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Traditional financial advice often ignores allocation to alternative investments like venture capital. However, comprehensive research by Hardman & Co in November 2021, applying Nobel Prize-winning Modern Portfolio Theory to UK venture capital markets, suggests this conventional wisdom may be leaving returns on the table.
The analysis, which examined historical returns, volatility, and correlation data, demonstrates that venture capital can:
*Based on historical data and modelling assumptions and using Modern Portfolio Theory models of risk represented by standard deviation of returns. Investing in early-stage companies will always be high risk. Past performance is not a guide to future performance.
The research suggests that venture capital behaves differently from quoted equities because companies are at different lifecycle stages – developing products and finding product-market fit rather than scaling mature businesses. This fundamental difference creates the diversification benefit.
Since venture capital companies succeed or fail based on different factors than public companies, their returns don't move in lockstep with the stock market. By adding venture capital and simultaneously rebalancing an investor's portfolio (reducing equities and increasing bonds), an investor can capture the higher expected returns of VC (15-22% vs 7% for equities) while the diversification benefit of the low correlation offsets the higher individual risk of venture investments, with a view to stabilising overall portfolio risk.
How this works: Based on an investor's current equity/bond allocation, we estimate the research-backed optimal seed-stage venture capital weighting using the modern portfolio theory.
Key assumptions: Expected returns of 7% for equities, 2% for bonds, and 15-22% for seed-stage venture capital (24-37% after S/EIS tax relief). Risk measured by standard deviation: 15% for equities, 7% for bonds, and 32-47% for venture capital. Correlation of 0.47 between venture capital and equities.
Note: This maintains your overall portfolio risk level by rebalancing equities and bonds alongside the seed-stage venture capital allocation. Seed investments typically qualify for S/EIS relief (50% tax relief vs 30% for EIS). This model will change for scale-up venture capital.
Important: Portfolios with higher proportions of equity will have higher risk. The calculator suggests how to maintain the risk balance of an equity portfolio when incorporating venture capital, with a view to maintaining estimated risk and optimising return potential.
The UK offers some of the world's most generous tax incentives for venture capital investment. These schemes can significantly enhance an investor's returns.
It's important to note that tax treatment depends on individual circumstances and may be subject to change. The availability of tax relief depends on the company maintaining its qualifying status.
While the research makes a compelling case for venture capital allocation, successful implementation requires careful consideration:
Venture capital investments can and do fail. Research by SyndicateRoom suggests that a portfolio of 30+ investments reduces the probability of capital loss whilst improving an investor's probabalistic returns. This is why fund structures or portfolio approaches are crucial – single company investments carry significantly higher risk.
Adding venture capital isn't about bolting it onto an investor's existing portfolio. The research indicates an investor needs to rebalance their entire allocation. For a typical 60/40 investor adding 8% seed venture capital, this means reducing equities to 37% and bonds to 55% with a view to maintaining a similar risk level.
Venture capital investments are typically illiquid for 7-10 years. Ensure you have adequate liquid reserves before allocating to venture capital. The tax reliefs also have minimum holding periods – EIS relief is clawed back if you sell within 3 years.
UK investors can access venture capital through:
A common mistake is waiting until pensions are maxed out before considering venture capital. The research suggests that building venture capital allocation alongside pension contributions optimises long-term returns. The power of compound interest means even small improvements in annual returns create significant wealth over time.