All posts by Andrew Woods

The History of The Canadian Venture Capital Industry

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Humble Beginnings (1945)

The Canadian Venture Capital industry traces its roots back to the year of 1945 – with E.P Taylor forming a closed investment trust (essentially a VC enterprise) in order to acquire adequate shares to influence decisions in high growth companies. Now, more than 70 years later, the Canadian Venture Capital Scene has made a myriad of success garnering international interest and investments.

Being less volatile and relatively more stable than our US counterparts, the Canadian VC industry has also had its up and downs. This article will take a look at some of Canadian Venture’s highs, lows and our current state.

The Late Boomer (1997-2000)

In the early 1990s, the Canadian VC industry was considered modest – at best. Institutional investors stopped backing private funds due to lower than expected returns while Corporate Canada (Canada) was still coping with the recession and had little interest in venture capital.

However, funding recovered mid 1990s with the growing popularity of labour sponsored venture capital corporations (LSVCCs) and re-commitment of banks in 1994. Together, LSVCCs and bank groups captured 80% ($1.5 billion) and 15% ($740 million) respectively. The growth in this sector was predominantly driven by LSVCC tax benefits, liberalization of rules for institutional and foreign investors and the introduction of government equity funds through the business development bank of Canada (BDC).

Through the late 1990s, the Canadian VC industry experienced tremendous growth. The number of funds grew by 117% and VC investments increased by 460% between 1996-2000. Canada became increasingly sophisticated in the new world of tech while venture investment became more innovation oriented. In 1999 specifically, 824 companies obtained 989 rounds of financing backed by 2.7 billion – the highest it’s ever been.

Post dot.com Bubble Burst and Recovery (2000-2010)

When the technology bubble burst around the early 2000s, the initial blow did not hit the Canadian venture scene as hard as it did to the US (which experienced a decline of 70% in venture funding) – but the aftermath was felt gradually for over a decade.

In 2010, the venture funding scene experienced a historic low for the second time since the 2000 high at $819-million (government. Venture Capital Monitor). Evidently, the fallout of the technology sector in the 2000s had a lasting impact on the venture capital environment.

The lack of funding at the time was mainly attributed to two factors:

  1. Low levels of Canadian VC fund returns: Canadian VC incurred a 3.9% loss over the 10 years ended June 30, 2009 (CVCA) compared to the US VC index return of 8.4%.
  2. Low risk preference: A concentration of funds to a specific number of highly proficient companies with as much certainty as possible. In an article published by the Globe and Mail in 2010 quoted VCs to “wait for a market to be proven before making a bet on it” – an example being Facebook.

It’s also important to note the comparative youth of the Canadian venture capital industry compared to the US.”No comparable net to catch them”

When The Public Sector Stepped Up (~2013)

In 2011, Canadian VC fundraising remained stable and virtually unchanged over the year as $1.03 billion was raised. With the prolonged void in the startup sector, the government gradually increased their injections into the industry through the late 2000s into 2012. With the goal of encouraging more institutional, corporate and retail investors to back VC funds, the government offered forms of tax credits for angel investments and forming Investing in Business Innovation (IBI).

2012-2013 Signaled the positive change in direction for the Canadian VC industry. 2012 was the decade high VC fundraising year at $1.75 billion while 2013 was the introduction of the Venture Capital Action Plan (VCAP) established by the federal, Ontario and Quebec governments. While the increase in fundraising activity signaled positive market sentiment, the VCAP signals the focus the government has to increase venture activity.

Where We Are Now (2016 onwards…)

2016 marks the year of excitement as Canada puts itself on the worldwide destination for venture capital investment. With more and more founders STAYING in Canada, IRR returns for Canada increasing, strong engineering talent, and an increasingly proficient ecosystem around start-ups (i.e. accelerators, incubators) has attracted international attention.

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Venture Capital Terms Every Investor Should Know

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Measuring Returns

Cash-on-Cash

A rate of return that calculates the cash of income earned on the cash invested. It’s expressed as a ratio of annual before-tax cash flow to the total cash invested.

Internal Rate of Return (IRR) – Net

The measure of a portfolio or a fund’s performance that is equal to IRR after management fees and carried interest have been accounted for.

IRR – Gross

The IRR based on the performance of assets before taking account management fees or carried interest.

Minimum Viable Product (MVP)

The most basic form of the product that’s required to achieve proof of concept. Typically used to create new software that will be beta tested and upgraded with additional features.

Returned Capital

Refers to the principle payments back to the capital owners (partners, shareholders) of a business or investment.

Total Value Paid In (TVPI)

A rate of return ratio calculated by adding the current value of all remaining assets in the fund to all distributions to date, then dividing that by the total amount of capital paid into the fund to date.

VC Partnership Format

General Partners

Raise funds from a set of limited partners and manages the fund by allocating it to a portfolio of investments.

Limited Partners

Investors who provide capital to Venture Capital Funds. These may be high net worth individuals or pension funds.

General VC Terms

Capital Under Management

The amount of money a fund has to allocate to investing decisions.

Churn Rate

The percentage of customers lost in a subscription service during a given period of time.

Exit Strategy – (or liquidity event)

The IRR based on the performance of assets before taking account management fees or carried interest.

Follow-on Capital

When existing investors invest more money in a second round. Think of this as doubling down on a good bet.

Lead Investor

Usually the investor who puts in the most money into a company during a given round. They will often also negotiate, set terms, and take a seat on the board.

Micro-VCs

Smaller venture capital firms that often invest in seed stage companies. They often have a fund size less than $50 million and will invest between 50k to 500k in companies.

Subscription as a Service (Saas)

Selling a software as a subscription product. Saas moves the task of managing software to a third party service. Examples include: Google Apps, Salesforce, Dropbox.

Platform as a Service, cloud computing(PaaS)

Functions at a lower level than SAAS, providing a platform on which software can be developed and deployed. Examples include Heroku, OpenShift.

Proof of Concept

A demonstration of the feasibility of a concept or idea that a startup is based on.

Stages of Investment

Pre-seed Capital

An alternative to traditional family and friends round of financing. Typically, these rounds consists of 100k-500k of investment in exchange for 5-10% of equity at the idea stage, before any proof of concept. Funding is usually for early stage development of a minimum viable product (MVP – or a prototype). Known as the NEW seed.

Seed Capital

The round of financing after companies have already validated their value proposition, and will thus use this level of funding to find true market, develop scale and grow. Raising target is usually $500k to $2m.

Series A Preferred Stock

The name given to a company’s first significant round of venture capital financing in exchange for preferred stock. . Typically occurs when the Startup is generating strong revenue but generally no net profits. Raising target is usually $2m to $10m.

Series B (and C…etc)

The name given to subsequent rounds of preferred stock. Typically the higher the series, the less risk it carries due to validation and expansion of the company.

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Benefits of Alternative Investing

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What Are Alternative Investments?

Alternative investments (“alternatives”), refers to any asset other than stocks, bonds, or cash. Real estate, private equity, infrastructure, hedge funds, commodities, and venture capital are some of the most well known and invested in alternatives. Many of the largest and most sophisticated investors (i.e. Harvard, Yale) have been taking advantage of the benefits of alternative investing for decades.

Yale Relies Heavily On Alternative Investments

Yale Endowment’s Allocation to Alternatives Investments Continue to Increase Over Time

Sources: Yale Endowment Reports

The 5 Benefits of Alternatives Investments

1. They Diversify Your Portfolio

Rewind to 2008/2009. Your investment advisor proclaimed that your portfolio was adequately diversified because not only did you have Canadian assets, but you had equity and fixed income exposures to the American and international markets as well. The subprime mortgage bubble burst, correlations to the above-mentioned assets all went to 1, and you saw your portfolio decline by almost half.

Even Balanced Portfolios Correlate Strongly To Stocks

Correlation of Traditional 60/40 Portfolio to Risk Sources Over the Past 15 Years, 2000-2014

Sources: BlackRock, Federal Reserve, Informa Investment Solutions

AI could have helped lower your portfolio’s exposure to this financial crisis. To see why we can examine one of the main differences between a mutual fund (traditional) and a hedge fund (alternative). A mutual fund manager will construct portfolios by purchasing securities that they believe will perform well, while ensuring that there is no deviation from the investment mandate of the fund. On the other hand, a hedge fund manager has much greater flexibility in how they can construct portfolios. They can hedge, short-sell, and use derivatives, which allows them to capitalize on both rising and falling market environments. This flexibility results in hedge fund portfolios that are less correlated, uncorrelated, or even negatively correlated to the stock market.

Correlations Climb In Times Of Crisis

Regardless of Geography, All Stocks Moved in Sync With One Another

2. They Have an Absolute Return Mandate

That same advisor that thought you were properly diversified was also pleased with himself when your portfolio ‘only’ declined 35% vs. the 50% drawdown in the S&P 500. This ‘relative’ return mentality makes it difficult for you to know when your portfolio is doing well or not. In a bull market, you would be disappointed with a 5% return. However, in a bear market, you would be jumping for joy for that very same 5% return. Many alternative investments ignore their performance relative to any benchmark, but rather focus on generating absolute returns, that is, making money in all market environments. For example, take a portfolio that is comprised of various first mortgages that focus on residential, industrial, and commercial lending. A group of investors pool their money to invest across a diversified pool of income producing properties in the hopes of earning interest every month. The performance of the mortgage fund will depend on the manager’s ability to assess the credit worthiness of the borrowers, not whether the market was up or down that month.

3. They reduce portfolio volatility

Adding alternatives with lower correlations and absolute return mandates help reduce overall portfolio volatility, which to many professionals, means it helps reduce risk. Extreme market fluctuations are driven by human emotions. During a financial crises, investors notice substantial declines in many of their holdings. Scared that there is no bottom in sight, many investors panic and sell – usually at the worst possible time. A portfolio that exhibits lower volatility can help mitigate these dangerous swings in investor sentiment.

4. They capitalize on opportunities not offered in the public markets.

Have a look at Yale’s performance verse the traditional 60/40 model.

Yale Has Outperformed the 60/40 Model

Growth of a Hypothetical $10,000 Investment Over the Past 15 years, 1999-2014

Sources: BlackRock, Informa Investment Solutions, Yale Endowment Reports 2005-2014

How have they been able to achieve significant outperformance? Well, a handyman that has a full tool belt at his disposal is going to achieve better results than the handyman that has just a hammer and a nail. Right now the public markets are at elevated levels and finding compelling opportunities within them is proving extremely difficult even for veteran investors. What if you could look to the private markets and invest in a proven high cash-flow generating business where the person who founded the company several decades ago is looking to retire? Or, companies that are using cutting edge technology to try to revolutionize a certain industry, meet consumer demands, and improve society? The private equity and venture capital asset classes have historically provided investors with returns in the 15% and 20% range, and is one of the main contributors to Yale’s outperformance.

5. They enhance portfolio returns

In addition to tapping into high growth private market opportunities, there are other ways that alternative investments can beef up your portfolio’s return. First, realize that the alternatives industry attracts the best and brightest investment talent. How fees are structured and the resulting interest alignment between GPs and LPs means that successful managers can earn significantly more money than if they operated in the public markets. Now this doesn’t guarantee higher returns, but it surely increases the probability. What does guarantee higher returns is the liquidity premium that alternatives command. When you own a stock or bond, you can sell it at any point in time and convert that asset back into cash. Because many alternatives are illiquid compared to public market assets, investors should be compensated for this with higher returns.

Investment Returns Generally Increase with Degree of Illiquidity

Sources: Bloomberg, JP Morgan

Blackstone noticed that over the last 40 years, less liquid large capitalization stocks outperformed those with higher liquidity by almost 3% per annum. The outperformance was even greater with small capitalization (even less liquid) stocks and estimated to be well beyond 3% per annum for illiquid alternatives (private equity, real estate, infrastructure, venture capital, etc).

Typical Time Between Transactions

The Tradeability of an Asset Directly Influences its Value

Sources: Bloomberg, JP Morgan

Going forward, the returns from a traditional 60/40 stock-and-bond portfolio will likely fall short of satisfying your investment requirements. Including alternatives in your portfolio will ensure you’re actually diversified (when you need it the most) and most importantly, help you achieve the return required to meet your financial goals. Like stocks and bonds, not every alternative is created equally and there are risks that an investor needs to be aware of. The key is finding the right AI to include in your portfolio.

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Why Your 60/40 Stock-and-Bond Portfolio Is Dead

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Your portfolio is riskier than you think

Now that should be a big bank slogan! But we all know the banks will never say it, so we’ll be the one to warn you that your traditional 60/40 stock-and-bond portfolio may be dead. It has been the poster child portfolio allocation for a generation of investors, and has performed exceptionally well, especially since The Great Recession almost 10 years ago. That being said, the stock and bond market bulls are getting tired. It’s impossible to know when the bulls will go into hibernation and the bears will come out to play, but the following are good indicators that it may be sooner rather than later.

“I think it’s essential to remember that just about everything is cyclical. There’s little I’m certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.”
Howard Marks, Co-Chairman of Oaktree Capital, legendary investor and prolific writer.

Has the 30-year bond bull market topped?

As we know, interest rates typically have an inverse relationship to bond prices – as rates go up, bond prices go down and vice versa. If we look at history from a 10,000 foot view we would notice that the first bond bull market started after World War I and lasted until after World War II – a period of just under 30 years. Increased government spending to support the war efforts resulted in an inflationary environment which would typically lead to higher interest rates; however, the government kept rates artificially low during these times. It wasn’t until the government lifted these restrictions in 1951 that the bond bull market came to an end. Interest rates began to properly reflect this new inflationary environment, rising from sub-2% to nearly 15% by 1981.

Globalization + Market Innovations + Higher Demand

Then, during the 1980s, Federal Reserve Chairman Paul Volcker and then Alan Greenspan worked hard to reduce the annual inflation rate, leading to lower interest rates. Combine that with the globalization of the world’s markets, bond market innovations, and significantly higher demand from retail investors, and investors got to enjoy the next great bond bull market as bond prices rose to levels not seen in over 60 years.

A Look At Over 30 Years of Bond Yields

The chart below is where we are today. The magic number seems to be 30 with bond market cycles. But if you recall the inverse relationship between interest rates and bond prices, investors today have little to look forward to as there is only one direction interest rates will realistically go (taking a page from Howard Mark’s book, trees don’t grow to the sky and few things go to zero). Combine that with inflation expectations and the potential capital requirements to implement many of President Trump’s policies (unless he can get Mexico to pay for everything), and we have a very grim outlook for bonds.

Whither Equities?

Does anyone remember the subprime mortgage crisis, toxic derivatives that plagued the banks’ balance sheets, TARP bailouts, Bear Stearns, and Fed Chairman Henry Paulson asking his wife to pray for him just before Lehman Brothers collapsed? The Great Recession may be a distant memory of the past for many investors as the equity bull market just celebrated its eighth birthday! The S&P 500 bottomed on March 9, 2009 and has more than tripled since then.

History reveals a couple interesting points about this bull market and why its days may be numbered:

  1. The current bull market, at 96 months, is the second longest bull market since WWII. The longest bull market in modern history lasted 113 months, from 1990-2000.
  2. The current bull market is the third strongest in terms of market appreciation at 249%. The dot.com and baby-boomer bull markets garnered stronger market performance at 417% and 267%, respectively.
  3. Most importantly, no bull market has lasted more than 10 years.

Be Aware of the Role Time Plays and The Investment Cycle

Investors need to be cognizant of the role timing plays on investment results. How difficult or easy it will be to produce satisfactory returns will be foreshadowed by where the market is in the overall cycle. By looking at the table below from two distinct periods in time, we should be able to understand why investors from the 80s enjoyed such healthy returns and why investors from today should proceed with extreme caution. We can use the PE Ratio of the S&P 500 and the 10-Year Treasury yield as proxies for the health of the stock and bond markets. Simply, in 1980, stocks and bonds were well below their historical averages and therefore priced to deliver strong robust future returns. Today, assets are trading above their historical averages and therefore priced to deliver below-average future returns.

Year S&P 500 PE Ratio 10-Year Treasury Earnings Yield (1/PE ratio) Expected Portfolio Return (60/40 split)
March 1, 1980 7.39 10.80% 13.50% ~12%
March 1, 2017 26.31 2.50% 3.80% ~3%
Historical Average (since 1871) 15.65 4.58% 6.39% ~6%

What Alternatives Do Investors Have?

Unfortunately, when it comes to bull markets, there’s no listed expiry date. Deceivingly, the bull is at peak strength just before it goes into hibernation. If you, like most investors, have significant exposure to stock and bonds, then what options do you have to increase expected future returns while simultaneously reducing portfolio risk? Well, if stocks and bonds are the problem, then you need to look elsewhere, and alternative investments may be your best bet.

Learn More About Investing In Alternative Assets

What is Blockchain?

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Fintech Driving Blockchain Technology

Although there are number of key technological developments that are behind the emergence of Fintech, there is one technology innovation, Blockchain, that has emerged from the financial sector itself and is now being applied in other industries.  It has the potential to not-only transform financial services industry but also impact several other major industries.  Blockchain was developed as the foundational technology for cyber currency, Bitcoin.  Its potential is being explored across the financial services value chain.

What is Blockchain?

Blockchain is an implementation of a distributed database of transactions or distributed ledger.  The concept behind this is rather than having a single clearing party for a transaction, the network becomes the clearing house. The business ledger is shared across the network and each trusted party validates the transaction. The primary benefit of this is efficiency and increased transparency. Blockchain has the potential to reduce the cost of a transaction to near zero thereby potentially wiping out many traditional business models.   For more information on how Blockchain technology works we have provided links to several sources at the end of this article.

blockchain
things investors should look for in a startup

6 Things to Look For When Investing in Startup Companies

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Financial Performance

Is the startup company financially stable? Generating any revenue? Showing signs of growth? When investing in startup companies,  their current financial performance and future financial plans are vital to evaluating its potential.

Background & Experience

Is the management team experienced in the industry they are operating in? Have they had success with prior ventures? Research the company’s management team, look at their past business experience and make sure they are committed entrepreneurs.

Company Uniqueness

Is the company’s product or service unique and doing something new or different? A unique product or service sets the company apart from the competition and has a higher chance of success.

Business Model

Take a close look at their business model to see when they are planning on generating profits and how. The company has a higher chance to generate profits if the business model is clear, strategic and well thought out.

Market Size

It’s important that the company is solving a problem in a large or growing market. This allows the company to grow and scale, and tap into multiple revenue sources. Look at the competition operating within the market, a large growing market with low competition is a recipe for success.

Traction

How large and stable is their customer base? The amount of traction the company has achieved shows the impact they are having in their industry and helps indicate future performance.

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