Most Retail Investors Should Avoid Venture Capital Firms

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There has been increasing pressure in recent years to “do retail investors a favor” and “allow” them to invest money in high-risk investments. An ability that was traditionally only allowed to those with significant financial means due to the risk that people could lose what they had in their retirement accounts, without any recourse.

And, one by one, these offers turned out to be less benevolent than mechanisms to extract money. The latest evidence is a study suggesting that venture capitalists are largely mismanaged because they needlessly waste a lot of money backing companies they should have known would fail.

The push to get those in the financial industry known as retail investors — or, given understandable levels of cynicism, what you might call consumers who still have cash in their pockets — has been significant and extended to government assistance. In 2020, the SEC wanted retail investors to invest in private equity firms.

Private equity firms were all for it because, collectively, retail investors had a lot of money that the general partners managing the private equity wanted. Management fees are high compared to many types of investments, averaging 1.5% to 1.75%, and once a target level of return is achieved, the private equity firm earns 20 % extra profit.

Think about it, individuals could invest in companies that could buy their own employers and fire them to reduce costs and improve returns on investment. If they didn’t eventually push the company to default to greedily absorb as much money as possible.

And just the other week, Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) were on camera with CNBC’s Squawk Box, literally. encourage people to invest part of their hard-earned retirement savings in cryptocurrency. The same kinds of financial gibs that have seen billions in investment losses of late, with one company after another collapsing under the weight of the Ponzi scheme, much of this area is.

Lummis went so far as to say that crypto investing “should be part of a diversified asset allocation, and it should be on the end of the spectrum of a store of value.”

Well, technically zero is a value that can be stored.

Another area that has been proposed is for ordinary people to help fund venture capital firms. As one company with an ax to grind — and the ability to promote its views on the site of Nasdaq, the venture capital-dependent tech-heavy stock index — put it, “retail investors are the future of capital risk”.

This seduction also occurs elsewhere in the world. “UK venture capital firms are inviting retail investors to help start-up entrepreneurs, opening up a part of the market that is difficult for private investors to access but also carries special risks,” the Financial Times wrote. last summer.

Major risks, indeed, because of the business model. A venture capital firm hopes to realize returns on investment on perhaps 10% of its portfolio, by hitching a ride on a wildly successful company. That’s why you see so many jockeys for an early position on Twitter or Facebook or whatever hit of the day. They need a massive slice of success because a big chunk of their portfolio will be fine, and a good chuck will be pretty much written off.

But is this structure necessary? Diag Davenport, a doctoral student in behavioral science at the University of Chicago Booth School of Business, just released a working paper that answered the question with a succinct “no.” Here is the summary :

Are institutional investors investing efficiently? To investigate this question, I’m combining a novel dataset of over 16,000 startups (representing over $9 billion in investments) with machine learning methods to assess startup investor decisions. By comparing investors’ choices to the predictions of an algorithm, I show that about half of the investments were predictably bad – based on information known at the time of the investment, the expected return on the investment was lower than the one readily available outside the options. The cost of these bad investments is 1,000 basis points, totaling over $900 million according to my data. I provide compelling evidence that overreliance on the founders’ background is one of the mechanisms underlying these choices. Together, the results suggest that high stakes and firm sophistication are not sufficient for effective use of information in capital allocation decisions.

He’s absolutely right that these companies have a strong focus on founder backgrounds. From long observation I would go even further and say they are catching up with the founders stories. It’s the kind of thing that explains why $700 million was poured into a company like Theranos, because the Elizabeth Holmes story was too juicy for them. (And the sexual connotation in the wording is intentional, as it’s becoming a big deal in much of the venture capital industry.)

If half of venture capitalists’ investments on average (and, yes, there will be those who are smarter) are predictably bad, their value as an alternative asset class needs to be reconsidered.

Responsible and efficient investing is boring. You see what a company does, not just what it says. It takes patience and a willingness to wait over time for returns to grow and get worse. Many “experts” and “people with lots of money” want a share of your funds. Yes, there is always a risk associated with investing, but you also have to be smart about that risk. Let the money work for you and don’t go paying for someone’s yachts without a big, real return that you’ll keep.

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