The Risk of Venture Capital Bubbles Beyond Wall Street
Herd behavior has long been a staple in financial markets. Boom-and-bust cycles are widely observed, creating opportunities for technical strategies, such as momentum investing. Simply chasing returns exacts a heavy cost from investors, however, and venture capital is no exception.
Tales of fantastic returns — now sensationalized by pop culture — support the growing popularity of venture capital. While The Social Network and Shark Tank make a positive impact by encouraging entrepreneurship and innovation, they are less effective at setting realistic investor expectations.
Herein lies the risk.
Increased flows to a space with low transparency and distinctly limited opportunities can be the classic setup for a bubble. In venture capital, this is magnified by the boom-or-bust nature of the companies themselves.
Public vs. Private Investments
All else being equal, private investments are structured to reward investors with higher returns than those of public markets due to the premium paid for liquidity. It is more difficult to sell a private stake in a company, and investors should be compensated for that. As this chart shows, they have been.
Thompson Reuters Venture Capital Index vs. S&P 500 Index
Since the August 2009 premiere of ABC’s Shark Tank, the Thompson Reuters Venture Capital Index has risen over 280%, more than double the return of the S&P 500. With this outperformance, a crowd of investors has followed. But investors’ ability to allocate capital efficiently limits this experience when other opportunities become more attractive.
Returns alone are an inadequate measure of bubbles, but they offer a reasonable place to start. Knowing valuation metrics, such as price-to-book and price-to-earnings, are approaching cyclical highs for the S&P 500, one has to consider how these look for private companies operating under the same economic conditions.
Rolling Three-Year Average Amount of Venture Capital Invested
Looking directly at venture capital funding, the most recent cycle provides useful context. In 1999, just before the bursting tech bubble caused venture capital to experience its worst returns on record, the three-year average amount of venture capital invested crested just above $30 billion.
Through year-end 2014, this measure was at its highest level in over a decade, more than $5 billion higher than it was in 1999.
Rolling Three-Year Average Number of Venture Capital Deals
While technology, public policy, and other institutions continue to support innovation, there remains a limit to the supply of good ideas and, as a result, profitable venture capital deals. As the above chart demonstrates, the three-year average number of venture capital deals is now at its highest level in 10 years — higher than it was in 1999.
Bubbles Built on High Expectations
Bubbles are rarely made clear in the moment, but observations in hindsight can provide useful context. As investors chased internet companies into the year 2000, brokerage made their stocks easier to buy, and the headlines touting huge profits further supported the frenzy.
Like the Gold Rush 150 years earlier, the dot-com bubble flooded California with unrealistic expectations. Instead of financial feasibility, unbridled optimism fueled the rise of now-extinct companies like DigiScents, iNetNow, and Pets.com.
Understanding businesses and their profitability took a backseat to awe-inspiring technology. Chasing this detached investments from their true valuations while profitable companies underperformed.
Today things are different, yet similarities remain, as companies like General Electric launch ad campaigns stressing their relevance versus apps. This example should sound the alarm for the future — according to the research firm Gartner, less than 0.01 percent of consumer mobile apps will be considered a financial success through 2018.
Due to the funding environment and burgeoning interest from the media, it is increasingly critical to set realistic investment expectations. With the chances of finding the next billion-dollar start-up estimated at one in five million, looking beyond rising bubbles for more tangible value may offer the best opportunity given the risks.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©iStockphoto.com/Hong Li