Understanding VC’s alpha generation edge

Alpha generation is a skill more frequently claimed by fund managers than genuinely earned. 

Alpha in public markets is defined as the excess return of an investment relative to the return of a benchmark. In a private markets context, alpha is a little more difficult to quantify given an absence of high-quality benchmarks, but it is made visible in the consistent above-average performance of certain fund managers.

This article will explain why private fund managers have greater scope to generate alpha than their public counterparts - and why this is particularly acute in venture capital.

Private markets feature a couple of advantages that provide sources of alpha relative to public markets:

1. Information asymmetries, including preferential access to deal flow and superior industry expertise

2. Scope for active value-add, including service support and active management

Where these advantages are ongoing, alpha generation has the potential to become persistent for these managers.

Information asymmetries

In public markets, funds have access to exactly the same set of securities with the same set of public information, mandated by regulations. Any public fund strategy, such as those of an exchange-traded fund or a mutual fund, is theoretically replicable by a competitor. Acting on inside information is a crime.

In private markets, asymmetric  information is an important driver of alpha generation. Funds do not have uniform access to information about potential investments, which makes the private markets pricing process far more subjective.

This information asymmetry creates greater space for better data to potentially lead to better outcomes - and on the flip side, worse information to lead to worse outcomes. The less information there is, the greater room exists for either finding value or misevaluating the potential of a company, which makes information asymmetries most acute among smaller, younger companies.

Information asymmetries are a major reason for the wider dispersion of returns in private markets than in public markets. And because these information asymmetries are typically greater the earlier in a company’s lifecycle you invest - there are far more unknowns - the widest range of outcomes within private markets tends to be in early-stage venture capital (VC) (see chart below).

Information asymmetries within venture capital

Better information within VC can take many forms, but can broadly be broken up into preferential access to deal flow and superior industry expertise:

• Preferential access to deal flow: A key source of outperformance in VC is that fund managers often have access to a network of entrepreneurs, angel investors, and other industry players. This can give them the opportunity to identify and evaluate potential investments before they become widely known. This network advantage is reflected in historical data, which shows that “centrality” within the VC ecosystem may help predict stronger fund performance. We leverage this insight in our fund due diligence process.

• Superior industry expertise: Successful VC funds often have deep knowledge and expertise in specific industries or sectors, which may allow them to identify and evaluate potential investments more effectively than other investors. This expertise can come from the fund manager's background or experience in the industry, or from the fund's team of advisors or consultants.

So, how does this information advantage manifest itself in the venture investment process? 

Well, venture fundraising rounds are the sole means by which to determine company valuations. Participating bidders (be they single funds or, more commonly, a lead investor and multiple secondary investors) typically do not know at what price other bidding groups have valued the company. If you have better information, be that through superior research, networks, or industry expertise, you can better judge the real value or, more pertinently, the potential value of these companies. 

In short, fundraising rounds allow you to apply and gain value from better information.

Scope for active value-add

The scope for active value-add is, again, much greater in the broader private markets than in public markets. 

Activist public investors may take a majority holding in a publicly-traded company, but unless they then take that business private they are still beholden to shareholders. Irrespective of this, almost all funds available to individual investors have very limited influence on their underlying holdings.

In contrast, private equity buyout funds, which typically have the maximum scope for value-add, take full control of companies and actively manage them. This offers much more space for alpha generation, though equally the chance of value destruction should the strategy be badly executed.

VC funds have limited day-to-day control as minority stakeholders, so while they may also provide hands-on support and guidance to their portfolio companies, it is typically limited to strategic advice. However, VC funds may provide services to their portfolio companies, such as supplying access to mentors, facilitating strategic partnerships, or connecting companies with potential employees, among other services.

Successful VCs are usually highly effective at empowering a founder - helping to amplify their strengths and allowing them to “do their thing” with the minimum necessary intervention.

Alpha generation can be persistent in VC

So, a combination of information asymmetries and scope for active value-add contribute to VC funds having much greater potential for alpha generation. And because both of these advantages derive from skill or knowledge, they are at least capable of being persistent over time. 

Indeed, there is significant quantitative evidence of persistence of returns in VC, also known as autocorrelation. This is largely derived from a combination of the qualitative factors discussed above, including network effects. And because venture funds unfold over a long period of time (10-plus years), skill has more time to manifest, while the impact of one or two lucky investments diminishes over longer timeframes. The cream eventually rises to the top.

The perspective of the founders themselves also feeds into performance persistence. An entrepreneur raising funds does not necessarily simply select the investment with the highest valuation. They frequently think about the longer term and may choose a lower valuation for the opportunity to work with a manager with a great reputation, a good track record, and strong networks.

Put simply, proven managers may be able to negotiate better deals.

Careful selection is imperative

What does all this mean for an investor?

Simply, manager selection is of heightened importance in VC. Persistent outperformance is inevitably mirrored by greater downside risk. If  some funds are outperforming the average, other funds must be underperforming it, and by an equal amount in aggregate. You want to be on the right side of this ledger.

For too long individuals have only been able to invest in what’s available, rather than what’s best in class. Many of the highest-performing funds are typically oversubscribed and do not need to work with brokers to raise capital.

We might be able to help. Come and talk to us about getting your clients access to highly-coveted VC funds.