Venture Capital: The Conservative Casino

Carmen Ventures is based in the Midwest, Columbus, Ohio to be exact. We are born and raised Buckeyes. Sure, we have done business around the country and in some cases, around the world. One thing that has not changed is that we have been raised to be conservative (this is not about politics!) – frugal, careful, blue-collar, or agricultural backgrounds. The Midwest is to a certain extent, insulated from what happens on the coasts. We are not naïve, but we are not the type to take a flyer on something we do not understand.


I bring this up because we have been speaking with many Limited Partners (LPs) and many potential LPs – institutional, investment professionals, and individuals. Some have done some non-traditional investing, angel investing, direct investing, and a few other efforts outside of stocks and bonds. Based on several of those conversations I wanted to address something.

Venture Capital investing is not gambling


I will explain why, but first a quick overview of the three types of investing we see going on around startups. Vicarious, angel, and venture.


Vicarious

These are the people watching from sidelines, reading headlines, imagining “what if” then sticking to a 60/40 stock/bond portfolio. They neglect to see their house as a real estate investment. Some people get adventurous and invest in second homes or rental properties. They view VC as exciting but too risky to try.


Angel

This can be gambling. Depends on the investment, your ability to move the needle, how much time you must invest and, in many cases, how much work you are willing to do. Since you have limited capital to allocate, concentration in a few investments that may be cash starved is a problem. I have seen many angels be a lifeline for entrepreneurs that cannot make the leap to scaling. So, the first check is not the last. I have seen angels sprinkle checks around and not really be able to leverage their expertise or network to help the companies. That is gambling. All that being said – you can make a killing as an angel, but it is not typical, nor does it happen often.


Venture Capital

VC is not gambling nor is it as risky as angel investing. Let me explain. The key concept is that it is investing. Which indicates portfolio management and diversification of risk with enough concentration to generate a healthy return. VCs invest in a portfolio of companies consistent with their thesis that when considered together are designed to generate an above average return on investment. At least the professionals do. VC has many factors contributing to its de-risking:


o Active and involved General Partners (GP), venture partners, and in Carmen’s case – LPs that want to contribute expertise/advice to help the portfolio companies succeed

o A large network from which to find expertise, customers, and talent

o High expectations

o More capital

o Not all funds are all-or-nothing investors. Many funds are still working on a thesis that does not demand unicorns but generates equal risk-adjusted returns to those that do.

o Diversification


Now that we have covered that, a bit of investing analysis...


We have all heard about buying low and selling high. Have a balanced portfolio of 60% stocks and 40% bonds and adjust for age. Keep a cash cushion for emergencies. Your house is a real estate investment if you own it and some people forget that. Beyond that, the picture gets hazy. Hedge funds are for the very rich and alternative investments like private equity (PE) and venture capital (VC) fall into an area that most people read or hear about but really do not understand.


If I were to ask many people what the average returns are for venture capital most would not even hazard a guess, and many would say it is either all or nothing and 90% of startup companies fail within five years. So, you could maybe come up with 10% if you are optimistic. That is not the case. The 90% of startups that fail include things that venture would never back. So it is not quite so bad. The more striking thing is the 10-year average return of venture capital is 26% and the 20-year average (so we get up and down markets included) is 15.7%. That does not seem so risky and backs the buy low (or early) and sell high axiom.


Some will claim the money is locked in the long term. Not really. There are distributions when there is an exit which means selling the stake to anyone including another investor. There is no need to wait until the company goes public or the fund winds down.


Another interesting aspect of VC is that startups are relatively immune to economic downturns. This is because startups are busy filling an unmet market need that customers want and for which they will pay. They are building a company and product/service that people want. Downturns decrease valuations and offer a great buy low for investors. When the market turns up, they will be ready to capitalize. The gyrations of the stock market and inflation do not impact them like a large company and there is a shakeout for those companies that never had a viable business model, to begin with, and were relying on the greater fool theory for raising capital. It is a symptom of cheap money sloshing around the system.


So why is it not a part of your portfolio?


The net is – VC is not that mysterious. It also does not get the “down-to-earth” exposure it deserves since there is no marketing behind it, like a traditional investment product. There is no incentive for most advisors to recommend VC unless they are independent and free from commission. It is also not out of reach for an investor that is not considered high or very-high net worth. When you consider the value of your entire portfolio, investing a bit in VC makes “conservative” sense.


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