Should I invest in a VC fund or buy a business?

Earlier this year, one of our M&A team had a conversation with a cashed-up serial entrepreneur who was contemplating a change of strategy that involved putting some of his money into Venture Capital funds. A couple of his buddies had done so a few years ago and struck a gold vein. He was sceptical, to be fair, but wondered what we thought about that strategy in the current climate?

The entrepreneur was told that we’re not investment advisers. But we could give him an idea of the general chances of success, given that he did not have a particular VC fund in mind nor had he even created a shortlist.

The big problem is that nearly all VC funds are neither high quality nor lucky. You have to treat money going into a VC fund as a moonshot investment. That is because they are inherently very high-risk. Many startups fail, and only a few provide significant returns. The hope is that one or two big winners will offset the losses from the majority of investments that don't pan out.

Most investors way overestimate the odds.

Now a report has come out from Edward Stanley and Matias Øvrum, equity analysts at Morgan Stanley, that looks at the returns from VC funds and stocks over the past 20 years. There’s a great summary of this report on FT.com.

They found that the average VC fund doesn’t reliably outperform the average stock.

In fact over half of all global VC funds (and 50% of US funds) have lost investors money, i.e. produced negative returns.

The power law is a proven phenomenon of the venture capital industry. Just a handful of VCs generate nearly all of the sector returns.



Earlier research from Horsley Bridge, an investor in many venture capital funds, found that 4.5% of dollars invested into venture capital investments produced 60 per cent of total returns.

You may point out that there are thousands of unicorns (actually close to 2700) worth over $1 billion, spread over hundreds of cities (420 to be precise) and that plenty more will be hatching soon. Hang on a minute. After the boom at the end of 2020 and the spate of SPACS in early 2021, unicorn creation has slowed down rapidly.

You’re going to have to be either on the inside of the inside track or insanely lucky to place your bet on the right VC fund.

What’s more, VC valuations are a scary can of worms. Each round of capital raising sucks value from the previous round’s investors. It’s a game played with different classes of stock and associated rights to essentially make money out of the process. Check out the paper by Will Gornall of the Sauder School of Business and Ilya A. Strebulaev of Stanford Business School : Squaring Venture Capital Valuations with Reality which illustrates how common shares in the average unicorn are 55 per cent overvalued. And that all unicorns are overvalued.

Getting back to our investor, we suggested he stick to what he has done so well in the past and go buy himself another company.

Obviously, investing in a VC fund and making an acquisition are two totally distinct strategies, but we can still compare some important factors.

Risks
There are still risks in acquisitions, which vary based on the target company's maturity and industry. Established businesses with a track record of profitability are generally considered lower risk than startups. However, integration risks, cultural clashes, and overvaluation can pose challenges.

Returns
The potential for startlingly high returns in a VC fund is there, especially if the fund invests in a startup that becomes a huge success like WhatsApp or AirBnB. But these outcomes are rare. We already mentioned the
In business acquisitions, exponential returns are also rare, however returns are generally more predictable and are based on the acquired company's cash flows and synergies realised post-acquisition

Investment horizon
VC investments are long-term, often requiring a horizon of 7-10 years or more before seeing significant returns, if any. The investment horizon of business acquisitions can vary. Some investors might seek to turn around and sell an acquired business within a few years, while others might aim for long-term value creation.

Liquidity
Investments in VC funds are typically illiquid. Investors commit their capital for the fund's duration and usually can't easily exit before the fund winds down.
With acquisitions, it depends on the structure, but there might be more liquidity, especially if the acquired business is part of a publicly-traded entity. However, private acquisitions can also be illiquid.

Diversification
A VC fund typically invests in multiple startups, providing diversification within the high-risk startup space. An acquisition is a concentrated investment in one company, which can increase risk. However, investors or firms can diversify by making multiple acquisitions across different sectors.

And of course, there’s the all-important control and influence. Investors in a VC fund have limited direct control over individual portfolio companies. The VC firm's partners make decisions regarding investments and exits. Acquirers of companies usually have significant control over the acquired business, allowing them to implement changes, realise synergies, and influence strategy directly.

We might have simply recognised that our investor/entrepreneur had a mindset more suited to buying companies. In that he was more analytical and detail-oriented, focused on numbers, processes, and efficiencies. Less willing to bet on innovative ideas and unproven markets, and dare it be said, less gullible.

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