Angel Investors and Venture Capitalists seem to be having the sharpest investing acumen. They invest in start-up companies at seed or early stages and reap 100-1000 times returns. In fact, seed investors in Uber—you could call them Uber Investors or Super Investors—made 5000 times their investment. Investors in LinkedIn made around 150 times returns, while those in Snap reaped 200 times their investment.
Investors hear about such stories and, wanting to reap the same returns for themselves, start exploring angel and venture capital investments. There is nothing wrong with that. In fact, as John Doerr of Kleiner Perkins says, “If you cannot invent the future, the next best thing is to fund it.” But, it might not be as lucrative as the above examples seem to indicate.
The above instances are exceptions, but given the extraordinary returns generated, they get talked about. However, for every such exceptional investment, there are at least a 100 or possibly 1000 investments where the capital is completely destroyed. Once you account for those, what are the returns to Venture Capitalists?
Indices deliver more
According to a study by Cambridge Associates, the US Venture Capital investors got compounded annual returns of 12.83 per cent (net) over the 10 years from 2008 to 2018, in USD terms. Now, that is not something small. However, over the same period the Nasdaq composite returned 15.45 per cent annually. In rupee terms the Nasdaq composite has returned around 19 per cent during that period which is higher than the returns on Nifty of around 14-16 per cent.
The above data clearly establishes that Nasdaq beat the returns of Venture Capital as well as the Nifty. Further, the Nasdaq is uncorrelated with Nifty, providing a diversified return profile compared to the Nifty. Thus, Nasdaq provides not only higher returns, but does so with lower risks.
While the Venture Capital companies are highly innovative, the risk in them is that their business models are not established. In many cases, customer demand is not yet established. Even where customer demand is established, they may not have generated significant revenues. Where the customer demand and revenues are established, they might not be able to service the customer demand and generate the revenues profitably. Where the profits are being generated, they might not be providing enough returns on invested capital. Further, investments in venture capital companies are highly illiquid, with typical holding periods of 10 years or more before the investments can be encashed, if at all. A majority of venture capital investments hardly ever reach a stage where an exit can be made.
In contrast, investments in Nasdaq companies are highly liquid. They can be exited at any time. Most of these companies have established business models, with significant customer demand, revenues and the ability to service the customer demand profitably. Further, a lot of these companies have persistent competitive advantages that ensure that the returns on invested capital are persistent too.
It is clear that in comparison to venture capital companies, Nasdaq firms are much safer from the point of view of their entrenched economic model. In addition, to obtain sufficient diversification, 15-30 companies might be sufficient. Another strategy would be buying 25 Indian and 25 Global stocks. The portfolio should not be any more concentrated than having 10 Indian and 10 Global stocks.
While to get enough diversification to obtain the fruits of venture capital investments would require investments across 10s of venture capital funds, each of which would invest in 10s of venture capital companies. Missing one single fund in which the 100x company exists could potentially result in the loss of all the returns.
Of course, new innovators can always disrupt existing innovators and established business models. Hence, these companies invest a lot of capital in research and development. The total R&D investments in US companies put together is around $400 billion annually. In comparison, the US federal R&D budget for 2019 is $131 billion.
The federal R&D budget of India is around $10 billion. The private sector R&D budget of India is negligible. It is clear that investors wanting to take exposure to innovator companies have to look outside India and especially to US listed firms.
There are 280 companies investing more than $100 million annually in research and development, with a combined R&D investment of $385 billion annually. These companies together generate a revenue of $5.4 trillion and net profits of $580 billion.
These companies are primarily from the technology and health care sectors. In addition, automotive, aerospace and defence are other related sectors are making significant investments in research and development.