to Value or Growth. But most VCs and their LPs will reference deals that “swing for the fences,” “bet the farm,” “return the fund,” or are “high beta.” These metaphors imply particularly risky deals that promise extremely outsized returns. Most venture-style deals might be considered risky, but the mere tagging of only some investments with high-risk hyperbole implies that, within the spectrum of such investments, some are in fact more about value and some more about growth.
As with public markets, private equity investors may see in a Style Box the opportunity to pick managers who focus on value, while others may prefer those who focus on growth. It is well known, for example, that certain managers routinely pursue high-growth “swing for the fence” deals. Traditionally LPs have viewed all venture capital deals as high-growth. Other LPs, aware of the market’s failure to reward venture investors for such strategies, may prefer a value-based investor with a lower mortality rate.
For example, many LPs will observe that 3x multiples on a fund’s most risky growth deals may not compensate for the 50%-75% loss ratio of those funds’ investments. Phrased in public market terminology, today “value venture funds” are likely to outperform “growth venture funds,” based on conservative expectations of the current exit environment. Should irrational exuberance return to the public markets, growth-venture funds may once again outperform.
Think inside the box
Using the Morningstar Style Box is a good place to start. For the Y axis, Large, Medium, or Small cap venture deals will reflect the total amount of capital (aka the capitalization) the underlying companies need to achieve a successful outcome. Funds that seek capital-intensive venture-projects—such as fabless semiconductor manufacturers, telecom service providers or other ventures needing $75 million or more in capital—are clearly Large Cap venture deals. Ventures that need $25 million or less are Small Cap venture deals. Every venture investment can fit in one of these categories, or in between.
The X axis can be similarly divided. Projects heavy on intellectual property (IP) and existing technology will be more value driven. Projects that swing for the fences based on momentum and critical mass are more growth-driven. In the former example, the venture began with a well-protected downside that provides the value of the deal. In the latter, high hopes and aspirations for meteoric growth are the primary “value” ascribed to the project.
This is just one of many viable proposals for a VC Style Box. We’ll leave it as homework for you to consider other ways to categorize the risk/reward tradeoffs of the private equity asset class. Whoever succeeds in creating and marketing the definitive VC Style Box can become the Morningstar of the VC asset class. Alternatives consultants: Sharpen your pencils. Here is your chance for fame and fortune.
Bart Schachter and George Hoyem are managing directors with Blueprint Ventures. Schachter focuses on comm. and IT infrastructure, wireless technologies, nanoelectronics, software and comm. semiconductors. Hoyem focuses on software, wireless, security and IT and comm. infrastructure. They may be reached at firstname.lastname@example.org and email@example.com.