Most Retail Investors Should Steer Clear Of Venture Capital Firms

There’s been increasing pressure over the last few years to “do the little people investors a favor” and “allow” them put money into high-risk investments. An ability that traditionally had been allowed only to those of significant financial means because of the chance that people could lose what they had in their retirement accounts, with no recourse.

And, one by one, these offers have shown themselves to be less kindness than mechanisms for extracting money. The latest evidence is a study suggesting that venture capital investors are largely badly run because they unnecessarily waste a lot of money backing companies they should have known were going to fail.

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

The PE firms had been all for this because in a collective view, retail investors had a lot of money the general partners running private equity wanted. Management fees are high compared to many types of investment, averaging 1.5% to 1.75%, and once a target level of return is reached, the PE company gets 20% of additional profits.

Just think, individuals could invest in the businesses that might buy their own employers and lay them off to cut costs and improve returns on investment. If they didn’t ultimately push the company into default from greedily absorbing as much cash 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 touting people to invest some of their hard-won retirement savings in cryptocurrency. The same types of financial offal that have seen many billions in investment loss of late, with one company after another collapsing under the weight of the Ponzi scheme so much of that realm is.

Lummis went so far as to say that crypto investment “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’s been floated is for regular people to help fund venture capital firms. As one company with an axe to grind—and the opportunity to promote its views on the site of Nasdaq, the stock index heavy in VC-dependent tech—put it, “retail investors are the future of venture capital.”

This enticement is happening elsewhere in the world as well. “UK venture capital companies are inviting retail investors to help back early-stage entrepreneurs, opening up part of the market that has been hard for private investors to access, but which also carries particular risks,” the Financial Times wrote last summer.

Major risks, in fact, because of the business model. A VC company will hope to make the investment returns on a maybe 10% of its portfolio, hitching a ride on a company that becomes massive successful. That’s why you see so many jockeying for an early position in a Twitter or Facebook or whatever the hit du jour is determined to be. They need a slice of massive success because much of their portfolio will do okay, and a good chuck will virtually get written off.

But is that structure necessary? Diag Davenport, a sharp behavioral science PhD student at the University of Chicago Booth School of Business, just released a working paper that answered the question with a succinct “no.” Here’s the abstract:

Do institutional investors invest efficiently? To study this question I combine a novel dataset of over 16,000 startups (representing over $9 billion in investments) with machine learning methods to evaluate the decisions of early-stage investors. By comparing investor choices to an algorithm’s predictions, I show that approximately half of the investments were predictably bad—based on information known at the time of investment, the predicted return of the investment was less than readily available outside options. The cost of these poor investments is 1000 basis points, totaling over $900 million in my data. I provide suggestive evidence that over-reliance on the founders’ background is one mechanism underlying these choices. Together the results suggest that high stakes and firm sophistication are not sufficient for efficient use of information in capital allocation decisions.

He’s absolutely correct in saying that these firms focus heavily on founders’ backgrounds. From long observation, I’d go even further and say they get caught up with founders’ stories. It’s the sort of thing that explains why $700 million was put into a company like Theranos, because Elizabeth Holmes’ story was too juicy for them. (And the sexual connotation in the wording is intentional, because that becomes a big thing in a lot of the VC industry.)

If half the investments of VC firms on the average (and, yes, there will be those that are smarter) are predictably bad, their value as a class of alternative assets needs to be reconsidered.

Responsible and effective investing is boring. You see what a company does, not just what it talks. It takes patience and a willingness to wait over time for the returns to grow and compound. Lots of “experts” and “big money people” want a cut of your funds. Yes, there’s always risk to investment, but there’s also being smart about that risk. Let the money work for you and not go to someone’s yacht payments without a hefty and real return that you’ll keep.