INSIGHTS AND RESEARCH
How are investors building more resilient portfolios? By embracing emerging managers during market volatility, blending VC vintages and acknowledging the advantages of leveraging ESG criteria in value creation. To learn how let’s take a closer look:
“Integra Groupe reimagines the alternative investment business model. Lean, diverse, hungry and opportunistic. We have the agility and cross-disciplinary approach to recognize trends that more established funds may be too large to react to quickly, namely both micro and mega trends.
Having spun out of larger firms we bring years of experience working with and learning from the heavy hitters. We are highly motivated with the knowledge that the IRR of early funds is the key indicator of success that makes it possible to recruit new LPs and increase check sizes from follow-on LPs. We must prove to the market how our market-first data approach and propriety ESG tools are innovative and improving upon antiquated industry practices. Emerging managers are now the bread-winners of the investment sphere.” – Francesca Whalen Managing Partner, Integra Groupe
“In wine production, prevailing conditions during the growing season influence vintage quality. Similarly, prevailing market conditions can impact private equity results” state Kunal Shah and Tatiana Esipovich of iCapital Network. [1] A “vintage” year in private equity is conventionally defined as the year in which a new fund makes their first investment followed by a classical trajectory of five years of investing and deploying capital and a further five years of so-called ‘harvesting’, thus a vintage has, on average, ten years from entry to exit. It is important to blend vintages as private markets are also prone to cycles and volatility, often mimicking the larger market conditions of public markets but not to the same extent. While some funds may have luck in investing at the lowest point in valuation environments, others may have “ill fortune” by investing right before an unforeseen market crash making for a ‘bad’ vintage. Moreover, because private equity investment by funds is not a one-point lump sum entry but flexible and spread out over several years, it is almost impossible to predict the profitability of the investment environment which is current for a given vintage, similar with attempting to predict whether one vintage year of wine is going to be good or bad at the time of bottling it - while soil, grape and climate conditions can be predicted as positive or negative, a ‘good’ wine is always valued retrospectively, as is a given fund’s ‘vintage’ and the then-current private market conditions.
The cyclical volatility of private markets has, since the early 2000s, [3] shown emerging managers and new venture funds diversify not only their asset classes but also their strategy of capital deployment – investing at different market and valuation environments to dilute the risk of having a ‘bad’ vintage. In essence, both smaller and larger funds are spreading out entry points to minimise the risk of investing all at the very peak. While a fund may claim to have a concrete ‘vintage selection process’ based on micro and macro conditions, this is inapplicable in real terms as it would require incredibly extensive market knowledge and perfect economic predictions far into the future. This is simply unattainable and not claimed to be done even by the leading economists in the world. That being said, investing in top-quartile managers remains nonetheless a priority: “A superior winery tends to produce a better product on average across vintages. Similarly, experienced, talented private equity managers demonstrate the ability to consistently add value in both bull and bear markets.” [4] A broader portfolio and a diverse vintage will harbour the best returns within venture capital, oftentimes with lower investment minimums for investors.
Strong managers know that blending vintages is a crucial part of any investment strategy.
Having spoken of the importance of managers, it is time to look at why emerging managers have the strongest results during public market volatility. The risk profiles of private investment, specifically Venture Capital, are not the same as 20 years ago (where fund managers were limited in numbers and hard to contact), now new funds and managers emerge daily and they “generate compelling returns relative to public markets.” [5] Cambridge Associates’ data has further shown that new and developing funds accounted for 72% of the top returning firms for the period of 2004 – 2016. [6] Newcomers and earlier-stage investing funds have a different approach than long-established, big-brand-name funds in their calculus – the managers are “optimizing for outsized returns to build their reputation, not for management fees.” [7] What does this mean, typically? Emerging managers are working harder and smarter. Moreover, emerging managers and first funds are often working in their own niche – an opportunity they saw others overlooking within private markets.
Conversely, despite better returns and opportunities presented by emerging managers and funds, they are greatly underinvested in; with less than half of all venture allocations going to first and new VC funds between 2004-2019, according to NVCA and Pitchbook data. In short, many still prefer the ‘blue-chip’. [8] With the stellar reputation of emerging managers, rightly earned by riding high during the pandemic market turmoil, more investment is abound. Forbes describes investing in emerging managers as “a smart bet” during market volatility, why so? [9] The answer is quite straight forward: larger potential for 2x, 5x and 10x returns in the long-run and relatively little risk. Of course, risk is still present, as with any kind of private equity investment, however, emerging managers have been shown to mitigate risks effectively through thorough due diligence and management strategies of their portfolio companies. Emerging funds are generally a median size of 10 million USD (data on US VC), [10] and invest in a variety of pre-seed, seed, and Series A companies: typically, a portfolio of 5-25 early-stage companies. The VC market is power law driven, as such, it is the outliers (namely ‘the unicorns’) who the ones generating almost all of the return. [11] Consequently, the more exposure a fund has to seed ecosystems globally, the greater their chance of selecting a unique company which will become a unicorn.
Finally, there is also a growing decline in public companies while the private market continues to flourish, with IMARC Groupe predicting its worth to reach $585.4 billion by 2027. [12] What this effectively represents is a shift in market structure, while unicorns exist many of them choose to remain private much longer meaning their larger equity and returns are limited to their initial investors; those from the pre-seed and seed rounds. Over the last two decades the number of publicly traded US equities has nearly halved, [13] while the number of part-realized and unrealized VC-backed companies grows stably year on year. Although not all companies will of course survive many will still generate sizeable returns for their investors even if they never reach the elusive ‘unicorn’ status. In 2019 private market capitalization was quite significantly higher than public, proving once again that emerging funds and managers are a safer investment even with all associated risks, skepticism and cyclical volatility.
Venture Capital grows companies from the very infant stages into big publicly traded entities, thus how they are managed at the earlier stages impacts the later buyers, investors and stakeholders when a company progresses upwards the investment chain. This appears to be common knowledge, however, while VC ecosystems may be becoming more institutionalised there is nevertheless a lack of early ESG incorporation practices. Why is this worrisome? If an early-stage company has negative or irresponsible practices or processes, even if the start-up is profitable and scaling well, as the company grows so will its problems. Principles for Responsible Investment highlights the following: “Venture capital investments have the potential to be incredibly disruptive to the broader economy and society and can be exposed to a range of ESG risks with significant consequences, including privacy violations; human rights abuses; poor governance and climate-related risks.” [14] At later stages of company growth and development all initial practices, whether good or bad, become ingrained and thus difficult to change.
ESG non-compliance will not only be costly for the founders and later stage investors due to risks incurred through malpractices (intentional or not) but it will also reduce the company’s functionality, efficiency, and reputation (especially important when a company decides to become publicly traded). Oftentimes, due to a lack of regulation around ESG and also an inexistent standardised practice, start-ups prefer to do a “growth-at-all-costs approach” to counter the high failure rate of investments and simply as a result of them being very early stage. Many see ESG as ‘something’ they will need to implement later on, say at Series C level, but not from the onset. [15] This is a big mistake made both by the companies themselves but also GPs and LPs. Although it is difficult for any given company to be fully ESG compliant (for reasons of the asset class or the product itself for instance), it is nonetheless important to implement ESG practices and measure ESG metrics as much as possible from the first round of funding. ESG, as well as preventing risk-associated costs also aids in value creation.
Integra Groupe and our Better Future Fund allows our investors access to very real benefits of the strategies and practices discussed above which we incorporate wholly and actively within our investment thesis when looking at existing and future portfolio companies. The strategy is driven by bottom-up founder and firm financial analysis, top-down industry and macro assumptions and an industry first proprietary ESG framework, to produce outsized returns by investing early in the market leaders of tomorrow.
Reference:
[1], [2] & [4]https://www.wealthbriefingasia.com/article.php?id=184740#.Yzw7sS0w173
[3] https://www.preqin.com/insights/research/blogs/the-rise-of-emerging-managers-in-venture-capital
[6], [10], [11] & [15] Ibid.
October 18, 2022
Potential for venture returns while changing the world.
