The coming segmentation of venture capital as an asset class


There are countless guides to venture capital for budding entrepreneurs on the web. Marc Andreesen, the founder of the seminal VC success story Netscape and the recently launched Ning (an extremely interesting social networking platform), among many other ventures, has provided his own guide in a three part series:

Part 1: VC basics and what they look for

Part 2: Going deeper, including comparing VC firms

Part 3: Long-term perspectives, including why VCs continue to be successful today

The most interesting by far is Part 3, looking at long-term cyclicality in the industry, and how venture capital has become accepted as an asset class for professional investors. Over the last couple of decades I’ve spent in and around the capital markets, I’ve seen a number of “new” asset classes struggle for acceptance among institutional investors. Portfolio theory shows that if the investment performance of different asset classes are not fully correlated, you can get better returns for a given risk by including additional asset classes. As such, investors actively want to bring in new asset classes into their portfolios, but there are all sorts of hurdles to cross. High-yield debt, emerging markets debt, venture capital, hedge funds, and other investment vehicles have all gone through a process of being examined by trustees and committees, recommendations provided by asset consultants, eventual approval for small investments by innovative investors, and then larger allocations across most institutional investors. In the US, university endowments have substantially outperformed mutual funds and other institutional investors over the last decade or so, partly through being ahead of the pack in taking on new asset classes such as venture capital.

As Marc points out, venture capital is now firmly established as an asset class, and as such it has a guaranteed flow of funds. In an ageing population with increasing emphasis on individual financial self-sufficiency, the weight of investment funds will continue to increase apace, meaning flows to the venture capital sector will not be highly correlated to investment opportunities or even past performance. Right now it appears that there is a bigger weight of capital than there are opportunities, resulting in inflated pricing in the funding rounds for some tech sectors.

I predict increasing segmentation in institutional investor asset allocation. As I’ve written in the past, I believe there will be very strong demand for new investment vehicles that tap the burgeoning proportion of the economy that is not capital-intensive or ever likely to raise funds in public capital markets. In addition, venture capital will not remain one large undifferentiated asset class – it will be segmented, primarily around size of investments. Industry and sector allocations will happen within the venture capital asset class. However there are different performance dynamics between, for example, early stage and late stage investments. This means that, whatever the VCs think, investors will prefer to invest in different types of ventrue capital opportunities through different vehicles, leading to better opportunities to structure their portfolios, and better risk/ return dynamics. This will probably take up to a decade to happen, as the process of definining and approving new asset classes takes a long time. However the reality is that institutional investor asset allocation is the primary driver of where money flows, and that process will become more refined over time. It will be interesting to see how the venture capital – and associated non-public investment sectors – become further segmented.