Most Investors Are Underweight Venture Capital

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Most Investors Are Underweight Venture Capital
Most Investors Are Underweight Venture Capital

For some time, the VCT and EIS fund industry has wrestled with balancing the tax and investment aspects of its products. Unfortunately, the former is easier to articulate, and usually ends up being emphasised over the latter.

new white paper from Hardman & Co, How much should clients invest in venture capital? firmly tips the balance back in favour of the investment case. It applies a rigorous approach, using standard asset allocation methods to show that, for most investors, the best portfolio includes some venture capital, even without any tax reliefs. This can raise expected returns for clients. Importantly, the paper shows how this can be done without raising portfolio risk.

The key to this result is that venture capital is a diversifying asset class, almost as good as bonds when comparing with equities. This means that, even when allowing for the higher risk, including venture capital in investor portfolios can improve expected outcomes. For investors with an average risk profile, this suggests venture capital proportions in the mid-teens, comfortably above the usual rules of thumb.

All assets matter

The key to improving returns, while keeping risk profiles fixed, is to adjust the exposure to the other assets. The paper examines the effect on equity/bond portfolios when adding venture capital. The exposure to equities needs to be reduced by more than the new venture capital exposure, with the proportion of bonds increasing. This makes intuitive sense: venture capital is riskier, so we need to reduce risk in the rest of the portfolio. But it is worth it? This can add 0.5%-1.0% to annual returns, which adds up over decades.

This means that we can highlight two common fallacies about VCT and EIS investing:

  • “Investors need to have a high-risk appetite to invest in venture capital”: the analysis shows that even investors with ‘natural’ equity proportions as low as 25% can benefit from adding a little venture capital.
  • “Venture capital products such as VCTs and EIS funds are for when pension allowances are used up”: most investors cannot access venture capital through pension plans, and could miss out on higher returns for decades. Venture capital exposure should be built up alongside pensions, not after they are full.
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Tax still helps

While the paper focuses on venture capital without tax reliefs, they still make a big difference. The paper shows that they can increase expected IRRs by roughly 1.5x to 2x, with a slight benefit to risk. This makes them even more attractive from an asset allocation perspective, increasing target proportions significantly and boosting returns even further. Of course, in practice, pensions have similar levels of tax reliefs, so the original analysis is more appropriate. However, it does suggest that the original analysis has a degree of conservatism.

Brian Moretta, Head of Tax Enhanced Services at Hardman & Co said “the paper makes a compelling case for venture capital to be a normal part of most investors’ portfolios. Perhaps the VCT/EIS industry can move from ‘tax-efficient’ to venture capital with benefits!”