Why pension funds are moving beyond stocks and bonds
Pension funds are shifting from traditional stocks and bonds to alternative investments like venture capital and private equity in an attempt to boost returns and reduce risk....
Finance
Why diversification could be a winning formula for VC funds
New research suggests that VC funds that diversify across geography or industry can increase the chances of their portfolio’s success.
Nine out of 10 startups will fail, at least six won’t return the money invested in them, whereas only one will return 5x or more. In addition, 70% of tech companies will go out of business within 20 months of raising money. The facts around venture capital funding can be downright discouraging. So why bother? Investors might as well blindly throw darts at a dartboard, argue the critics.
One of the myths around VC investing is that it pays off to be a specialist. If the hunt for the next unicorn (a private company valued at $1bn or more) is like looking for a needle in a haystack, it should make sense to focus your resources by dividing the haystack into distinct sub-quadrants. If the needle is in your part, fantastic! However, the needle may simply not be in your part of the haystack and your very detailed search efforts may be completely in vain. This leads directly to a second strategy: to diversify. If your search involves a larger share of the overall haystack, you have a higher chance of having the needle in your part of the haystack – but you also run the risk of not recognizing it.
Of course, real-world venture investing involves a more complex interaction of activities than in this intuitive example. Venture capital is not only about the early identification of the one-out-of-ten fund-returning startups but also about accompanying and mentoring them until their exit, the so-called “liquidity event”. With the humility of experience, no one can know upfront which of a VC’s investments is going to become a unicorn, or even if any will. Thus, the VC needs a disciplined and validated portfolio strategy.
What makes venture investing so hard?
Specialists argue that in an environment of omnipresent uncertainty, it takes enormous experience and a great network to identify and mentor promising startups. We wholeheartedly agree. Anyone who has ever made a startup investment decision knows how hard it is.
- First, there is usually a lack of history and data; it’s impossible to extrapolate or build models to predict where the firm will go.
- Second, some aspects of the venture are likely to be new – technology, product, market, or business model – so there isn’t an out-of-the-box recipe to follow.
- Third, the founder or founding team may never have built a startup previously, so their professional track record won’t tell you much about how they’ll perform in a new venture.
- Fourth, if the product isn’t yet on the market, we don’t know how users and customers will react to it.
- Fifth, there is always competition, but we can’t know a priori how they’ll react.
- Sixth, there are our biases as investors in perhaps seeing what we want to see (confirmation bias), group thinking (everyone else is investing in this field), the Lake Wobegon effect (the human tendency to over-estimate our abilities), or basing our decisions primarily on personal experience (saliency bias).
Specialists and generalists both must handle this uncertainty and these biases. The specialist approach seeks to structure the haystack by building sub-investment universes in which each piece of straw is familiar to the specialist VC. Specialists hypothesize that you can master investment chaos and uncertainty if you focus.
But what does it mean to specialize in focused universes? We begin with a naïve categorization of the investment universe into geographies and industries. A specialist approach might be to focus on early-stage startups of the Swiss ecosystem that are active in the life-science sector. A VC may have developed a track record in detecting promising startups from these categories and leading them to a successful exit. This involves experience in recognizing early-stage potential – a process that is less numbers-driven and more about pattern recognition – and foreseeing team dynamics in novel roles as well as environments. The VC will have a local network with the best universities, research institutes, startup hubs, investment banks, lawyers, or corporates in that specific industry and region. The industry specialist will have acquired a proficient understanding of decision-makers, regulation, and market structures. He or she understands product life cycles and common obstacles in go-to-market campaigns in that field.
While these characteristics are convincing and – beyond a doubt – valuable assets for every venture capitalist, empirical evidence is rather against specialization. Instead, it reveals that diversification outperforms specialist funds.
The case for diversification
One of this article’s authors (Oender Boyman), analyzed data from the CEPRES database for the period 1980-2023 covering 1,840 funds and 28,452 deals that are analyzed for the effects of diversification regarding industry and geography.
The results for industry diversification revealed that the internal rates of return (IRRs), serving as a measure of profitability, are highest for mixed funds with a median IRR of 13.5%. This gave a premium of 3.5% relative to the focused high-tech/IT industry funds.
The second part of the research looked at geographic diversification and the performance of funds investing globally, versus those specialized in North America, Asia, Europe, or the rest of the world. The results showed that global funds outperform North American funds – historically, the number one geography for VC – with 11.5% versus 10.2 % in terms of median IRRs. Asian funds realize 16.2% in the median, but the superiority of Asian funds vanishes when looking at more complex measures such as the Adjusted Sharpe Ratio, which measures on a risk-adjusted basis how much additional return an investment is returning compared to a risk-free investment.
A drawback of the analysis and even the notion of specialization is a lack of common understanding in the profession of what specialization means. For instance, high-tech could mean that a startup is building software for an AI product, engineering parts for drones, or licensing the use of patented materials. A VC that invests in all three of these functions is already diversified in a certain sense. Do they need to invest in antibiotics or an Alzheimer’s cure to be considered diversified? Furthermore, can a VC that invests across Europe be called a geographic specialist? Deciding a fund’s investment thesis, and how it constructs its portfolio, requires a clear definition of these terms as well as discipline in applying them.
The study provides evidence in favor of diversification rather than specialization. But why?
An intuitive reason might be the high failure rates. Good startups are rare and few, such that VCs moderate their returns by specializing. Specialization is a proactive self-limitation of the investment universe. A generalist hypothesis is thus that you cannot proactively forgo promising projects from the right industry but the wrong geography or vice versa.
Another reason may be that entrepreneurs may possess part of the specialist knowledge themselves. Entrepreneurs are not all young and inexperienced. Having a track record in their industry themselves, they know what they are doing. For them, a generalist VC that has experience in transferring their product into a different industry may be exactly the complement they need. This leads to a second generalists’ hypothesis: the characteristics of a successful VC are more transferable between industries and geographies than a specialist might think.
What this means for VCs, entrepreneurs, and limited partners
Historically, many stakeholders in the profession have favored specialization. Many VCs have branded themselves as industry specialists and invested a lot to build a specialist reputation, and some have been successful. Expanding the boundaries of a specialist fund to provide a certain measure of diversification not only involves a dramatic change in the investment model but also a big move in the fund’s positioning and branding in the market.
“Dogma has no place in venture investing.”- Fergal Mullen, Highland Capital Europe
If a VC wants to specialize in certain industries, the fund should then at least diversify over different geographies and vice versa. Does this mean that diversifying funds must grow in personnel and thus in costs and fees? Not necessarily. The resources needed to run a venture fund are growing with the number of deals, not necessarily with the number of geographies or industries. The intellectual capital of VCs is transferable across those categories. A VC that has experience with regulated industries – for instance, pharmaceuticals – may leverage that when transferring this knowledge to food. An alternative route is simple diversification; VCs may invest in a higher number of promising startups with the commitment not to take an active role in their management.
For entrepreneurs, the results indicate that generalist funds may be the right partner when moving the business between industries and geographies. This particularly holds true for disruptive ventures or platforms that apply to various industries.
For limited partners (LPs), the results imply that portfolio diversification outperforms specialized portfolios, such that venture capital is in line with lessons learned from the risk management of public equity.
As expressed by Fergal Mullen of Highland Capital Europe, in a recent IMD podcast, dogma has no place in venture investing. If your fund, or the fund you’re considering investing in, is specialized, whether that be by geography or industry, ask the fund manager if the expertise they’ve built up could perhaps generate better returns through diversification.
Authors
Related
Museum of art that exhibits appetite for risk and innovation
30 August 2024 • by Adam Levine in Finance
The Toledo Museum of Art takes a novel approach to bringing art to the masses, unusual in a sector dominated by conservative thinking....
The beginner’s guide to starting an art collection
14 August 2024 • by Magnus Resch in Finance
Bestselling author and art market expert Magnus Resch shares insights that every collector should consider before making their first purchase....
Future ready? A methodical approach will repay you
9 August 2024 • by Howard H. Yu in Finance
Singapore-based DBS bank was being shaken by nimble competitors from China, and it needed to change fast. But CEO Piyush Gupta knew that blowing a fortune on the latest technology was not...
Learn Brain Circuits
Join us for daily exercises focusing on issues from team building to developing an actionable sustainability plan to personal development. Go on - they only take five minutes.
Explore Leadership
What makes a great leader? Do you need charisma? How do you inspire your team? Our experts offer actionable insights through first-person narratives, behind-the-scenes interviews and The Help Desk.
Join Membership
Log in here to join in the conversation with the I by IMD community. Your subscription grants you access to the quarterly magazine plus daily articles, videos, podcasts and learning exercises.