Investing in venture capital goes against everything the text books recommend as an appropriate investment. Venture capital in Australia has a minimal track record, the funds are mainly illiquid and the risks inherent in the portfolio of companies chosen by venture capitalists are pretty well as high as you can get. Having said that, venture capital investments offer the potential for sizeable capital gains – sometimes far in excess of the returns gleaned from sharemarket investing.
Venture capital managers normally require a 10-year timeframe to select a portfolio of companies, provide first or second-round funding and sell the companies at a trade sale (where it is sold to another industry player) or initial public offering (IPO). Once invested in the fund, you can’t get your money back.
In a fund consisting of 20 start-up companies, the reality is many of them will be average performers and a few will blow up. Venture capitalists aim to hit on two or three “shooting stars”, whose exceptional growth rates will average out underperformers in the fund.
Unlike ordinary unit trusts, investors only receive a distribution once the investment manager has realised its investment. If there is a write done or a total trade write-off, then you won’t get your money back from the investment in that company.
Investors weighing up the differences between funds should consider at what stage of the life cycle the companies exist. Riskier funds are those that invest in companies at their earliest stage of stgelopment – what venture capitalists like to call “seed capital”.
Essentially, seed capital can be as basic as a person with a good idea and a business plan. It could be someone with a hand-made invention in their garage, or a university looking to commercialise its intellectual property. Without a corporate structure or even an accountant, these businesses take a long time to stgelop.
Less risky funds are those that target companies at “mezzanine” or the pre-IPO stage, which may include a Sydney-based company currently employing 50 people looking to expand into Perth.
Most venture capital funds will target one area, allowing investors to decide what level of risk they are willing to accept. But the later the stage of venture capital that you go into, the less return that you are likely to receive.
The trick to venture capital investing is to pick ideas that can come to the market relatively quickly.
Exposure to the venture capital sector isn’t limited to unlisted private equity funds. Much simpler to buy into and considerably more liquid, listed venture capital funds are an alternative way of gaining exposure to the sector.
The downside with choosing listed private equity funds over buying ordinary shares in mature companies is that distributions to shareholders are more irregular.
Listed venture capital funds are also extremely sensitive to sharemarket activity, performing well during boom conditions and struggling when the number and demand for floats flattens out or falls.
The main difference between listed and unlisted venture capital funds is that listed funds are “perpetual vehicles” – once the manager sells an investment, they will recycle the capital to buy other investments. Unlisted venture capital funds, on the other hand, return all capital to the investor immediately after exiting an investment.