The Christmas break gave us an opportunity to revisit a two-year old Michael Mauboussin paper which focuses on using 30 years of US data to highlight the stark (and counterintuitive) differences between Venture Capital (VC), Private Equity (PE) and public market investing. If you work in the financial markets or are investing your hard earned money in these asset classes, we strongly recommend you read this paper carefully. Mauboussin’s paper uses American data but it is unlikely that relative returns between VC, PE and public market investing India over the next 20 years will be very different from what America has demonstrated over the past 30 years.

The first stunning finding of the paper is that over very long time periods (i.e. decades), the returns from VC and public market investing are actually identical (see pg 9 of the PDF)! Given that money is fungible, this ‘no arbitrage’ long term finding makes sense but it also shows that VC investing in America, other than in exceptional periods like the late 90s, does NOT give a higher rate of return to compensate for the higher risks posed by early stage investing.

Within the Indian stockmarket, we have found similar ‘no arbitrage’ results eg. Indian smallcaps do NOT give higher returns than Indian large caps over decade long time periods (even though smallcaps are MORE volatile than large caps).

In contrast, over very long time periods, PE investing in America produces median returns which are around 1.1x higher (i.e. 10% higher, NOT 10% points higher) than public market investing (see pg 8 of the PDF). Why are PE funds as an asset class able to produce higher returns than the stockmarket? Whilst superior operational & management skills of PE funds arguably play a part in driving this excess return, financial leverage (i.e. PE funds using their privileged access to low cost debt to gear up the equity they raise from their clients) has almost certainly played a critical role over the past 30 years.

Mauboussin repeatedly says that he has had to trawl through lots of data to get to the figures mentioned above. You might want to keep that caveat in mind.

The second remarkable finding of this paper is that there is NO average VC fund i.e. VC returns are incredibly polarised insofar as you have a handful of star VC firms and then hundreds of VCs who struggle to make money – see Exhibit 7 on pg 10 of the PDF.

In contrast, in public market investing, the vast majority of managers give similar returns with outliers (negative and positive) being rare in the stockmarket. In fact, exceptional public market investors are rarer than exceptional VCs. PE investing is in-between public market and VC investing – there is some clustering around average returns in PE investing but exceptional PE investors are more common than public market investors (although less common than exceptional VCs). In short, the exceptional VC is the rarest of rare creatures in the fund management universe.

The third remarkable finding of this paper is around persistence of returns. Mauboussin says: “Returns for top venture capital funds are persistent, whereas there is limited evidence for persistence in buyout funds since 2000.” Exhibit 42 on pg 51 of the PDF has stunning data on the persistence of returns in top quartile VC funds: nearly half the VC funds who are top quartile in period t stay top quartile in period t + 1 i.e. if you are already invested with a star VC fund, you need to look after the relationship very well!

In contrast, pg 39 shows that such persistence is elusive for PE funds: only a quarter of PE funds who are top quartile in period T, stay top quartile in T+1. As is well known, persistence of returns in listed market investing is even lower.

Finally, along expected lines, dispersion returns is the lowest in public market investing, highest in VC investing and middling in PE investing.

Our conclusion from re-reading Mauboussin’s paper is that we should focus on what we do best (which is public market investing) as there are no free lunches available in VC investing, PE investing or indeed in any other form of investing.

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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.

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