The Role of Venture Capital in Modern Capital Markets

VC investing, at least in the United States, is really nothing new. Chris — who terms it “innovation investing” — traces its roots back to the innovation wave that emerged from the post–World War II boom in North America. Even then, a good deal of private funding was involved, and the concept was to provide capital to develop and then commercialise ideas.

Yet, as Eric observes, the model has changed since then. Today, it is all about using the capital for marketing dollars to capture market share rapidly. Growth is the focus — the idea is to grow first and then maybe to figure out things like business moats a little later. As he puts it, “slow and steady wins the race does not apply to venture.”

This change has occurred in tandem with the shifting expectations of asset allocators (aka investors). They are looking at VC investing for high-return potential, causing founders to create “big vision” companies. This further supports these investors’ expectations, creating a sizeable feedback loop.

Although these investors all have the same core expectation of VC investing — potentially meteoric returns in exchange for extremely high risk — their profiles are rather diverse.

VC investing typically has been the purview of high-net-worth individuals (HNWIs) — who also may invest through family offices — and institutional investors. Even though the industry is gradually becoming more democratised, these two classes still form the main investor base. And both of these classes view VC quite differently.

In his experience working with Asian family offices, Chris observes that these business tycoons are looking to play the “high-risk high-reward” game so that they can leave something to support the next generation. The VC space is also exciting for them as most of them have built their own businesses. As such, they may feel that if they had this sort of backing when they started out, they could have scaled their businesses much faster.

In contrast, in the United States, VC has been an institutional asset class for at least three decades. Eric points to the famous Yale endowment fund, which has seen much of its returns come from private assets. In 1985, the fund’s allocation to buyout partnerships and VC was less than 1%. By 2001, it had reached 25%.²

As such, VC in the United States has strong validation, expertise, talent, and franchise value. The next stage of development is trying to shift the perception of VC among the non-institution crowd to that of an institutional-level view. Of course, many such investors still have questions about the entire VC model — particularly its sustainability and seemingly sky-high valuations.

Is VC investing akin to a game of musical chairs, in which only top-line growth matters? Is it all about finding investors willing to fund the next round? How sustainable is this? Alan poses these questions, bringing up the case of the Chinese online apartment rental platform Danke. After multiple rounds of VC financing, the company, which had gone public, saw its business crumble in late 2020 after its thin margins and debt-fuelled growth ran headfirst into the pandemic.³

Eric, however, points out that only a small percentage of VC exits are through initial public offerings (IPOs). The vast majority occur through mergers and acquisitions, typically five to seven years down the line. This makes Danke an outlier — with Eric also pointing out the media often highlight only spectacular failures as that is what captures reader interest.

On the topic of seemingly unjustifiable valuations, Eric takes what he admits is a “slightly cynical” view. He says valuations are just placeholders used to measure the company both in terms of its funding stage and the technology it is operating relative to its peers. Supply and demand dynamics also drive valuations: – the more investors want to invest in a particular company, the higher its valuations will soar. He emphasises, “such valuations are not a tradeable or mark-to-market valuation.”

It is worth remembering that VC investing follows power law returns. One successful VC investment could more than make up for 20 failed ones. As Eric puts it, it is a “game of outliers.”. Those sky-high valuations you hear about are the successful outliers. You never hear about the dozens of others that fizzle out. These power law returns also lead to the tech bias in VC investing.

There is a common perception that most VC funding flows toward tech companies. Eric did not dispute this claim but pointed toward the nature of VC investing as being most suited to these sorts of tech-focused big-vision companies. Because VC investors are looking for high growth, they want to fund “moonshot” ideas that require a lot of time and money — not to mention a particular type of founder.

This is where VC and private equity diverge. VC is about funding a big vision, meaning the milestones are all about reaching that moon-shot and are not necessarily revenue driven. Because tech companies can rapidly scale and reap the benefits of network effects, it is natural that much of the traditional VC funding has flowed toward them.

But this could be changing.

Eric points toward the rise of “emerging funds” — VC funds that focus on very early-stage investments in highly specialised niches. Many of these are run by first-time fund managers, who may come from non-software backgrounds, and thus may be more willing to fund these non-software sectors. Eric estimates there are more than a thousand such funds in the United States alone. These funds will cut the first cheque, and then the larger, more established funds can come in at a later stage.

As Eric puts it, “Whatever you imagine, in terms of a silo or slice within a particular vertical in these different industries, there is a venture capitalist, and there is an early-stage fund going after that.”

Certain catalysts are also helping this trend. The pandemic has compressed a five-year innovation cycle into one and has highlighted gaps in investment sectors, such as health and education. The fiscal stimulus in response has also led to President Biden’s ambitious infrastructure plan, which should see substantial money flowing into the sector.

Chris believes VC has moved from being a “nice to have” to a “must have” portfolio allocation in today's low-yield world. This also could apply to retail investors, who are slowly but surely gaining access to this increasingly democratised asset class. This democratisation is good not just for investors but for the industry. It will demand and create transparency — a positive thing in what is still considered an opaque space.

As democratisation creates more options for investors, they risk being inundated with too many choices. Eric and Chris believe this eventually will lead to more productised, curated, and customised solutions. It is not just about providing access to the VC space – but also about adding a financial and structural wrapper around these assets. That is how they are building their business at Revere VC.

All in all, they are optimistic about the future of VC investing. They point toward the “special purpose acquisition company (SPAC) craze” as evidence of investor appetite for these sorts of assets. After all, a SPAC could be thought of as a publicly listed venture fund (albeit one that can invest in only a single company). Yet, as the VC space grows, so too must education. There is a need for more experts at every level in the VC value chain, and those who are willing to put in the work also could reap the rewards.