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

For some time, the venture capital trust (VCT) and enterprise investment scheme (EIS) industry has wrestled with balancing the tax and investment aspects of its funds. Unfortunately, the former is easier to articulate, and too often ends up being emphasised over the latter.

A new white paper from Hardman & Co, How much should clients invest in venture capital?, firmly tips the balance back in favour of the investment case. It applies a rigorous approach, using standard asset allocation methods to show that, for most investors, the best portfolio includes some venture capital, even without any tax reliefs. This can raise expected returns and, importantly, can be done without raising overall portfolio risk.

Diversification wins out

The key to this is that venture capital is a diversifying asset class. Whether a venture-funded company is successful depends on whether it can develop a product, find its first customer or scale up operations once it has found 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 the company exit depends on large companies being flush with cash – so venture capital investments are not totally independent of quoted ones. Research shows that, in practice, the correlation of venture capital and quoted equity investments is just under 0.5.

Research also shows that venture capital has a good expected return, with most surveys suggesting internal rate of returns (IRRs) of high-teen or 20-plus percentages. Of course, there is a risk that goes with that. On a standalone basis, these are high-risk investments. Even after allowing for this, the diversification wins out when using standard asset allocation methodologies.

For investors with normal risk profiles (equity:bond portfolios that are 60:40 to 80:20), adding an appropriate proportion of venture capital can add 0.5-1% to expected annual returns without increasing overall portfolio risk, even without any tax reliefs. Long term, these small percentages add up. Over 20 years, an extra 0.7% annual return on a lump sum will add 15% to the final amount.

Rule of thumb

Venture capital is not homogeneous, and, in the paper, we split it into two. We use seed to denote early-stage investments – companies that are starting out or finding their first customers. Scale-up is used for companies that are further along, have established a product and market, and need funding to grow. Having progressed further, scale-ups should be less risky than seed investments, and we assume a lower return and risk for them.

Optimal venture capital portfolio allocations

Venture capital weight (left axis) vs standard deviation %

Source: Hardman & Co

Optimal venture capital portfolio allocations shows the optimal allocations. The vertical dotted lines correspond to a 60:40 and 80:20 investor. We can see that, for average-risk investors, the optimal allocation is mid- to high teens in scale-up investments or low teens in seed. This is comfortably above the usual rule of thumb of 10%. What is perhaps more interesting is what happens to the allocation of the rest of the assets.

Changes in optimal allocations for a 70:30 investor

Source: Hardman & Co

Equity Bond Venture capital shows the changes in optimal allocations for a 70:30 investor after adding either seed or scale-up. This is the key to improving returns while keeping risk constant. The equity:bond proportion in the rest of the portfolio needs to be adjusted, too, with equities being reduced. This makes intuitive sense. If we are adding a risk asset, even a small amount, we need to reduce the risk elsewhere in the portfolio. In this case, we move assets from a higher-risk asset (equities) to the lower-risk one (bonds).

Clearing up misconceptions

This analysis undermines a couple of common reasons why investors avoid these areas. Sometimes there is a belief that high-risk investments are for high-risk investors only. The white paper shows that this can be completely wrong.

If the asset diversifies, then adding a small amount can improve returns for most investors. The analysis suggests investors whose default portfolio has only 30% equities, which most would consider very low-risk, would still benefit from adding some venture capital.

The second misconception is that VCTs and EIS are to be looked at only once pension allowances are used up. However, it is hard to invest in venture capital through pensions, and, by ignoring it for decades, investors could be missing out on additional returns. The strategy should be to build up venture capital investments alongside pensions – although not instead of!

What about those tax reliefs?

All of the above has looked at raw venture capital, with no tax reliefs. The EIS and VCT schemes are among the most generous in the world, and the tax reliefs are there to reduce risk for investors.

Most investors can work out their effect on returns 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 seed enterprise investment scheme reliefs almost double IRRs. We estimate there is a small reduction in risk, too.

Unsurprisingly, this has 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, with no increase in portfolio risk. While these are big changes, they perhaps need to be treated with caution on a practical basis. As we suggest above, these are often ‘competing’ for investor money with pensions, which also have a generous tax break. The reliefs can be seen as levelling the playing field, making the original analysis more appropriate. The paper also shows that the timing of payments from tax reliefs means illiquidity factors can become important. Nevertheless, the analysis with tax reliefs does underpin the analysis without, suggesting the latter is conservative and that investors can use it with more confidence.

New normal

The research shows that venture capital should be a normal part of portfolios for most investors. It can improve returns and diversify risk. It suggests investors and advisers now need to demonstrate why they aren’t including venture capital in their portfolios – not justify its inclusion.

See also: Can investing responsibly boost your portfolio?