Earlier today I was talking with an investor about the the venture investment model and some of the challenges. Venture, as an asset class, is one of the more unusual ones and has been in the news a good bit lately with many high-flying tech startups raising money at huge valuations. While time will tell if we’re a little frothy or a lot frothy in the markets right now, it’s clear that tech is white-hot. Let’s look at some of the challenges with the venture investment model:
- Lack of Liquidity – Stock in private tech startups, especially ones in the earlier stages, is incredibly illiquid, making it almost impossible to get money out of the fund before a material exit occurs
- Long Horizon for Any Returns – Funds typically invest their capital in the first 3-5 years and then look to generate returns in years 7-10 (with the option to extend for a few more years), meaning investors aren’t likely to see returns for at least seven years, if not more
- High Portfolio Concentration – Many funds only invest in 10-20 companies and one or two of them must be incredibly successful to generate great returns, which is a much higher required hit rate than many people acknowledge
- Higher Entry Prices Require Higher Exit Prices – With valuations up significantly to buy into startups, exit valuations need to be up as much to generate the desired returns (if you buy in high you have to sell even higher)
The venture investment model is more challenging than people realize. On the positive side, it’s positioned as potentially delivering great returns (target of 17%+ per year rate of return) and being uncorrelated with the public markets (can’t be the case completely).
What else? What are some other challenges with the venture investment model?