"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.