Trends Watch: Venture Capital Deals and Opportunities

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Nick Markola, Venture Partner, VU Venture Partners.

What is your outlook for venture capital?

Outlook for venture capital (VC) remains positive, both for the number of deals and the opportunities in the space. I believe we will continue to see strong inflows into VC and a number of very promising startups to invest in. There has been a significant amount of capital allocated to the space in the recent years, but looking at the VC space from the portfolio construction perspective, there is still significant upside, despite slower flows recently (2019) or well-publicized debacles such as WeWork. In my opinion, there are three main reasons why we could continue to see strong flows into VC:

- Most investors have either zero or a very small part of their investment portfolios allocated to the space that has historically generated very attractive returns. One can expect allocations to VC to increase as the space continues to perform well, or if there is a correction in public markets. 

-The U.S. is still the global engine of innovation and with the developments in technology, machine learning, artificial intelligence (AI), etc.; we are in the midst of a revolution that is changing the world. The best way to capitalize on this revolution is through venture capital and smart money sees the opportunities. In addition, plenty of capital from recent successful exits is earmarked to be recycled back into VC.

- The risk-on, liquid public markets are due for a breather or correction at some point. When that happens, private investments could be the main beneficiaries, especially venture capital. Numerous studies have shown the challenges and difficulties of market timing and the longer-term benefits of private investments. Instead of fighting the losing battle of trying to time the markets, I believe more investors will embrace the approach David Swenson successfully deploys at the Yale Endowment -- that is, to allocate significant part of the investment portfolio to privates such as VC.   

What areas present the greatest opportunities?

The greatest opportunities I currently see are in fintech, frontier, consumer and the health care space.

By some estimates, machine learning and AI could impact close to 50% of current jobs in the U.S., by transforming, disrupting or eliminating many of them. The world of finance and banking is in the midst of such a transformation with many banks looking to lower cost, increase efficiencies and productivity via AI, machine learning and headcount reduction. Fintech startups are playing a role in this disruption. The world of lending, payments and transfers is rapidly changing thanks to the fintech innovation. Platform type companies in the fintech space, in my view, provide great opportunities.

The frontier space is the last unexplored frontier. Three of the greatest business minds and innovators of our time (Jeff Bezos, Richard Branson and Elon Musk) are dedicating significant personal resources and time for space exploration where the opportunities seem endless and unknown. Combine that with the recently created 6th division of the U.S. military, the U.S. Space Force, and that spells good opportunities for some innovating frontier startups to capture part of the upside.

The consumer space, I believe, will continue to see great opportunities. World population now exceeds 7.5 billion and by 2050 that number is expected to exceed 10 billion. Increased population size will result in increased demand for consumer innovation such as lab grown or plant-based foods and sustainability. I see more innovation and more opportunities in the sustainable food categories with seafood, chicken and milk being prime targets.

Increase in global population size and the continuous rise of people out of poverty in emerging and frontier markets are expected to result in increased demand for health care services and innovation as total addressable market (TAM) and the serviceable addressable market (SAM) are continuously growing. We may see major breakthroughs in biotech but I believe we could continue to see successes in the medtech category, especially in early diagnosis and treatment of some deadly diseases.  

What keeps you up at night?

Geopolitical risks and non-idiosyncratic risk. We live in an interconnected world where social media is disseminating (uncorroborated) panics/fake news faster than traditional news outlets can keep up. The world seems to be in the constant crisis mode, whether it is crisis in the Korean Peninsula, the Middle East, tensions coming out of Iran, wild fires in Australia or deadly virus that could impact the global trade. And certainly, one of these crises could easily get out of control, impact global trade, financial markets and consequently scare customers or dry out capital for startups.

In terms of VC specifically, the frothy IPO market is a concern as it delays exits. Another concern is the amount of liquidity in the space. Consequently, this liquidity has driven some valuations to very high and even unrealistic levels. Overfunding of some companies could cost investors dearly. Idiosyncratic risk can be managed to a degree by judicious investing; however, non-idiosyncratic risk is what really keeps me up at night.

What should investors consider about VC?

VC is a good diversifier in most investment portfolios. Actual allocations are investor specific but a healthy range should be approximately 3-10% percent of a portfolio.

There is always the itch to go directly, look for direct deals and avoid VC fund fees. If the investor has the capacity and resources to do the due diligence on many deals and has access to outstanding deal flow, then do it yourself (DIY) makes complete sense. However, it is prudent to engage a professional VC when above criteria is not met.

Another point to consider is the size of the fund. Oftentimes, size is the enemy of performance in asset management and this holds true for venture capital. Smaller funds tend to perform better than larger funds and earlier funds tend to deliver better results than later vintages.

Investors should consider what the right allocation to venture capital for them is and have detailed conversations with smaller, nimbler funds.  Despite the itch for direct deals, investors may be better served in the long run, if they focus on what they do best, and leave VC investing to pros.