All Posts By

Andrew Woods

Venture Capital Management Fees and Carry Explained

By | Uncategorised

What is a management fee?

Traditionally, the GP (i.e. the fund manager) is compensated through a combination of a “management fee” and a “carried interest”. The management fee is an annual percentage of the funds committed to the VC that is used to pay the salaries and overhead of the GP. Expenses associated with creating and operating the fund, however, will normally be borne by the LPs (that is, is over and above the management fees). Most VC firms will charge a management fee ranging from 2% to 2.5% per year though some firms charge no fee at all. Larger funds may also see the fee decrease after 4-5 years and/or only apply to invested capital at that point.

What is a carry?

VC fund managers look to the carry (also known as the “carried interest”, “promote”, “back end”, etc.) as their primary form of compensation. The carry is the GP’s share of any profits realized by the fund’s investors, and can run from 15% to 30% but will typically be 20%. That is, after the LPs have received all of their invested capital back from the fund, 80% of any future distributions will be paid to the LPs while 20% will be retained by the GP (together with the management fee, this is often referred to as the “2 and 20” model).

Some funds may also have a “hurdle” rate, which is a rate of return that must be realized by the LPs before the GP will earn a carry. In other words, the LPs must first receive all of their invested capital back plus an annual percentage return (e.g. 8%) before the GP will receive their 20% of any remaining distributions.

For investors in venture funds, it would also be salient to ask when the carry is collected and whether it is net of management fees and expenses: though rare, some funds will collect the carry as funds are paid out (e.g. on the exit of a portfolio company); however, that creates the potential that the GP collects a carry before LPs have received their invested capital back. LPs should be looking for funds where they first receive all of their invested capital back before a GP is permitted to calculate its carry. This will also ensure that the carry is only calculated net of expenses and management fees.

 Venture Capital Fund Management Fee + Profit Split

Start Investing In Venture Capital Funds

More Articles on the Blog

How to Distinguish Between Venture Capital Funds

By | Uncategorised

In part 1 of our Investor’s Guide to Venture Capital we reviewed how VC funds are typically structured and how managers are compensated, in this post we’ll look closer at the Canadian landscape and the different characteristics of funds that potential investors should appreciate.

How do I distinguish between VC firms?

There are a variety of ways to differentiate one VC fund from the next, as different funds will have different focuses and investment theses on how they will create outsized returns for their investors. Every fund will have a specific mandate that has been pitched to its LPs, and it may be defined by a variety of factors, including those set out below:

1. Stage Of Companies They Invest In

One defining characteristic of a fund is what stage in the lifecycle of a company at which the firm is willing to invest. The industry typically sets out three stages for VC investment:

  1. Seed Stage
  2. Early Stage (also referred to as Growth Stage)
  3. Later Stage

Investment Stage Comparison

The Differences Between VC Funds Based on Stages They Invest In

Seed stage VCs will tend to invest smaller amounts at an earlier stage in a company’s growth, with a typical seed round investment of $250k to $1M for a target ownership of 10-25%. Typically, the company will have a small team in place, some market validation and an early working version of their product offering. Seed investors are making many small investments, “seeding” their portfolio in the hopes of nurturing as many as they can into growth stage companies. Many seed funds will also operate “accelerators” which are programs where they work closely and intensely with their portfolio companies to educate the management team and refine their focus and execution. The more active technology seed investors in Canada include Version One Ventures (Vancouver), Extreme Venture Partners (Toronto), Golden Venture Partners (Toronto), MaRS IAF (Toronto), Real Ventures (Montreal), Business Development Bank of Canada (“BDC” – national) and 500 Startups (national). Mark MacLeod, one of the pre-eminent observers of venture capital funding in Canada examined some of the data behind Canadian seed funding in a post from last year.

LP’s investing in a seed fund should be focused on:

  • The investment thesis underlying the fund in order to get a diversified exposure to opportunities that conform to it;
  •  The fund managers’ ability to source and select the most promising startups at an early stage; and
  • The fund managers’ ability to guide and influence their portfolio companies through a chaotic period of growth and execution.

Early (Growth) Stage

As a company progresses from seed to later stages, they generally carry less risk and are able to obtain more funding. They will generally target a “Series A” round to fund its continued growth and execution of its business plan – cheque sizes run from $1M to $5M in these rounds, usually split between a number of investors. Compared to ‘Seed Stage’ companies, early stage and later stage companies will be characterized by positive revenues; however, most will still have negative net income as they will continue to invest in order to scale the operations. At the early stage, Series A funding will typically be used to significantly ramp sales and marketing efforts to drive revenue growth and to correspondingly increase production. Some of the more active early stage venture capital funds across Canada include Vanedge (Vancouver), Plaza Ventures (Toronto), Relay Ventures (Toronto), iGan Partners (Toronto), Celtic House (Ottawa), iNovia (Montreal) and Innovacorp (Halifax).

Later Stage

As a report recently published by the Canadian Venture Capital Association (CVCA) shows, later stage VC is characterized by less deal flow with higher dollars invested. Funds investing in Series B, C and up tend to be larger funds writing bigger cheques. They include Avrio Capital (Calgary), OMERS Ventures (Toronto) and Georgian Partners (Toronto). While much has been made in the press about the shortage of late stage capital for Canadian companies, the reality seems to be that good companies will attract deep pocketed US and international investors. An interesting take is presented by Wellington Fund’s Mark McQueen, whose blog posts never fail to entertain. Recent studies by BDC and CPE show that US investors now represent roughly half the capital being invested in Canadian late stage companies.

Note that while some venture firms may specialize in a specific stage, there are also some that are agnostic (ex. BDC and OMERS Ventures). Also, many funds will reserve capital in their fund to participate in follow on financings undertaken by their portfolio companies, giving their investors exposure to the subsequent stages.

Venture Capital Funding Per Stage

 Amount of Venture Capital Funding Per Stage From 2013-2016 ($M)

Sources: CVCA

2. Industry Focus

The second way to distinguish between funds is through their focus on specific industries or sectors. Although the Canadian venture capital landscape doesn’t allow for as much specialization as their American counterparts, different funds will have different target focus. Similar to stage of investment, venture capital firms may also be agnostic when it comes to sectors.

The distinction may be based on industry focus, at a high level. Although the majority of Canadian VC funds will focus generally on technology, some will target any growth opportunity in specific sectors such as healthcare and life sciences (Lumira, Genesys), agriculture (Avrio), energy (EnerTech), water (XPV), cleantech (Cycle Capital, BDC) and retail & consumer (Campfire, Brand Project, District Ventures). Within software and technology, funds may be further defined by technology or vertical focus, such as fintech (Information Venture Partners, Portag3, Impression, Ferst), mobile (Relay, Golden) and Internet of Things (McRock).

3. Fund Size

The third way a venture firm can distinguish itself is through the size of the fund it raises – which also differ in levels of risk and return. Due to the high level of risk venture capital carries, the required rate of return for investors is often around 20% to 30%. As a result, large funds require a significantly higher number of large exits for investors in their portfolio to achieve meaningful returns. In contrast, microfunds can more easily generate the target 20% return with smaller exits that are more common with Canadian startups. While not a hard and fast rule, the larger the fund size, the more likely it is to focus on later stage investments.

Active Canadian VC Funds

 Overview of Active Canadian VC funds

Sources: BDC

It’s up to you…

When it comes to selecting a venture capital fund in which to invest, it’s important to understand how that fund selects their opportunities. Making sure their investment thesis matches with your personal goals as an individual investor will allow you to decide whether the fund’s opportunities and risk profile match your investment objectives. As shown in the below graphic the Canadian landscape is diverse and active.

Start Investing In Venture Capital Funds

More Articles on the Blog

An investor's guide to venture capital

An Investor’s Guide to Venture Capital

By | Uncategorised

For the average Canadian investor, the venture capital industry is an inaccessible, mysterious black box where Ferrari driving fund managers roll the dice in search of the next “unicorn” emerging from all of our collective Snaps, Likes and Tweets. Stories of instant (though sometimes unsuspecting) millionaires being minted off the latest tech IPO add to the mystique of early stage tech investing. The reality is a little more mundane, where conservative institutions such as pension funds, endowment plans and family offices have long allocated portions of their portfolio into carefully laid out investment theses put forward by individuals with enough credibility to attract millions of dollars worth of backing.

The Rise of Venture Capital

Simply put, venture capital (“VC”) firms use private capital to invest in high growth companies, typically in exchange for equity or instruments convertible into equity. The need for this source of capital arose from the lack of traditional funding (e.g. bank loans) available to entrepreneurs with little collateral. Such businesses carry a high level of risk and uncertainty unsuitable for bank loan portfolios, and as a result, are in need of risk capital that is willing to invest based on long term prospects rather than short term fundamentals. Alternatively, a growing business may require a large infusion of capital to rapidly expand its operations or to gather market share. This is where a venture capital firm comes in.

Investing in Venture Capital

Participating in a venture capital fund gives investors indirect ownership in a diversified portfolio of high potential technology startups. Though many startups will fail, the bet in investing in a fund is that the gains generated by that fund’s winners will more than offset the capital invested into the failures. Investors rely on the ability of the fund manager to not only select the right entrepreneurs and business ideas, but also to actively manage and nurture their portfolio companies into successful exits. Contrary to mutual fund managers, who can make a healthy living by collecting a percentage of assets under management regardless of performance (i.e. the management fees subsumed in the much maligned MER), the compensation of the venture capital fund manager is heavily tied into his or her ability to generate positive returns for the fund’s investors.

Structure of a Venture Capital Fund

how venture capital funds are structured

How VC Funds are Structured

Most VC funds are structured as limited partnerships in Canada. A fund manager’s first job is to raise investment capital for the fund, typically from high net worth individuals and/or institutional investors (i.e. pension funds and endowments) who become limited partners (“LP”s) of the fund. The fund manager(s) will usually create a separate corporate entity as the general partner (“GP”) of the partnership, which acts as the operator and manager of the fund’s activities. The goal of the GP is to deploy its capital into rapidly growing companies with the hope of earning a high level of return through an eventual sale or public offering of its investee companies. Most VC funds have an expected life of 7-10 years, where the managers are busiest in the first 1-4 years finding and evaluating new portfolio companies and deploying capital into them. Rather than collecting all of the money up front, larger VC funds will often seek “commitments” from its investors, and only collect the money through capital calls over the life of the fund. Smaller funds, on the other hand, will typically collect all of the committed capital up front.

How VC’s Make Money

Traditionally, the GP (i.e. the fund manager) is compensated through a combination of a “management fee” and a “carried interest”. The management fee is an annual percentage of the funds committed to the VC that is used to pay the salaries and overhead of the GP. Expenses associated with creating and operating the fund, however, will normally be borne by the LPs (that is, is over and above the management fees). Most VC firms will charge a management fee ranging from 2% to 2.5% per year though some firms charge no fee at all. Larger funds may also see the fee decrease after 4-5 years and/or only apply to invested capital at that point.

What is a carry?

VC fund managers look to the carry (also known as the “carried interest”, “promote”, “back end”, etc.) as their primary form of compensation. The carry is the GP’s share of any profits realized by the fund’s investors, and can run from 15% to 30% but will typically be 20%. That is, after the LPs have received all of their invested capital back from the fund, 80% of any future distributions will be paid to the LPs while 20% will be retained by the GP (together with the management fee, this is often referred to as the “2 and 20” model).

Some funds may also have a “hurdle” rate, which is a rate of return that must be realized by the LPs before the GP will earn a carry. In other words, the LPs must first receive all of their invested capital back plus an annual percentage return (e.g. 8%) before the GP will receive their 20% of any remaining distributions.

For investors in venture funds, it would also be salient to ask when the carry is collected and whether it is net of management fees and expenses: though rare, some funds will collect the carry as funds are paid out (e.g. on the exit of a portfolio company); however, that creates the potential that the GP collects a carry before LPs have received their invested capital back. LPs should be looking for funds where they first receive all of their invested capital back before a GP is permitted to calculate its carry. This will also ensure that the carry is only calculated net of expenses and management fees.

Venture Capital Fund Economics

venture capital economics

VC Fundraising + Allocation

Venture capital fund managers will most often raise a fund with a fixed amount of capital – e.g. they will raise “ABC Ventures Fund I” that will close off from any new investors once it has raised a targeted amount (e.g. a $50M fund has that much capital committed by its LP investors). Larger funds will allocate a portion of that capital towards initial investments into a portfolio of companies, and will reserve another portion to be set aside for follow on fundraises by those companies. The VC will have a pro-rata right to deploy more capital into any new rounds of fundraising undertaken by their existing portfolio companies in order to avoid dilution. By doing so, the fund is doubling down on its presumed winners to allocate more of the fund towards its highest growth companies.

Fund I, Fund II, Fund III..

As a fund nears full deployment of its capital allocated to initial investments, the managers will often raise a new fund (e.g. “ABC Ventures Fund II”). This will be a completely separate pool of capital and investors in Fund II will have no rights to profits generated in Fund I. That is, just because a manager has Uber, AirBnB and Spotify in its Fund I portfolio doesn’t mean investors in Fund II will benefit from those investments. Existing portfolio companies should only be used as a benchmark for the ability of the fund managers to choose and nurture successful startups. Having said that, some funds, such as Plaza Ventures, do not reserve capital for follow on investments but rather use capital from new funds to take up their pro-rata rights – that is, investors in Fund IV may acquire ownership in companies from Funds I to III if and when those companies undertake new rounds of financing. Other funds, such as Extreme Venture Partners, may syndicate their follow on rights to its limited partners – that is, they might let their investors invest directly into future rounds undertaking by its portfolio companies.

Becoming an Investor in a Venture Capital Fund

Traditionally, it has been difficult for individual investors to access VC funds. You generally need to know someone already in the the fund or be invited to participate by the Managing Partners. Furthermore, even if you are given the opportunity to join, most venture capital funds mandate that their investors write cheques of $100,000 or more to participate. This obviously makes it difficult for individuals to allocate just a portion of their portfolio to this asset class.

At Crowdmatrix, we are removing these barriers and providing accredited investors with access to venture capital funds without having to be an insider, and with a much more affordable minimum investment.

We currently have two of Canada’s leading venture capital funds raising on Crowdmatrix: Extreme Venture Partners Fund III and Plaza Ventures Fund IV. Participating in these funds can give investors an exciting diversified portfolio of high potential, high growth technology startups at an affordable minimum investment of $2,500.

Start Investing In Venture Capital Funds

More Articles on the Blog

The History of The Canadian Venture Capital Industry

By | Uncategorised

1945

Humble Beginnings

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.

1997-2000

The Late Boomer

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.

2000-2010

Post dot.com Bubble Burst and Recovery

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”

~2013

When The Public Sector Stepped Up

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.

2016 & Onwards…

Where We Are Now

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.

Start Investing In Canadian Venture Capital

Venture Capital Terms Every Investor Should Know

By | Uncategorised

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.

Start Investing In Venture Capital Funds

Benefits of Alternative Investing

By | Uncategorised

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.

Start Investing In Alternative Assets

More Articles on the Blog

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

By | Uncategorised

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

More Resources

What is Blockchain?

By | Uncategorised

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