The state of venture capital
Rising interest rates and ensuing market dynamics have significantly impacted the venture capital ecosystem as evidenced by falling valuations and slowing fundraising. But in general, the earlier the stage of company, the more insulated it has been from these effects.
Venture capital can be an important source of diversification and growth potential in portfolios. But risks exist: illiquidity, technological, and product scaling. It’s important to invest with experts, across market cycles and in line with your broader financial goals.
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Venture capital today
In July 2023 we hosted a webinar on the state of venture capital with Samir Kaji and Matt Curtolo of Allocate, a platform we partner with to offer funds to our clients and that enables access to high-quality venture funds. We covered a lot of ground during our discussion, including the current venture market dynamics, trends that are in/out of favor, and waded into endowment-style due diligence processes. Here’s a clip highlighting Allocate’s shared optimism for improving venture conditions:
Different types of venture
Venture capital covers a spectrum of strategies and it's hard to fit the asset class into a box. As an investor, it’s important to know that these different strategies come with different exposures to risk. Furthermore, because venture evolves through different market cycles, it’s important to invest across cycles and avoid timing. For context, highlighted in the slide below (“Types of venture”) are a few distinguishing features between the different stages of venture. So what is happening at different stages of the venture market?
Today can be an attractive time for investors to evaluate deals and deploy capital given the moderating valuations from the past few quarters and the challenging exit environment for late-stage venture-backed businesses.
As the market’s appetite for later stage venture companies has waned (and companies are hesitant to go and raise capital at lower valuations), early stage companies, especially in sectors like artificial intelligence, have raised funds at higher valuations relative to the rest of the market.
Researching and selecting opportunities to invest
From a diligence perspective, it is critical to do your homework and focus on what matters most: at a minimum, selecting a better than the median venture fund, and ideally a top-quartile fund. Venture has the potential for the highest returns of any asset class, but it also has the greatest variability as shown below in the chart titled “Distribution of Asset Class Returns”.
Right in the center of the chart is the distribution of venture fund returns, which has the most stretched distribution profile meaning venture funds have the most variability. This means that picking the right venture fund (or “manager selection”) matters when it comes to achieving outsized returns with the median venture fund returning less than other median funds in various asset classes. You want to find the best venture manager, but how do you do that?
Evaluating funds before deciding to invest requires a comprehensive approach - not a gut feeling or cursory review of a pitch deck. And while the approach will vary based on a variety of factors, the graphic below (“Diligence Steps”) highlights an overall framework you should expect of an institutional due diligence process. Not to be skipped is Step 7, where it is critical to thoroughly understand the legal, tax and operational complexities of a particular investment. For example, understanding the mechanics of carried interest and catch-ups is crucial, given how significantly that will impact net returns to limited partners.
The bottom line
While we have seen falling valuations, slowing fundraising, and fewer deals closing within the world of venture capital over the last ~18 months, it's important to remember that to invest in venture capital, is to invest in innovation. Innovation accelerates, it doesn’t stop. The price someone is willing to pay for a company will fluctuate, but founders will continue to pursue their dreams of building generational companies and solving hard problems. The right amount and quality of due diligence matters: too little and you expose yourself to avoidable risks, too much and you might miss the opportunity.
We do not attempt to time the market, but rather find and evaluate high quality venture funds in the pursuit of outsized returns and exposure to innovative companies.
The Compound way
At Compound, we pride ourselves on delivering exceptional value to our clients through a robust screening of managers and a thorough exploration of investment opportunities, particularly in the venture sector. We understand that sourcing, diligencing, investing, and staying on top of venture deal flow is a time-consuming and full-time job.
Navigating the intricacies of the investment landscape and process, especially when it comes to crucial steps like the "legal, tax, and ops review" (Step 7), requires expertise. Our team possesses the knowledge and experience to unravel the complexities of things like carried interest structures, tax implications, and the overall impact on net returns.
Outsourcing the Chief Investment Officer-like responsibilities to professionals like us offers you access to exclusive deal flow from platforms like Allocate and a well-structured evaluation process. We take on the burden of identifying, scrutinizing, and recommending compelling opportunities to our Financial Advisors and our clients. We build cohesive asset allocations that may recommend a diverse set of commitments to alternatives, where appropriate. We are fiduciaries and are always putting your interests first in finding the best investments to complement your portfolio, goals, and timeline.
By entrusting us with this critical aspect of the investment journey, our clients focus on their core competencies because they have a dedicated partner who is committed to them and their needs in navigating the ever-changing investment landscape. At Compound, we’re bringing experience, research, and access together to create a compelling investment platform for our clients.
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