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Lower returns on horizon for venture capital

Jonathan Grabel said venture capital has more binary win-or-lose outcomes than other asset classes.

Venture capital investors are going to have to lower their expectations for the asset class that, not that long ago, produced outsized returns, industry sources said.

Companies are staying private longer and venture capital firms are raising huge funds, better positioned to invest in larger, more mature companies. That's making some investors worry their venture capital managers could underperform because the valuations are high for companies across stages — from startup to more mature — and there is no clear exit route.

Venture capital firms have a combined $119.5 billion in dry powder, according to a March PitchBook report. Nearly half, about 45%, of the venture capital raised in 2017 was in megafunds — those greater than $5 billion, the PitchBook report shows.

The larger venture capital fund sizes might provide some investors opportunities, but there are concerns.

The $349.3 billion California Public Employees' Retirement System, Sacramento, for one, could commit more capital in "interesting, exciting ​ companies," said Steven Hartt, principal with consulting firm Meketa Investment Group, speaking at a CalPERS investment committee meeting Feb. 12.

However, there are issues with this approach, he was quick to add.

"I think there are at least two major questions. One is the valuations (at which) those investments are being made and two, ultimately, what will be the exit," Mr. Hartt told the committee.

"Those are things that would have to be considered" if CalPERS invests in these larger funds, Mr. Hartt said.

CalPERS had $904 million invested in venture capital as of Dec. 31. Its venture capital portfolio earned a -0.92% net IRR for the one year, 4.58% net IRR for the five years and 2.95% net IRR for the 10 years ended Dec. 31, according to CalPERS latest performance report.

The anticipated result is that investors should expect lower returns from venture capital portfolios.

No 25% anymore

"We will not see 25% rates of return," that investors had expected from venture capital, said Timothy C. Ng, chief investment officer of outsourced CIO firm Clearbrook Global Advisors LLC, New York. It's all part of the maturation of venture capital. Investors should expect lower returns but less risk, he said.

The asset class is already struggling to outperform the public markets. Venture capital's internal rate of return for the 12 months ended June 30 was 8.1%, compared to 24.7% for the Russell 2000. It was 9.1% for the 10-year period ended June 30, outperforming the Russell 2000's 7.5% and 25.4% for the 20-year ended June 30, vs. 8.7% for the Russell 2000, according to Cambridge Associates.

But investors have been flocking to venture capital as a return booster, even though most consider venture capital one of the riskier asset classes.

"In what is widely viewed as a low expected return environment, it's harder to meet a stated return objective with a traditional reference or 60/40 portfolio. This environment may be a result of an extended period of central bank intervention that may have accelerated returns and may have pushed asset allocations further along the risk spectrum. Venture capital is certainly an example of this type of allocation behavior," said Jonathan Grabel, CIO of the $56.5 billion Los Angeles County Employees Retirement Association, Pasadena, Calif.

"There is a big demand for riskier assets that may be greater than the supply of those investment opportunities," Mr. Grabel said. "As a result of a supply-demand imbalance, the potential returns may not be as attractive in the short term. Specifically, the increased supply of capital increases the bid or purchase price for an asset and thereby reduces the potential appreciation or gain for those opportunities."

Venture capital is risky because often investments either make a lot of money or are a complete loss, he said.

"The challenge relating to venture capital is that venture capital has more binary outcomes than most investment strategies," Mr. Grabel said. "There are more swings and misses than other asset categories. … In venture capital if you overpay, you do not change the return distribution, you just lose more money on the write-offs."

LACERA has a target range of 10% to 25% to venture capital and growth equity within its 10% overall private equity target allocation. About 9% of LACERA's $5.3 billion private equity portfolio now is invested in venture capital. LACERA's venture capital portfolio earned a 10.6% IRR for the year, 14.4% IRR for the five years and 10.9% for the 10 years ended Sept. 30.

Even absent extreme circumstances, venture capital is facing headwinds.

Prices for venture capital investments are extremely high right now, and venture capital-backed companies are staying private longer than ever before, said Peter Denious, head of global venture capital in the Stamford, Conn., office of manager Aberdeen Standard Investments.

Company executives can get higher valuations by staying private than if they take the company public, he said.

"Part of the reason companies are not going public is that (private) capital is cheaper than in the public market," Mr. Denious explained.

The question, he continued, is what will be the exits for the 200 global unicorns — companies valued at $1 billion or more — that are worth an aggregate $660 billion, Mr. Denious said. "That's where I think we are in uncharted territory," he said. "How does that money get out?"

Complicating matters is that the biggest investors in these unicorns have the ability to block an initial public offering if the IPO would not raise a minimum amount of money, he said.

"It gets very complicated very quickly," Mr. Denious said.

An IPO has always been the preferred exit route for venture capital-backed companies because a public offering generally is the highest returning form of exit, said Gregory Stento, Boston-based managing director at alternative investment fund of funds firm HarbourVest Partners LLC.

Former practice abandoned

Venture capital firms have been abandoning their former practice of making investments in companies for three to five years and then taking them public, Mr. Stento said.

"They (venture capital firms) are creating more substantial businesses in more than three to five years," he said. "Private financings are taking the place of what had been an IPO and companies are avoiding the scrutiny of being a public company."

However, investors shouldn't try to adjust their investment in venture capital due to expectations of lower returns.

"Investors should be thinking about venture capital with a long-term perspective," said Joan Heidorn, managing director and co-founder of Oklahoma City-based venture capital fund of funds Spur Capital Partners LLC. "I've been doing this for 20 years and saw the tech bubble burst (in 2000). Those investors that try to pick the best time to get into venture capital have been the ones that have been hurt."

LACERA's Mr. Grabel agrees. "After the financial crisis, a lot of plans cut back on venture capital and private equity and it turned out that those were good vintage years. You have to keep investing through cycles."

CalSTRS made a small change to its allocation last year but executives at the $231.6 billion pension fund are staying the course overall.

"We are aware of the ever-changing environment and we look at the whole portfolio to make sure we are positioned for the long term," said Michelle Mussuto, spokeswoman for the California State Teachers' Retirement System, West Sacramento, in an email.

In November, CalSTRS officials tweaked the target allocation range for its $1.8 billion venture capital portfolio to zero to 15%, from 5% to 15%. CalSTRS' venture capital portfolio outperformed its benchmark for the year ended March 31, 2017, but underperformed for longer periods, according to its most recent private equity report. The portfolio earned 9.2% for the 12 months, compared to 8.6% for its benchmark; 9.8% for the five years vs. the 13.8% of the benchmark; and 6.7% for the 10 years, underperforming its 10.1% benchmark, the report showed.​