The Alternative Investing Stack in July 2016
In alternative investing, stories percolate up the stack (from companies and assets to investors to LPs) in hopes that money trickles back down.
This is true in venture capital, where the ascending story is one of economy-wide, software-driven disruption featuring slow incumbents ceding to aggressive startups leveraging expanding addressable markets and the proliferation of trends like cloud and mobile computing.
It is true in the buyout world, where the story always boils down more to bottom lines than to dotted ones.
And it is true in the world of hedge funds, where the story has always simply been, “we are smarter than everyone else in the market”.
In an environment where the U.S. 10 Year yields less than 2% and where yields in other countries have dipped below 0, pension funds and other managers of large pools of capital have been forced to look increasingly to alternatives.
This turn to alternatives by major money managers isn’t simply a recent reaction to low yields in other asset classes, however. In 1973, Yale’s endowment, led by David Swenson, first exposed itself to the Leveraged Buyout market. In 1976, it began investing in Venture Capital. And a few years later, the endowment added Absolute Return assets (known more commonly as Hedge Funds) to the portfolio. By the mid-1980’s, the endowment had moved sharply away from a traditional allocation strategy (public equities and bonds) to one more focused on the alternative asset classes mentioned above.
"In the past three decades the University’s Endowment more than met expectations, returning 13.9% per annum and exceeding results for traditional marketable asset classes by wide margins. In comparison, during the period, domestic equities generated 10.7%, foreign equities 8.7%, and domestic bonds 7.1% per annum. The University outperformed the equal-weighted mean return of colleges and universities measured by the National Association of College and University Business Officers by 5.0% per annum and bested its passive benchmark by 4.0% per annum over the thirty-year period."
Hedge Funds, Venture Capital, and Leveraged Buyouts continue to play a major role in Yale’s allocation strategy. As of its most recent annual report, the three asset classes mentioned above account for over 50% of Yale’s Endowment holdings. This alternatives-heavy approach is mirrored by many other top university asset managers.
Coupled with diminishing yields elsewhere, it is clear that allocating capital to non-traditional asset classes should be looked at as an important part of any portfolio.
Venture Capital
For most of 2015, VCs and other onlookers predicted a major shakeout driven by over-inflated valuations, high burn rates, and an IPO window firmly sealed shut.
The start of 2016 provided some further support for this view as no technology companies went public in U.S. markets and non-traditional investors like Fidelity (who are required to mark to market their portfolios) continued to downgrade former VC darlings like Dropbox.
The narrative has started to change recently, however. Q1 saw a record influx of capital into the venture market , much of it focused on backing growth stage companies. This news came on the heels of what turned out to be another strong year of fundraising among Micro-VCs (sub $100M funds that support companies earlier in their lifecycle).
At the company level, venture volume in Q1 — both in terms of capital and number of deals — was much higher than many expected. Add to that a trickle of encouraging financial news out of the so-called Unicorns and it is clear that much of last year’s hand-waving about a downturn was premature.
And with Twilio’s (pre-Brexit) IPO — which closed up over 90% on its first day — and Line’s impending or recent (depending on when you read this) IPO, it seems each phase of the venture funnel is and will remain in relatively strong health for the foreseeable future.
Leveraged Buyout
As with VC, 2015 was a year characterized by strong deal volume and fundraising from funds. Unlike the VC space, 2015’s LBO market was characterized by strong liquidity driven largely by cash-rich corporations willing to pay up to buy growth.
Deal volume increased year over year while exits and capital raised, although down from 2014, remained at strong levels.
For the most part, it seems the same headwinds driving increased allocation to venture capital are also making an impact on the buyout market. As noted by Ecstrat’s Emad Mostaque, it comes down to simple math :
The largest investors in the world are the so-called “real money” accounts such as the California Public Employees’ Retirement System (CalPERS) pension fund, which runs $300.3 billion, with $3 trillion of money managed like this. These funds typically have a long-term return target. In the case of CalPERS, to pay pensions a return of 7.5% nominal a year is assumed to pay future pensions while the pot is topped up by current public employees pension contributions. In an environment where the US 10 year bond yields 2%, this is very difficult to achieve. For every billion dollars you place in US 10 year bonds, a traditional safe asset, you would need to generate 13% a year on another billion dollars to make the return target.
This math problem, combined with a recent streak of positive cash flows to LPs via distributions from Buyout funds, signals a likely continuation of inflows to the space. And as large, potential acquirers continue building cash reserves and looking externally for innovation and growth, it is reasonable to expect the virtuous cycle to continue.
Hedge Funds
Above, we mentioned the influx of non-traditional investors into the world of Venture Capital. As Hedge Funds and other non-traditional venture investors failed to outperform in other asset classes, they turned their sights to the private venture market. This led to a boom in late stage funding (and valuations) and led many traditional venture players to l ament the new price-insensitive members of their ecosystem.
In Q1, this hit an inflection point as Hedge Fund managers became disillusioned with seeing only paper gains and began to slow down their investment pace .
At the same time Hedge Fund managers were souring on the idea of investing in the VC market, their backers seemed to be souring on the concept of Hedge Funds at all. As of April, the asset class saw net outflows in 6 of the preceding 8 months. On top of that, large asset managers like Metlife, JP Morgan, and AIG made headlines for reducing or completely cutting their exposure the to asset class (for what it is worth, Yale increased its allocation to Hedge Funds this year).
The pull back in hedge funds may have helped lead to the major run up in growth stage venture funds raised by firms — like Accel and Founders Fund — with a track record of performing across all stages in Q1 of 2015 as major money managers soured on the idea that paying whatever necessary to get involved in the market was a winning strategy. With the relative size difference, a small trickle out of hedge funds can make a major impact in the venture world.
More of the Same
So where does this leave us today? A 2015 Cambridge Report — that we have referenced multiple times in our writing — may say it all. Among a broad set of tracked asset classes and across almost every time horizon, early stage private investments (on a net to Limited Partners basis) outperform.
As trillions of dollars across the globe sit on the sidelines in sovereign debt with negative yields, the prevailing logic seems to be — as Andreessen Horowitz General Parter Ben Horowitz recently put it — that there is more available capital than ideas.
Like Horowitz, we have a daily, on-the-ground look at the real innovation happening across industries and across the globe and believe that this wave of innovation — along with the capital and ecosystems to support it — is still in its infancy and has a long arc of true value creation in its future.
