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Assessing Venture Capital Returns for Efficient Investing in NanotechnologyBy Pearl Chin - Managing General Partner, Seraphima Ventures |
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(Editor's Note: Here is a short version of Dr. Chin's entire article, which is being printed in the Nanotechnology Law & Business Journal.)
With the advent of nanotechnology and the emergence of venture capital funds investing in early stage start-up nanotechnology companies, now is the time to take a closer look at the venture capital industry and ask some questions on how to evaluate venture funds who claim they can successfully invest in nanotechnology and avoid the investment pitfalls of the dot.com and biotech era.
In the aftermath of the dot.com and biotech bubble bursting, it becomes very important for investors to be savvier about how to prevent the considerable investment losses sustained during those periods of investing in technology. Nanotechnology is the next big thing in which to invest but investors are now much more cautious about investing in technology. However technology still offers excellent opportunities for significant returns but it may be useful for investors and venture capital funds to learn from past history.
A number of recent academic studies provide analyses of the returns to private equity that support this assertion. First, the findings show that private equity funds, both venture capital and buyout, generated returns that were roughly equal to and sometimes less than the returns of public equity. This contradicts the belief that private equity has been a source of abnormally high returns compared to public equity. This should be distressing to most investors in venture capital funds because this result indicates that the returns do not justify the risks and management fees.
This should not discourage investors from investing in private equity as there is still a need to diversify portfolios. However, this argument to invest in private equity for that reason would not satisfy the many small investors, whose 401K and other retirement plan monies is being managed by LPs that invest in such vehicles as venture capital. These small investors will demand a better management of the return for the risk being taken on investing their retirement monies. An investment manager that does not garner higher return for higher risk to his/her investors will likely not stay in that position for long.
A conclusion presented based on this data was that value can be created through more management and control by the VC. The studies also conclude that good venture capital management is a key factor for success. Funds with good performance was partly attributable to management limiting the size of their portfolio allowing them to select only the best possible investments which is a very targeted approach at choosing a few good deals rather than a carpet bombing approach. It was found that funds that concentrated their investments in a particular industry or investment type produced better returns. In other words, focusing on a particular sector or sectors of deep expertise can maximize returns. Of course, this increases your risk, but also the potential reward, because the portfolio is implementing a lower diversification strategy and because risk and return are directly related.
The conclusions drawn from these independent studies of the returns to private equity, in particular venture capital, indicate that it becomes important to pay more attention to assessing management potential, aside from just searching for fund managers with previous good track record to ensure a fund's success. The chances of a good management team member of a successful fund leaving to start a new fund is slim as they often have equity stake in those prior funds that require their continued participation. However, the upside is those types of managers are not the only game in town. The downside and the risk is how to figure out who is the real deal. However, how these potential abilities are currently being assessed without demonstrated ability or track record is limited in scope. There must be greater efforts to improve their understanding and the assessment of value of management. It is important to remember that good information and how a good manager makes appropriate use of information mitigates risk.
Perhaps this following illustration to describe management and its value may be helpful to elucidate the purpose and value of management. "Four workers can make 6 units in an eight-hour shift without a manager. If I hire you to manage them and they still make 6 units a day, what is the benefit to my business of having hired you? On the other hand, if they now make 8 units per day, you, the manager, have value." It is also evident that if they subsequently make 4 units a day, that there is a problem with the manager. The same analogy applies to service, or retail, or teaching, or any other kind of work. Can your group handle more customer calls with you than without as a manager? Sell higher value merchandise? Impart knowledge more effectively? That is the value of management - making a group of individuals more effective.
Hence, how will a manager of a venture capital fund return more value than the industry average which is in this case is also that of the public equity markets?
Another result of the data demonstrated that funds started by new firms in boon years exhibiting the largest capital inflows subsequently performed the worst. Such inexperienced funds resulted in too much money chasing too few good deals becoming more of a carpet bombing approach. The increase of capital flowing into venture capital during these flush times does not go to the best performing funds, but rather to those inexperienced new funds that are trying to jump on the bandwagon.
In addition to that, European VC funds lagged in performance relative to US VC funds. One possibility for that gap was the assessment that European VC's were more deal-makers than they are active monitors and still seem to be lagging in their ability to select projects and provide value-added services to their portfolio companies. This is supportive of the idea that an appropriate VC management could create similar value add to European deals as is done with U.S. deals as there is no evidence that the quality of deals in Europe are any worse than the ones originating from the U.S. If that being the case, imagine the opportunities available in Europe with a U.S. style investment and management philosophy and if there were a venture capital fund that could invest in European nanotechnology as put forth.
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Dr. Pearl Chin has an MBA from Cornell, a Ph.D. in Materials Science and Engineering from University of Delaware's Center for Composite Materials and B.E. in Chemical Engineering from The Cooper Union.
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This is another monthly column contributed by Dr. Chin to Nanotechnology Now. The full article appears in our January 2005 Premium Newsletter, along with other outstanding pieces by leaders in the field.
Read all her articles.
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