Macro Investing and Where VC Fits In Your Portfolio
Updated: Jan 7, 2022
Authored by: Erik Hoffstadt, Edward (E.J.) Leo & Ashley Sogge
The simple truth is that most people, including veterans, are not very savvy when it comes to investing. There might be a few people in a given wardroom who understand the difference between the C-Fund and G-Fund or the tax advantages of a Roth IRA versus a traditional IRA. Even this basic knowledge isn’t as widespread as it should be. While service academies are excellent at delivering technical curriculum to their students, they often fail to address personal finance and investing topics. Before the Blended Retirement System, being a career military officer meant doing twenty years of service, at which point a lifetime pension would kick in upon retirement. The situation is now more nuanced, and more significant financial literacy and attention are needed to secure one’s financial future.
Risk and the Time Value of Money
Military officers are doing themselves a financial disservice by not investing outside of the Thrift Savings Plan. Investing is not “rocket science” despite what Wall Street might lead you to believe -- far from it. Investing is all about risk. Taking more risk means the opportunity for a greater return on your investment. Putting your money into a savings account is extremely low risk, and as a result, you will only enjoy 0.2% interest (on average) on those funds. That figure doesn’t even come close to keeping up with inflation, which is historically in the neighborhood of 1-2% (but can get as high as 10%+, like in the 1980s). This means if you just tuck your money away in a savings account, it will lose its purchasing power over time. The $1,000 you tucked away in your USAA savings account can buy you an iPhone today. However, 10 years from now, it won’t grow at a rate that will let you buy that same iPhone. Inflation will have driven up the iPhone price to approximately $1,200, but your savings account’s money will have only appreciated to approximately $1,020.
The answer to this problem is investing. While investing is inherently risky, not investing is historically far riskier. Every individual has specific circumstances that qualitatively determine their risk level.
Factors which determine risk level
Age - the further you are away from retirement, the more risk you can assume
Savings rate - the more money you can stash away each month, the quicker you can build or restore an emergency fund
Debt level - the more debt you have, the less money you can attribute to investments
Job security - the more secure your job is, the less likely you are to unexpectedly lose your income and ability to support yourself without liquidating assets needed for retirement
Net worth - the more money you have to your name, the more you have to lose
Personal risk appetite (the amount of risk that you can comfortably sleep at night) - the higher your risk appetite, the more you can comfortably lose while still pursuing your desired investment strategy
Planned major expenditures in the near term (buying a house, paying for graduate school, paying for a child’s college tuition, etc.) - the closer large expenses are, the less risky you want your investments to be so that you do not risk losing the money you’ll need in the short term
Looking at the above list, which we acknowledge is not exhaustive, service academy graduates (SAGs) can incur greater risk (if they are personally comfortable doing so) than a portion of their civilian counterparts. SAGs graduate with zero student debt and often make more than $100,000 a year by the time they are a few years into the military if you factor in tax benefits, health care savings, etc. Some specialties like medical doctors, special forces, and submariners often far exceed those figures. On top of that, SAGs have a degree from a top U.S. university, making SAGs competitive for well-paying employment once leaving the service.
The table below illustrates the different asset classes most common and available to SAGs and their corresponding historical returns in descending order of risk. There is a correlation between the amount of risk incurred by an investor and their return on investment. However, one must be aware that past performance is not always indicative of future performance.
Levels of Risk (riskiest at the top)
NOTE: There are countless other asset types like options, REITs, municipal bonds, corporate bonds, foreign developed market stocks, emerging market stocks, emerging market bonds, dividend growth stocks, cryptocurrencies, etc. The above list is only meant to be clearly illustrative of relative risk.
Below is a table that provides a more detailed illustration of an early-stage VC index versus the S&P 500 with an associated value-add. As you can see, the VC index outperformed the S&P 500 every time. This outperformance is despite the most significant bull market run in the United States’ (U.S.) history. For those with access to the venture asset class, the data clearly indicates that it is wise to consider adding it to your portfolio. The aim of the Academy Investor Network (AIN) is to provide SAGs with access to this relatively exclusive asset class.
Cambridge Associates LLC September 2019 Venture Capital Index (Data as of Sep 30, 2019)
AIN is not advocating that a SAG goes “full tilt” on risk, liquidates his or her life savings, and puts it all on red 12 at the roulette table. AIN is also not advocating that most of your investment dollars go into venture assets - far from it. Instead, we hope you’ll better understand there’s an opportunity for venture assets within your broader investment portfolio if your risk appetite permits (AIN will address how much you should consider allocating later in this article).
Value Creation Shift to the Private Markets
“On an absolute basis over the last five years, annualized private market gains for private companies was 33% higher than the gains of public companies. For Goldman Sachs, this means that value creation has recently shifted in favor of private markets.”
There are several factors to consider to understand the relative outperformance of early-stage venture capital to the broader U.S. economy. Since the “dot-com” bubble in 2000, there has been a significant shift towards value creation in the private markets. As Figure 1 below illustrates, the number of companies coming to the public markets for financing decreased significantly since the dot-com bubble burst. Breaking it down by decade, Figure 2 further illustrates the depressed number of companies going public since 2000.
Figure 1: NYSE and NASDAQ IPOs since 1980 with an offer price of at least $5.00
Figure 2: NYSE and NASDAQ IPOs with an offer price of at least $5.00 by decade
There are several reasons why this dynamic exists. Some of the primary reasons include:
Increased access to private funding and the rise of “private IPOs” (Series-D,E,F funding) means startups don’t necessarily need public funding to fuel their venture.
Startups are increasingly considering alternatives to IPOs such as acquisitions, direct listings, or special purpose acquisition companies (SPACs). In the past few decades, acquisitions constitute a very significant percentage of exits achieved by VC-backed firms. Thus, the general public never had direct access to invest in the company.
The increased regulatory burden and added costs associated with going public and maintaining a public company infrastructure deter some companies from doing so.
The 2012 US JOBS Act increased the threshold for the number of shareholders required to disclose financial statements (from 500 to 2,000). For example, the 500 shareholder limit played a role in Google’s decision to go public in 2004.
For the purposes of explaining why value creation has shifted towards the private markets, we will focus on reasons #1 and #2. According to the University of Florida professor Jay Ritter, the average age of U.S. tech companies going public in 1999 was four years. In 2018, that age increased to 12 years. Spending more time as a private company results in larger valuations before going public. According to Crunchbase news, investors invested $47B n private companies in 2010. By 2019, that number ballooned to $295B. Spending more time as a private company and the resultant higher number of late-stage funding rounds isn’t the only contributing factor to rising valuations. More money is flowing to private companies during the earlier stages (pre-seed, seed, and Series-A). The result is that companies don’t need access to the public markets to fund their venture.
This means that by the time a company goes public, the opportunity to have massively outsized returns has significantly decreased. When Amazon went public in 1997, it was only three years old and debuted at a valuation near $400M on $150M of revenue. Today, Amazon is one of three companies valued over $1T with a market capitalization of ~$1.5T. A $1,000 investment in Amazon during its IPO would be worth approximately $2M today. Now let’s compare Amazon’s story to Uber, who went public in May 2019. Uber had a market capitalization of ~$70B after its first day of trading. For someone who bought shares of Uber on the day of its IPO to realize the same returns as someone who did the same for Amazon, Uber would need to achieve a valuation of over $250T.
Another aspect to consider is that the general public never even has an opportunity to invest in many startups because they never enter the public markets at all - whether via an IPO, a direct listing, or a SPAC (another method of going public). According to the SEC’s data, only ~22% of VC-backed firms exited via an acquisition instead of an IPO in 1990. In the past three decades, this dynamic has completely flipped. Increasingly more companies are exiting via mergers and acquisitions (M&A). In 2008 and 2009, the percentage of M&A exits for VC-backed firms peaked at ~95%. Since then, the M&A exits rate has slightly decreased but remains relatively high at ~67% in 2019. This fact means that the general public never can invest in more than two-thirds of VC backed firms, which are some of the most exciting and high growth companies. While this public market to private market shift has been occurring, military members have been engaged. Further, many veterans may not have the professional contacts that will enable them to gain access to these private companies, particularly best-of-breed early-stage venture-backed companies. AIN intends to remedy this situation.
So How Much of My Portfolio Should Be Venture?
Unfortunately, there is not an exact answer to this question. So many different personal factors play a role in formulating a response. Thus, the percent allocation will be different for almost everyone. But using the Thrift Savings Plan lifecycle funds (target retirement date) as an example of risk tolerance based on age alone bears the following results.
Percent Asset Allocation of Various TSP Lifecycle Funds
Note how % allocation to capital preservation assets (G and F funds trend up as retirement dates draw nearer and % allocation to risk assets (C, S, and I Funds) trends down. The G Fund promises complete capital preservation (i.e. you are guaranteed not to lose any money).
TSP L 2060 Allocation Weighting Over Time
As the numbers show, the further you are from retirement (all other things equal), the “riskier” your portfolio should be. For example, the L 2060 fund is made up entirely of equities with a significant portion being in the I Fund, which tracks the MSCI EAFE index (developed equities markets outside of the U.S. and Canada). With these numbers in mind, it is reasonable to assume that a SAG could attribute anywhere from 2-10% of their portfolio to the venture asset class, depending on the wide range of risk factors to consider laid out earlier in this article. Someone with a higher savings rate and net worth could reasonably find themselves in the upper end of that range (or higher), while someone with children and college tuition coming due, might trend towards the lower end of the spectrum. It all comes down to your situation and risk appetite. Any investment decision should be made only after extensive thought and consideration.
You need to invest across a wide range of asset classes to include the public equity markets, bonds, and real estate. For most SAGs, these asset classes should be the significant majority of your investment portfolio. However, we hope the above information has at least illustrated a place for venture assets within your portfolio - somewhere to the tune of 2-10%, depending on your situation. AIN hopes to have demonstrated that while there is a real risk to not investing at all, there is also a risk of not investing in the early-stage venture asset class given market trends observed over the past few decades to continue for the foreseeable future.
If you have additional questions, please contact Emily McMahan (Emily@academyinvestor.com) and/or Sherman Williams (Sherman@academyinvestor.com). To contact the authors of this article, please email Erik Hoffstadt (email@example.com, Edward (E.J.) Leo (firstname.lastname@example.org), and Ashley Sogge (email@example.com)
Cambridge Associates US Venture Capital Index and Selected Benchmark Statistics, September 30, 2019, Report.
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