Not as much as you may think.
Conventional wisdom says that only ten venture-backed investments matter per year and that an equally concentrated number of certain venture firms makes those investments. However, our analysis shows that, on average, deals outside the top 10 have driven the majority of value creation in the asset class, and that in every year since 1995 at least 61 firms per investment year have accounted for investments in the top 100. In short, conventional wisdom may lead investors to miss attractive opportunities with managers that can provide exposure to substantial value creation.
Make no mistake: there is substantial, broad-based value creation in venture capital. As we discuss in a recently published paper, deals that generated a gross multiple on invested capital (MOIC) of 5x or greater accounted for an average of 85% of total gains in the top 100 investments per investment year, and, in most years, at least 60% came from investments that generated a gross MOIC of at least 10x. The pooled gross MOIC for investments outside the top 10 was greater than 4.6x in all mature years included in our sample set, and the average pooled gross MOIC of deals outside the top 10 across the entire data set was 8.5x.
It’s not just Silicon Valley–based, consumer Internet investments driving returns—companies represented in the top 100 investments show increasing diversity. Although many investors have abandoned investing in health care venture capital, health care investments accounted for 10% to 30% of the total gains produced by the top 100 investments in most years. Seed- and early-stage investments have accounted for the majority of investment gains in every year since 1995, suggesting that despite the deep pockets of late-stage investors, early-stage investments hold their own when compared on a total-gains basis.
Within the United States, the share of the top 100 investments originating from outside of the traditional venture capital hotbeds of California, Massachusetts, and New York has consistently been at least 20% of the total gains created within the United States. International investments have also accounted for a larger share of the top 100 gains: from 2000 through 2012, they represented an average of 20% of the total gains in the top 100, compared to an average of just 5% from 1995 to 1999. The tailwinds of lowered costs of company creation and increased access to cloud computing infrastructure, coupled with changing cultural mindsets around entrepreneurship and risk taking, suggest that international deals will account for an increasingly large share of the top 100 deals going forward.
Further, the composition of venture managers participating in the top 100 investments is not static. To be sure, certain franchise Silicon Valley firms continue to invest in an impressive number of the top 100 investments, but in every year since 2000, at least 57 firms have accounted for at least one of the top 100 investments, with the profits from those investments shared more broadly across the industry than conventional wisdom would assert. Although the top 10 firms in a given year have accounted for (on average) roughly half of the total gains generated for each year since 2000, there is little concentration in the firms that represent the top 10 over time.
More important, for the last ten years, 40% to 70% of total gains were claimed by new and emerging managers, a clear signal to investors to maintain more constant exposure to this cohort. Emerging managers have shown an increased willingness to capture the greater diversity in investments occurring in the top 100. Emerging managers are also highly likely (though not necessarily more likely than established firms in the top 100) to make their initial investments at the seed- and early-stage. Therefore, it behooves investors to have adequate diversification in their venture programs.
In every era, new firms have emerged and succeeded with focused models, relevant experience, and fresh networks that address the opportunity set before them. Indeed, some of these firms have forced established firms to innovate their own models to stay competitive. However, venture capital portfolio construction remains challenging; rigorous due diligence and selectivity are critical in adding newer managers and established managers alike to a portfolio. Only institutions with truly long time horizons (10 to 15 years) and the ability to absorb an extended J-curve (negative returns) should embrace this high return asset class. The next era will contribute its own evolutionary traits to venture capital. Investors that selectively add exposure to managers embodying these traits should be better positioned to benefit from venture capital’s own version of creative destruction.
Theresa Sorrentino Hajer is a Managing Director on the Cambridge Associates Global Investment Research team. Nick Wiggins, Associate Investment Director, also contributed to this article.
Read more of this research in our new research note, Venture Capital Disrupts Itself: Breaking the Concentration Curse.