Searching for returns: Why early-stage venture outperforms
Venture capital (VC) continues to present attractive investment opportunities, providing return enhancement over what can be achieved in the public markets. VC set multiple records in 2021, in fundraising, deal activity and exits, showing remarkable resilience during an ongoing pandemic. In deal-making, USD 330 billion was invested, almost double the previous record, set in 2020. Even more astounding, venture-backed companies with an aggregate value of USD 774 billion completed exits in 2021 alone.
While VC fundraising and deal activity sustained momentum during the first quarter of 2022, VC-backed IPO and M&A activity slowed significantly—in tandem with the broader markets—demonstrating the onset of an impending recalibration period for the VC ecosystem.
Looking forward, we believe that rising interest rates and volatile, declining public markets will continue to incentivize investors to seek returns. The evidence is clear: For long-term investors who are willing to hold illiquid assets—and, most importantly, able to identify and access high quality managers—venture capital can provide valuable return enhancement.
In this article, we assess the VC landscape, focusing on early-stage VC, where we find particular promise.
Exhibit 1: Private equity and venture capital continue to outperform
Net IRR through December 31, 2021:2008–17 vintages
Returns across private markets
As shown in Exhibit 1, our framework defines the private market universe as private equity (predominantly buyouts and venture capital), private debt, real estate, natural resources and infrastructure. Buyouts and venture capital continue to outperform other private capital investments, delivering strong alpha above diversified public equity benchmarks.
Buyout funds typically take large, controlling stakes in a small number of mature companies across a wide range of sectors. Venture capital funds typically make smaller investments in a relatively large number of new companies with high growth potential. These often include sectors such as information technology, health care and life sciences, and increasingly in areas such as blockchain, fintech and e-commerce.
Venture capitalists tend to invest in portfolio companies over several stages (pre-seed, early-stage, late stage and growth equity), providing additional funding only as financial and operating objectives are achieved. This allows venture capitalists to assess the performance of management at critical milestones, to cease funding unsuccessful companies and to allocate capital as appropriate to successful ventures.
Though buyout and venture capital investing can produce meaningful return enhancement in an investor’s portfolio, it’s important to also note that relative to other private capital investments, buyout and venture capital investing have the widest dispersion of returns—i.e., the widest range between the performance of top-quartile and bottom-quartile managers. In aggregate, private debt, real estate, natural resources and infrastructure investment demonstrate a dispersion between top and bottom quartiles of 570 basis points (bps) of net internal rate of return (IRR).
By contrast, the dispersion between top- and bottom-quartile managers for buyouts is 1,500bps, and for venture capital it is an astonishing 2,350bps, or over 4x the dispersion seen in other private capital investments. Specifically, VC managers from the vintage years 2008–17 in the bottom quartile returned a net 12% or less IRR vs. top-quartile managers, who generated a net 35% or more IRR.
We see variations in historical performance and dispersion of returns in the various stages of VC investment. Looking across the different stages, we believe early-stage VC is potentially the most attractive. Due to the risk profile of early-stage investments (related to market, product development, technological and team development risks, among others), venture capitalists are typically able to obtain more meaningful ownership stakes with smaller investment amounts than they could in later stages. Furthermore, in early-stage investments, venture capitalists can have the greatest impact in helping a company establish its business platform and management team.
Late-stage venture capital can be characterized as equity investment in venture-backed companies to support transformational growth in revenue, market share or product offering. This stage is differentiated from traditional venture capital investment in several respects. The financing rounds and investment amounts are typically significantly larger, and the key investment risks are expected to be more execution related. This reflects the fact that companies generally have made further progress toward proof of concept with respect to their product or service.
Exhibit 2: By two key metrics, VC continues to deliver superior returns
Comparative performance of VC stages, 2008-17
As Exhibit 2 shows, early-stage VC continues to produce superior returns in both internal rate of return and total value to paid-in (TVPI), an industry metric that includes both realized profits and unrealized future profits. However, looking across the stages, we observe wider dispersion of returns at the early-stage of a VC-backed company’s development relative to later-stage or generalist venture funds.
Why early-stage VC outperforms
Two factors explain the outperformance of early-stage VC, in our view.
The halo effect of high performing early-stage VC firms creates a virtuous cycle for persistence of returns.
Competition is not as great in early-stage VC, as “crossover” investors (e.g., hedge funds, mutual funds and sovereign wealth funds) have found success in financing later-stage rounds, as the time to liquidity is shorter and the likelihood of commercial success is higher; thus, crossover investors have continued to drive up valuations.
The halo effect
Especially in the earliest stages of a company’s development, finding the right partner is critical. VC firms that have demonstrated success in building and exiting venture companies are more attractive to future entrepreneurs and repeat entrepreneurs, as well as top engineers and technologists. As a result, successful early-stage VC firms benefit from strong brand recognition in the form of increased deal opportunities, thus creating a platform for future opportunities and continued success.
We see evidence of this phenomenon in the persistence of returns in private markets. In one study that has been reviewed and updated several times over the past decade1, 30-plus years of VC fund data dating to the mid-1980s suggest a strong level of persistence in venture capital. Specifically, 45% of VC firms are likely to repeat their funds’ first quartile performance in a subsequent fund.
The challenge for investors is not necessarily identifying those top-tier VC investors that may exhibit persistence of returns but, rather, accessing the funds of those successful managers. Many long-standing VC firms have existing investors that have participated in their funds for many years—some for several decades. Often, these funds are not accessible to new investors. Additionally, it can be difficult to source and identify up-and-coming VC emerging managers before they become successful and capacity constrained.
Increased VC competition and the role of crossover investors
Venture capital has experienced significant growth in recent years due to increasing investor allocations and greater competition from crossover investors seeking outsize returns in the space. Over the last decade, deal sizes and valuations have grown across all stages of venture capital, as illustrated in Exhibit 3.
Exhibit 3: Valuations have been climbing across all financing stages, most notably late-stage rounds
U.S. VC pre-money valuations (USD millions), by stage
While valuations of early-stage venture have certainly grown, late-stage venture has experienced a much greater and more rapid increase in valuation. The median pre-money valuation reached USD 105 million in 2021 and climbed to USD 120 million in 1Q 2022, which is nearly 85% greater than the median pre-money valuation of USD 65 million in 2020. As the public markets have been very favorable over the last few years, notwithstanding current market volatility, investors have been able to generate strong returns despite paying higher prices at entry.
However, this rise in entry valuation creates an interesting dynamic for future return potential. Late-stage companies will have to grow into these valuations or they run the risk of having to raise capital in a down round, resulting in lower performance for investors. For early-stage investments, on the other hand, exits can be profitable at more modest outcomes, as valuations have not risen as much as their late-stage counterparts’. Additionally, the increase in late-stage activity creates deeper and wider pools of capital for early but maturing companies to sell into when pursing subsequent rounds.
Conclusion: The importance of manager selection in venture capital
Despite recent public market volatility and a slowdown across the private markets, we believe that venture capital continues to offer attractive investment options for sophisticated investors with a long-term outlook and a willingness to hold illiquid assets.
Given the wide dispersion of returns from top to bottom quartiles, manager selection continues to be vital in the private markets, most dramatically for early-stage venture capital. It is critical that an investor partner with a team that has long-standing relationships with successful sponsors, a due diligence process to identify top-performing managers and the selectivity and discipline to rule out groups that are unable to maintain their premier performance. Identifying and gaining access to high quality venture capital firms and building an appropriately diversified portfolio with a high concentration to top-tier early-stage VC general partners: These are the essential elements to consistently realizing the return-enhancing potential of venture capital.