And so, here we are.
“V” shaped, “L” shaped, Jagged. Who knows? One thing is for sure, uncertainty remains in abundance. And with that uncertainty so the price of risk remains rather difficult to fathom. Duff and Phelps estimated an increase in the equity risk premium of 20% to 6% with the advent of C19, and while we await the longer term potential of a vaccine or an effective viral management programme, it appears that this premium is the likely normalised investor expectation.
Risk on, risk off is a rather predictable function of the new paradigm that we face, at least as far as the public markets are concerned. That public equity markets seem overvalued, seems to this rather untutored eye, very clear. The cyclically adjusted Price/Earnings ratio, or CAPE, (our favored measure) sits at 29.07 for global equities, versus a mean and median of 16.72 and 15.59 over the past 120 years.
Many point out the relativity of yields across asset classes as a means of “justification” of such a valuation premium for public market equities against their long run average. This holds some limited intellectual curiosity but is a rather dangerous default position from which to invest, at least in our opinion.
It seems a little more than coincidental that the CAPE sat at 30 on Black Tuesday in 1929, and the chart below sets the 20-year performance of the market from 1929 through to 1950. For public market investors not familiar with this data, it may make for rather uncomfortable reading.
Source: Shiller/SBBi/IZY Capital
But we are not here to provide guidance on public market asset allocation. The question for us is what the current and future perception of risk means for the private, and more particularly venture markets. Here, long run data is rather difficult to come by, as frankly, the Venture Market is rather new.
Looking at the OECD data for venture capital funding over the last economic cycle does provide some insights.
Source: OECD, IZY Capital
According to the OECD data, venture capital funding has seen a 28% CAGR since 2008, even allowing for the negative compressions of 8%, 23% and 5% in 2009, 2010 and 2013 respectively. In many respects the past dozen years represents both a maturation and expansion of the industry. Venture has begun to grow up. And with it, so asset allocation has begun to shift in its favour. The National Bureau of Economic Research estimates that the average annualised return within Venture Capital is around 25%, a number not unsuprisingly often used as the hurdle rate in those interminable GP/LP agreements.
Of course for LP’s it is about selecting the right GP’s. For GPs alpha is generated from the neatest orginination process, and to some extent the ability to see trends 15 years or so out. Industry returns remain highly skewed to the leviathans, but in general our prose is not seeking to explain the reasons for this.
Rather we seek only to take a view on the following question:
“What is the likely outturn for VC asset allocation over the next economic cycle”
With a ceiling on public market equities created through current valuations, we might suggest that while we may be in an uncertain risk on/risk off period, if we had to gaze into the crystal ball we might expect asset allocators to look ever more favourably at venture. Contextually, there remain substantial issues over liquidity, but we would expect the maturation of the secondary markets to increase as the asset allocation does likewise. This requires a more concerted and joined up approach within an ecosystem which purports to embrace collaboration but in reality remains largely siloed and self interested. And this is coming from someone who sits in this ecosystem.
That private equity and venture capital are now part of the mainstream is evidenced by a number of datapoints (Source: McKinsey, Private Markets Comes of Age, 2019):
- The NAV in PE/VC has growth 7x since 2002, or twice that of the public markets;
- A more developed secondary market, capital call lines and longer duration funds are evolving to a point whereby patient capital and liquidity can co-exist in the private markets
Coming back to the earlier point around asset allocation, while mindful that these words are not prophetic nor biased by self interest, it seems that the valuation ceiling on the public equity markets combined with a distinctly unfavourable yield on sovereign, and treasury assets will continue to see capital flows into the private markets.
Venture is the life blood of our collective future. Even a marginal shift in asset allocation will have a significant bearing on innovation and productivity. Our simple math suggests that a 1% shift from public equities to venture would increase the total available annualised capital by in excess of 50%. A patient approach to capital allocation is a trend which will serve the forces of change well.