Nothing ventured…should you have venture capital in your portfolio?

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For some time, the venture capital trust (VCT) and business investment scheme (EIS) industry has struggled to balance the tax and investment aspects of its funds. Unfortunately, the first is easier to articulate and too often ends up being favored over the second.

A new white paper from Hardman & Co, How much should clients invest in venture capital?, clearly tips the scales in favor of the investment case. It takes a rigorous approach, using standard asset allocation methods to show that for most investors, the best portfolio includes risk capital, even without tax relief. This can increase expected returns and, importantly, can be done without increasing overall portfolio risk.

Diversification wins

The key to this is that venture capital is a diverse asset class. The success of a venture-backed company depends on its ability to develop a product, find its first customer, or grow its business once it has found the product/market fit. Unlike the stock market as a whole, success tends to be independent of the economic cycle. However, getting a good price for exiting the company depends on big companies having cash on hand – so venture capital investments are not entirely independent of those listed. Research shows that, in practice, the correlation between venture capital and listed equity investments is slightly less than 0.5.

Research also shows that venture capital has a good expected return, with most surveys suggesting an internal rate of return (IRR) of high percentages for teenagers or 20+ year olds. Of course, there is a risk that goes with it. Taken in isolation, these are high risk investments. Even after taking this into account, diversification wins out when using standard asset allocation methodologies.

For investors with normal risk profiles (60/40 to 80/20 stock/bond portfolios), adding an appropriate proportion of venture capital can add 0.5-1% to expected annual returns without increasing overall portfolio risk, even without tax breaks. . In the long run, these small percentages add up. Over 20 years, an additional 0.7% annual return on a lump sum will add 15% to the final amount.

Golden Rule

Venture capital is not homogeneous and in the document we divide it in two. We use seeds to refer to early-stage investments – businesses that are starting up or finding their first customers. Scaling is used for businesses that are more advanced, have established a product and market, and need funding to grow. Having progressed further, scales should be less risky than seed investments, and we assume they have lower return and risk.

Optimal allocation of the venture capital portfolio

Venture capital weight (left axis) vs standard deviation %

Source: Hardman & Co.

The optimal allocations of the venture capital portfolio show the optimal allocations. The vertical dotted lines correspond to a 60:40 and 80:20 investor. We can see that, for medium risk investors, the optimal allocation is the medium to high teens in scale investments or the low teens in seeds. That’s comfortably above the usual 10% rule of thumb. Perhaps more interesting is what happens to the allocation of the rest of the assets.

Changes in optimal allocations for a 70/30 investor

Capital risk

Source: Hardman & Co.

Equity Bond Venture capital shows changes in optimal allocations for an investor 70:30 after seeding or scaling is added. This is the key to improving returns while maintaining constant risk. The equity/bond ratio in the rest of the portfolio also needs to be adjusted, with equities reduced. It makes intuitive sense. If we add a risky asset, even a small amount, we need to reduce the risk elsewhere in the portfolio. In this case, we are moving assets from a high-risk asset (stocks) to a low-risk asset (bonds).

Dispel misconceptions

This analysis undermines a few common reasons why investors avoid these areas. Sometimes it is believed that high risk investments are only for high risk investors. The white paper shows that this may be completely wrong.

If the asset diversifies, adding a small amount can improve returns for most investors. The analysis suggests that investors whose default portfolio contains only 30% stocks, which most would consider very low risk, would still benefit from additional risk capital.

The second misconception is that VCT and EIS should only be reviewed after retirement allowances have been exhausted. However, investing in venture capital through pensions is difficult and, by ignoring it for decades, investors could miss out on additional returns. The strategy should be to build venture capital investments alongside pensions – but not instead!

What about these tax breaks?

All of the above has been on raw venture capital, with no tax breaks. The EIS and VCT regimes are among the most generous in the world, and the tax breaks are there to reduce risk for investors.

Most investors can determine their effect on return on capital, but IRRs are more complicated. Using a distribution of returns drawn from research data, we show that EIS reliefs can increase IRRs by 1.5x, while the seed business investment program alleviates almost double IRRs. We estimate that there is also a small reduction in risk.

Unsurprisingly, this is having a dramatic effect on asset allocations, with much higher allocations to venture capital and improved returns. Our 60:40 investors can now add 1.7% to their expected annual returns, without increasing portfolio risk. Although these are significant changes, they may need to be treated with caution on a practical basis. As we suggest above, these often “compete” for investor money with pensions, which also enjoy generous tax relief. The reliefs can be seen as leveling the playing field, making the original analysis more appropriate. The paper also shows that the timing of tax relief payments means that illiquidity factors can become important. Nonetheless, the analysis with the tax breaks underlies the analysis without, suggesting that the latter is conservative and investors can use it with more confidence.

new normal

Research shows that venture capital should be an integral part of most investors’ portfolios. It can enhance returns and diversify risk. This suggests that investors and advisers must now demonstrate why they are not including venture capital in their portfolios – not justify its inclusion.

See also: Can responsible investing boost your portfolio?

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