August 9, 2022
“Contemplation teaches us how to observe our own small mind and frankly, to see how inadequate it is to the task in front of us.” - Eckhart Tolle
“98% of human thought is repetitive and pointless” - Eckhart Tolle
----------------------------------------------- I would again like to emphasize the importance I place on stepping back from the noise, breathing, taking no action, and allowing myself to concentrate on:
What I do not know.
What I do know.
The motives and biases of others trying to convince me to act in a particular way.
Recognizing that those actions may not be beneficial to myself nor to the person doing the convincing.
This reflection (hopefully) allows me to simplify a situation by filtering out the noise. The “noise” is often the information delivered to me from people with incentive (motives and biases) to convince me that making an investment in a particular vehicle will be to my benefit.
Sometimes that information is beneficial, and sometimes it is not! Paying attention to the incentives and context of the person bringing me information has always been paramount in my investing process.
For the non-professional investor it is useful to have a fiduciary advisor to help you navigate whether to invest in a particular product. However, additional due diligence is required if your trusted fiduciary wants to lock up your money for a long period of time. Investing in illiquid assets that require long term investment can certainly be beneficial to you. Under most circumstances, you should be compensated with higher returns because of the time value of money and the inability to access your money in the short term. Structured products, private equity, venture capital and hedge funds can be useful, but being compensated with higher returns for a given assumption of risk is essential if you are considering these investments.
From a financial advisor business perspective, if you, as the client, are locked into investments for the long term, it obviously gives greater clarity on fees paid for advisory services over long periods of time. It is not as easy for these assets to be moved to another firm or advisor. Therefore, there is a non- negligible incentive to place some clients into longer term investments (e.g., alternative investments, private equity, venture capital, hedge funds, etc.). It may skew judgement, and therefore I believe it necessitates closer inspection of the facts to determine if it is in your best interest.
Should you really invest in Venture Capital?
The Financial Times is part of my daily reading, and the two articles below* reinforced my personal skepticism of using venture capital to achieve our long-term goals in most instances. I should state very clearly, I believe venture capital plays an important function in our economy. It funds new businesses at early stages where they may otherwise not have been able to execute on innovative new ideas and technologies. It is just that for most investors, I am not convinced it is in their best interest. As I learned long ago from Greg Brady on the ever-popular US television show, The Brady Bunch, “Caveat Emptor” which is Latin for: “let the buyer beware”.
Obviously, it is easy to write articles about performance in hindsight, but it draws attention to some facts that were known well in advance of the current difficulties in the venture capital market.
There are many excellent fund managers of venture, private equity, and hedge funds that are arguably worth the fee’s investors must pay. They generally provide capital preservation, account growth, and diversification from the S&P through superior risk management strategy. Finding the best talent and having access to invest alongside them is another matter.
What was known prior to the current difficulties?
Fees: I add a quote from Terry Smith below that I have highlighted from my commentary last August. Basically, at fees of 2% of assets and 20% of profits, this is going to eat up most of your successful investment returns (see below**).
Most start up companies fail. If you are to invest in venture capital, you need diversification. Your winners must hit big returns because most new companies fail. I do not know any investor that can pick the next Google (without being remarkably lucky) without investing in some losers along the way. Successful diversification in the private markets is much more difficult than in the much larger public stock markets.
Money was free in 2020 and 2021. The Federal reserve set the Federal funds rate at essentially zero from early 2020 to early 2022. Money was easy to obtain, most investors borrowed easily, and plowed cash into all kinds of investments, including venture capital.
It was clear that free money would not last as the Fed told us this in 2021. Environments change, and successful investors change course as incentives change. The Federal Funds rate is at 2.5% and likely heading over 3% by early next year according to Fed Funds futures pricing.
You cannot make a change in the short term if you are in a venture fund for 7-10 years. It is not liquid. This may be perfectly acceptable to the ultra-high net worth investor that invests in an appropriate size given their risk and goals, but it is unlikely to be appropriate for most.
According to the FT article entitled Venture Capital’s Silent Cash:
1 “The scale of the most recent venture boom has dwarfed that at the end of the 1990s, when annual investment peaked at $100bn in the US. By comparison, the amount of cash pumped into American tech start-ups last year reached $330bn. That was twice as much as the previous year, which was itself twice the level of three years earlier.” 2 Fear of Missing Out was prevalent as investors poured money into Venture Capital funds at exactly the wrong time in pursuit of companies promising higher growth rates than those available on the public stock market.
It is questionable whether the returns generated by venture capital are sufficient to justify the risk and illiquidity of the investments. It seems to depend on the manager, early-stage investment vs. later stage, and diversification as to whether it is additive to an investment portfolio.
Venture funds typically do not report their net asset value daily, and this perversely makes some investors more comfortable knowing that they do not have to pay attention to fluctuation. I would argue that this is not a positive attribute of any investment; it is just something that may or may not make you “feel” better.
To summarize, when the Federal Reserve is providing lots of money to the economy, it will find its way into companies with a great "idea" or "technology"; even companies that are funding growth with no profits. In such an environment, investing in the growth of small innovative companies makes a lot of sense to us.
However, as most of us know, most startups fail due to higher-than-expected costs, inability to fund growth, and other reasons around execution of business strategy. Underlying issues within a company can be hidden when there is always more funding available. But, when the cost of capital is significantly higher (as it is presently), that money becomes less available. In other words, the flow of money to startup companies with the promise of growth (no matter how good the idea is) is constrained. The idea or technology may still be a fantastic opportunity for future investors, but the early investor in the venture capital fund may still lose because the company can no longer fund their growth.
The August Wealth Approach:
Look, I am not writing to begrudge venture capital fund managers or those trying to market their funds for profit. They may feel this is the best way to help their clients. There may be fund managers that can consistently beat the market and provide the risk adjusted returns that will benefit you. They are rare to find at a reasonable price in my experience, but they do exist.
For our clients and ourselves, I always want to achieve goals in a simple, liquid, and low-cost way without compromising on what we aspire to achieve. Ask the questions: What are we trying to solve for? What do we need to achieve? What risk can be tolerated? How will you feel if scenario A or B happens? What is the plan if your financial circumstances change? How can we help you manage the emotion and anxiety of a portfolio that fluctuates in value daily?
How do we invest in the growth of small, innovative companies? As many of our clients know, in 2020, we used a proxy for venture capital by purchasing the Vanguard Small Cap Growth ETF. This fund seeks to track the CRSP US Small Cap Growth Index. It charges 0.07% annually on your investment and 0.00% of the profits. As compared to many private venture capital funds charging 2.00% annually and 20.00% of the profits.
It is not the same at all as investing in smaller cap private companies at early-stage investment, but in my view, this is a reasonable proxy at a very inexpensive price. Here was my rationale:
Money was readily available from the Federal Government and Federal Reserve, and it would flow into innovative companies with the ability to grow quickly.
It provided diversification across approximately 700 companies.
It provided diversification across various industries.
It was liquid; meaning we could sell it on the public market on any given day (no lock up period).
It was inexpensive compared to almost any fund; not just venture capital funds.
We were able to use this proxy investment for venture capital at a time when money would flow to these companies and lift their valuations. When the Federal Reserve started signaling that rates would need to increase (making money less available), we exited this strategy.
None of this means the strategy was bound to work, nor does it mean that it will work in the future. However, I believe it is reasonable to suggest that there is a strong correlation between small growth companies in the private sector and small cap growth companies in the public sector.
It is certainly not the same as venture capital especially for those investors with access to diversified early-stage company investment with seasoned venture capital fund managers. It is however very satisfying as an investor in this Vanguard Small Cap Growth Fund that when circumstances change that create a more challenging environment for illiquid and higher risk investments, we can change course by simply reducing our exposure to it.
As always if you would like to discuss your portfolio or our views, we welcome your questions.
* Unfortunately, these articles cannot be accessed without a subscription, but if you would like to hear more, please call us.
Venture Capital’s silent crash
Investors sell stakes in buyout funds at a record pace
**Quote from August Wealth August 2021 Market Commentary
“If you had invested $1,000 in Berkshire Hathaway in 1965, your investment would be worth $4.3 million by 2009. Buffett’s company compounded your capital at 20.46%/year. If Warren Buffett had set up Berkshire Hathaway as a hedge fund however, he would have charged you 2% per year and gathered 20% of any annual gains. If you had the same performance numbers, your $1,000 would have only grown to $396,000 by 2009. Only $396,000 would belong to you, the investor. This means that of the $4.3 million that you would have earned without fees, $3.9 million would belong to the hedge fund manager. This of course is the result if your hedge fund manager had a performance that is as great as Warren Buffett’s.”
Joe Joseph Cardello, Principal August Wealth Advisors, LLC 51 Riverside Avenue, First Floor Westport, CT 06880 Direct (916) 461-9451 toll free (800) 985-9477
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