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The Challenges & Opportunities in Venture Capital Investment

Artesian is a specialized alternative investment manager with a unique, highly scalable, diversified portfolio approach to venture capital investments from seed to exit, targeting both financial and strategic returns for HNWI, corporate and institutional investors. Artesian manages $255M in venture capital strategies in Australia and China. As well as agnostic technology VC funds, Artesian manages specialised funds in agtech, cleantech and medtech.

The Rise and Rise of Venture Capital

Venture capital is a small but growing alternative asset class, a subset of private equity, that is focused on investing in relatively early stage, high growth-potential companies. According to Prequin/McKinsey[1] data, total global private equity assets under management (2017) was USD $2.83 trillion of which approximately USD $621 billion (22%) was venture capital.

In Australia, the venture capital market has grown significantly in the last 5 years, culminating in a record AUD $1.25 billion invested in Australian startups during 2018, an almost 10x increase on the AUD $144 million invested in 2013[2] (but still significantly lower than the USD $131 billion invested in US startups in 2018[3]).

The growth in the venture capital market has been mirrored in the rise in importance of technology companies in public markets, where Apple, Amazon, Alphabet (Google), Microsoft, Facebook, Alibaba and Tencent Holdings are 7 of the top 10 companies globally by market capitalisation. Just 10 years ago, only Google made it to a similar list. It should be noted that this is not the case in Australia where the top 10 companies in 2018 are still dominated by, the big banks and Macquarie, BHP, Telstra, Wesfarmers and Woolworths. As a result, for Australian investors, there is probably even a more pressing case for diversification into technology innovation exposure.

Key Trends in Venture Capital

1. Bifurcation of the VC market: There are 2 key types of startups. One is the global domination play (Uber, Airbnb) which chase growth before revenue. These startups require enormous amounts of capital to capture market share, and may stay private for longer, even at enormous valuations, before seeking an IPO. The second is the capital-lite startup. These startups may require as little as $10-20 million of lifetime capital before exiting via a trade sale to corporates seeking innovative business models and new revenue streams.

2. VC is Globalising: Silicon Valley remains the centre of the venture capital world, but its stranglehold is being challenged. China has moved from being a fast copier to an innovation powerhouse. The low cost of starting up and the increasing availability of risk capital means that startup ecosystems are growing across developed and emerging markets. SE Asia and China are key opportunities for Australian investors and startups looking to participate in rapidly growing markets.

3. Mega VC Funds: Even with the world awash in capital looking for relatively higher returns, and the emergence of massively successful startup companies, the arrival of the Vision Fund run by Softbank’s Masayoshi Son is no less astonishing. The Vision Fund has rewritten the rules for what a VC fund can look like, shaking up Silicon Valley with an unprecedented $100 billion fund that’s buying big stakes in fast-growing technology companies. Time will tell whether venture capital can scale to the extremes to which this fund is predicated.

4. Specialisation of Funds: With startups disrupting every industry and business model there is increasing demand by institutional investors, corporates and impact investors for venture capital funds focused on specific verticals (e.g. fintech, edtech) and horizontals (e.g. artificial intelligence, robotics). In Australia there are a number of key verticals where we have a competitive advantage, access to leading research institutes and where technology is addressing major themes for rapidly growing economies in SE Asia and China. These verticals include AgriFood Tech (food security), Clean Tech (renewable energy) and Med Tech (emerging middle class and aging populations).

Non-Traditional Risk & Return

Venture Capital has a very different risk profile to traditional asset classes such as equities and bonds. Traditional asset classes are relatively liquid and have reasonable asset price transparency. Their returns generally follow a normal distribution, leading to the domination of low fee, beta generating indexed funds.

In contrast, venture capital returns follow a power law distribution. Returns are asymmetrically skewed with the majority of individual startups failing, and just 10% of the startups producing 80-90% of investment returns. The asset class is illiquid, with startups generally requiring 7-12 years to progress from seed stage to exit. The asset class requires patient capital and alpha generating, active management to deliver sustainable risk adjusted returns of 20-25% (annualised IRR).

Financial Return + Distributed R&D/Strategy

Venture capital, and especially early stage venture capital, differs from other asset classes as it has additional benefits beyond attractive risk-adjusted financial return. Startups and venture capital markets attract financial investors looking for high return with low correlation to traditional asset classes. Corporates and other industry groups are also attracted to the startup sector as a key component of their innovation strategies. As well as a financial return, corporates are seeking strategic advantages that may include distributed R&D, partnerships, M&A activity and insights into potential threats and opportunities to their core business activities.

Investment Challenge and Scaling Due Diligence

Over the last 10 years as the cost of technology, and consequently the cost of starting up, has fallen, and the available investment capital has risen, the number of startups being formed has grown exponentially. In Australia, approximately 10-15,000 startups have been formed over the past 5-years. This explosion of entrepreneurial vigour, although positive for the general innovation ecosystem, has created a filtering problem for individual investors, professional VC firms and corporates looking to understand technology trends as they attempt to identify the small number of startups with the potential to deliver high growth and exceptional returns.

Filtering startups and trying to pick the small number of winners from an enormous pipeline is challenging enough when there is actual financial data, revenue, a product with market fit, customers and distribution. However, the challenge is much greater when investing in early stage ventures at seed or angel where there may be just a couple of founders, an idea, but no revenue, product or other key metrics.

Solving this scaling problem is critical for individual investors, venture capital firms and corporates.

Venture Capital in Australia

In Australia, there are now over 50 VC firms, managing between $4-5 billion in early and late stage strategies. Only about 10 of these firms have substantial funds under management (>$200M). As the current crop of VC funds, which have generally been investing for less than 5 years, begin to generate realised returns (current performance is generally based on unrealised mark-to-market) there may be further growth in both institutional and retail interest in the asset class.

In a portfolio with a relatively long investment horizon, an allocation to venture capital may add strong, uncorrelated returns. In addition, startup investments may provide strategic insights into new technologies and business models that may enhance or disrupt incumbent industry participants. Due to the asymmetrical skew of startup returns, investors need to consider diversification across a number of managers with different strategies (early and late stage) and vertical or horizontal focus (e.g. cleantech, agtech, fin tech medtech, artificial intelligence, robotics etc.)

[1] “The Rise and Rise of Private Markets” – McKinsey Global Private Markets Review 2018

[2] AVCAL annual data

[3] https://www.aei.org/publication/us-venture-capital-set-records-in-2018/

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