The case for Venture Capital during periods of market volatility

Venture capital, the once mysterious, indie-like asset class, has gone mainstream. The journey to get to where it is today wasn’t linear. Over the last 30 years, the road was full of highs, lows, booms, busts, doomsayers, preachers, etc. All of that has led to modern venture capital being the most stable, mature, and repeatable VC model we have ever seen. It is no longer play money or just backing your cousin’s pie-in-the-sky idea.

Ignore its success at your own peril.

The maturity of venture capital can be best illustrated through its risk/return profile which, according to Cambridge Associates, has become more similar to longstanding asset classes, private equity (PE) and global buyout (BO) in recent years. This has all played a part in the unsurprising boom in venture capital. Global venture investing totalled $643 billion in 2021, which represented a 92% increase over 2020.

The now-stabilised asset class has made it safer, and ultimately easier, for investors to reap the benefits of venture capital. Beyond the qualitative benefits, the numbers back it up as well. To keep it succinct, we will only discuss 4 major benefits, as venture capital:

1. delivers outperformance against almost every major market index (in a bull market, no less) over the last decade
2. is almost completely uncorrelated with public markets
3. acts as a natural hedge against inflation
4. has attractive tax benefits (in the early stages)

The (1) outperformance and (2) non-correlated returns are easily shown with data. For the former, Cambridge Associates data shows that their global venture capital index consistently outperformed the S&P 500 and Russell 2000 indices in every year they were compared. As for the latter, a half-decade AngelList study (ending March 2020) found that the monthly performance of the AngelList seed fund and the NASDAQ’s monthly performance had a correlation of 0.0 – in other words, perfectly uncorrelated. To those familiar with the asset class, these two findings come as no surprise. At their basic nature, venture capital managers (i.e., VC fund managers trying to find early stage companies building the future), do not concern themselves with the day-to-day volatility of markets or where a certain stock or bond is trading that day, or month for that matter.

(3) VC as a natural inflation hedge, is straightforward and better explained with a snapshot of secular trends, particularly with regards to what technology has given entrepreneurs: A proliferation of software-as-a-service, online tools and web/app-based business support has made it easier than ever for venture-backed companies to efficiently establish themselves, reduce operating costs and rapidly grab market share while building the future. These services enable startups to be asset-light thus experiencing less value-erosion, all the while giving these companies the green light to quickly scale and achieve hyper growth, which is the best inflation hedge of them all.

Last, but certainly not least, is the (4) possible tax savings via Section 1202. Congress passed Section 1202 in 1993 with the aim to promote long-term investing in small businesses. We are not tax advisors so this is not to be construed as tax advice, but a quick summary for informational purposes only: Section 1202 basically states that the capital gains from investments in qualified small businesses (among other rules, <$50M in assets) will not be taxed. VC investments generally fit this bill!

It’s easy to analyse this asset class in a vacuum, but it really begins to shine when we stand it up next to the current market environment. The NASDAQ is down >26%, S&P 500 is down >20%, bonds are down 10%; you get the point, it ain’t pretty out there.  Conversely, venture capital investors can’t sell based on daily (illiquidity is your friend as you can buy low, sell never), or even monthly, price shocks (recall the non-correlation discussed above). Thus, the asset class is insulated from violent, downturn-induced, price swings.

The best way to show this is by looking at venture fund performance from the height of the last downturn, the 2008 global financial crisis. Pitchbook shows that fund historical IRRs actually increased from ~10% (‘07), to ~8% (‘08), and then up to ~16% (‘09) during the period. VC actually outperformed both private equity and debt funds during this period, and further outperformance continued during the ups (strong economic recovery into the end of the 2010s) and downs (Taper Tantrum in 2012 and other volatile periods). Early stage valuations are generally low but during downturns, investors must remember that they are even lower. This gives startups a lot of runway to grow, while giving investors better (lower) valuation entry points.

Of course, venture capitalists have been aware of these benefits for years. However, now the data are robust enough to tell the story they knew all along: venture capital is a top performing asset class through good times and bad.

Ignore its (historical) success at your own peril.

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