I have been wondering recently about the drivers of VC investment. What tilts the scale between a term sheet and a ‘thanks but no thanks’. At a recent talk, I asked that of someone from a large UK based VC but the answer I got was about the light shining in the entrepreneurs eyes etc – well……So it was a welcome surprise to read a blog entry by Fred Destin from Atlas. It elaborated on the strategies being followed by VCs in the current environment and served to explained some of the recent investments and discussions I have seen and had respectively. Also, it was an interesting comparison of fixed income yield curve strategies to the VC investment focus.
First and foremost, what is a fixed income yield curve? – Its essentially the movement of short term interest rates expected over time. Hence, a downward sloping yield curve would mean that the market is expecting interest rates to fall. Corollaries to that are, of course, that the market is expecting growth to slow down, inflation to fall, the central bank to initiate supportive measures – one of which will be reduction of interest rates. As an investment manager, if you believe in the accuracy of the trend, you will start to increase your fund allocation in bonds and start moving away from stocks.
It’s completely the reverse for an upward sloping yield curve which would imply that in the medium to long term interest rates are expected to be higher than they are currently. Hence, it would mean that markets are going to expand, there will be restrictive monetary policies followed and interest rates will rise; further, prices of bonds will fall and hence the smart investment manager will move away from bonds to stock investments.
Disclaimer: For simplification purposes, we are considering only the impact of monetary policies and not fiscal policies etc on the shape of the yield curve.
Anyway, the next step is figuring out the investment strategies based on yield curves. The manager needs to decide the percentage allocation of funds across bonds of different maturities. There are various theories around the preferred allocation strategy and broadly they lead to the bullet, barbell and ladder strategies of investing – all funds in a single maturity, funds divided between early and late maturities – nothing in the middle, and funds maturing periodically, respectively. When would one go for the barbell – when the interim curve is anticipated to be flat and hence one hedges the risk between early and late stage. I can elaborate on this later. It could be an entry on its own.
And now we come to VC investment strategies. With recent discussions, the thought has been that VCs are shying away from high risk investments towards those where the revenue stream is validated and stabilised, there is a high visibility on the sales pipeline, and break-even is in sight i.e. a high growth firm where the VC is willing to pay a price to join the gang for a quick, lucrative exit. This would be the quintessential growth investing. High price, small equity share, good (nothing spectacular in terms of the multiple) exit. In fact, the most oft repeated VC words these days seem to be – ‘this is still too early for us’.
However, from the aforementioned article it seemed as if the tilt is more towards the barbell strategy of investing which includes the other half of the VC story i.e. extremely risky early stage investments – they may be very highly disruptive, with a high upside but with low capital intensity and a low burn rate i.e. value investing. The VC focus in this case is in identifying that unrecognized break-through player and getting a large equity share at extremely low prices. There wouldn't be too much competition but the exit, when it happens, will be a high multiple.
However, frankly, I would be interested in seeing what a VC LP memorandum looks like – how wide is the stage of investment. After all, we are moving from very early stage to perhaps even growth stage.
And a very interesting, albeit old blog: http://earlystagevc.typepad.com/earlystagevc/2006/09/vc_20_not_so_se.html
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