When you look at asset classes, venture capital is the one that people don’t plunge into with both feet. Money managers can allocate to five classes of alternative assets; Real Estate, Hedge Funds, Leveraged Buyout/Debt, Private Equity, and Venture Funds. VC is by far the smallest allocation.
Based on recent returns, it shouldn’t be.
I think one of the reasons that venture capital gets under-allocated goes straight to behavioral economics. I was thinking about this after reading Michael Lewis book, “The Undoing Project”. One of the psychological constructs that behavioral economists have uncovered in humans is loss aversion.
Loss Aversion is where “losses loom larger than gains” (Kahneman & Tversky, 1979). The pain of losing is psychologically about twice as powerful as the pleasure of gaining, and since people are more willing to take risks to avoid a loss, loss aversion can explain differences in risk-seeking versus aversion.
I have personal experience wrestling with loss aversion. It’s powerful and can cause you to make decisions that are not rational. This part of behavioral economics rings loud and clear with me. We can track it in different ways throughout our daily lives.
Chicago Booth Professor Richard Thaler wrote a paper with Kahneman and Tversky. It’s titled The Endowment Effect. I think it further explains preferences for asset allocation when layered over the concept of loss aversion. The endowment effect says that once people are given something, it’s very hard to get them to switch to something else-even if the something else is a better choice.
Based on recent returns, venture capital outperformed other alternative asset classes. Prequin writes, “venture capital funds have outperformed all other private equity strategies over the one-year period to March 2015, with a horizon IRR of 20.1%. In this one-year period, buyout achieved a horizon IRR of 16.7%, fund of funds 15.1%, all private equity 14.2%, mezzanine 12.4% and distressed private equity 6.2%, showing that distressed private equity vehicles have pulled down the overall private equity horizon IRR. The only private equity strategy to exceed the venture capital one-year horizon IRR is buyout, which posted a horizon IRR of 21% in the 10-year period to March 2015.” However, honest venture capitalists tell their investors that they are guaranteed to lose some money. When a money manager hears that, no doubt the “loss aversion” psychology creeps in. Since many of them aren’t invested in VC as an asset class, they look for information to justify their confirmation bias. Given the pressures money managers are under, it’s hard to blame them.
When one starts to dissect the venture asset class it gets interesting. Fund managers that are emerging have a tendency to get better returns. Funds that are smaller than $250M in fund size tend to get better returns. But, emerging managers and smaller funds have more trouble raising money than larger funds.
It’s counter intuitive but when you think about behavioral economic theory it makes total sense.