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Updated
Assessing Venture Capital Returns for Efficient Investing in Nanotechnology – Short Version

 

 

The entire article is being printed in the Nanotechnology Law & Business Journal but here is a short version of it.

With the advent of nanotechnology and the emergence of venture capital funds investing in early stage start-up nanotechnology companies, now is the time to take a closer look at the venture capital industry and ask some questions on how to evaluate venture funds who claim they can successfully invest in nanotechnology and avoid the investment pitfalls of the dot.com and biotech era.


In the aftermath of the dot.com and biotech bubble bursting, it becomes very important for investors to be savvier about how to prevent the considerable investment losses sustained during those periods of investing in technology. Nanotechnology is the next big thing in which to invest but investors are now much more cautious about investing in technology. However technology still offers excellent opportunities for significant returns but it may be useful for investors and venture capital funds to learn from past history.


A number of recent academic studies provide analyses of the returns to private equity that support this assertion. First, the findings show that private equity funds, both venture capital and buyout, generated returns that were roughly equal to and sometimes less than the returns of public equity. This contradicts the belief that private equity has been a source of abnormally high returns compared to public equity. This should be distressing to most investors in venture capital funds because this result indicates that the returns do not justify the risks and management fees.

This should not discourage investors from investing in private equity as there is still a need to diversify portfolios. However, this argument to invest in private equity for that reason would not satisfy the many small investors, whose 401K and other retirement plan monies is being managed by LPs that invest in such vehicles as venture capital. These small investors will demand a better management of the return for the risk being taken on investing their retirement monies. An investment manager that does not garner higher return for higher risk to his/her investors will likely not stay in that position for long.

A conclusion presented based on this data was that value can be created through more management and control by the VC. The studies also conclude that good venture capital management is a key factor for success. Funds with good performance was partly attributable to management limiting the size of their portfolio allowing them to select only the best possible investments which is a very targeted approach at choosing a few good deals rather than a carpet bombing approach. It was found that funds that concentrated their investments in a particular industry or investment type produced better returns. In other words, focusing on a particular sector or sectors of deep expertise can maximize returns. Of course, this increases your risk, but also the potential reward, because the portfolio is implementing a lower diversification strategy and because risk and return are directly related.

The conclusions drawn from these independent studies of the returns to private equity, in particular venture capital, indicate that it becomes important to pay more attention to assessing management potential, aside from just searching for fund managers with previous good track record to ensure a fund’s success. The chances of a good management team member of a successful fund leaving to start a new fund is slim as they often have equity stake in those prior funds that require their continued participation. However, the upside is those types of managers are not the only game in town. The downside and the risk is how to figure out who is the real deal. However, how these potential abilities are currently being assessed without demonstrated ability or track record is limited in scope. There must be greater efforts to improve their understanding and the assessment of value of management. It is important to remember that good information and how a good manager makes appropriate use of information mitigates risk.


Perhaps this following illustration to describe management and its value may be helpful to elucidate the purpose and value of management. “Four workers can make 6 units in an eight-hour shift without a manager. If I hire you to manage them and they still make 6 units a day, what is the benefit to my business of having hired you? On the other hand, if they now make 8 units per day, you, the manager, have value.” It is also evident that if they subsequently make 4 units a day, that there is a problem with the manager. The same analogy applies to service, or retail, or teaching, or any other kind of work. Can your group handle more customer calls with you than without as a manager? Sell higher value merchandise? Impart knowledge more effectively? That is the value of management - making a group of individuals more effective.


Hence, how will a manager of a venture capital fund return more value than the industry average which is in this case is also that of the public equity markets?


Another result of the data demonstrated that funds started by new firms in boon years exhibiting the largest capital inflows subsequently performed the worst. Such inexperienced funds resulted in too much money chasing too few good deals becoming more of a carpet bombing approach. The increase of capital flowing into venture capital during these flush times does not go to the best performing funds, but rather to those inexperienced new funds that are trying to jump on the bandwagon.


In addition to that, European VC funds lagged in performance relative to US VC funds. One possibility for that gap was the assessment that European VC’s were more deal-makers than they are active monitors and still seem to be lagging in their ability to select projects and provide value-added services to their portfolio companies. This is supportive of the idea that an appropriate VC management could create similar value add to European deals as is done with U.S. deals as there is no evidence that the quality of deals in Europe are any worse than the ones originating from the U.S. If that being the case, imagine the opportunities available in Europe with a U.S. style investment and management philosophy and if there were a venture capital fund that could invest in European nanotechnology as put forth.
There are many instances of venture capital deals achieving fantastic returns. This indicates that the private equity firms have not yet achieved their potential and there is much room for improvement and that new approaches in venture capital investing should be considered more seriously. Change can be a good thing but it will likely be scary for many who prefer to continue in the current methods because they have become accustomed to poor performance being the norm. However, this becomes a problem if even a few investors take the chance on a different investment approach, perhaps one that is considered a contrarian approach by some, and who then get rewarded with returns appropriate for the risks they took on for something new and untried. At that point, there will be many fingers pointing at investment managers as to why they were not able to recognize value when others did. This is certainly an indication that investors should change their decision process on how they choose venture capital funds in which to invest.


If a traditional VC fund is considered successful based on a 1 in 10 hit rate using a carpet bombing approach to deal selection; then when a new VC fund comes along offering a management team with as good deal selection abilities in terms of investment and technology experts they would be expected to do at least as well. If in addition, the new fund also offers credible management capability for each company invested, this can only increase the probability of success.


Seraphima Ventures’ business model is based on the assertion that better management oversight is what tips the scales in favor of a successful fund. These studies support Seraphima Ventures’ business model which asserts that management abilities is a major factor for determining fund performance and success. If a new venture capital fund with a team that professes to offer explicitly superior management capability, such as Seraphima Ventures, potential investors may wish to take a closer look at what they are offering as it seems they may well have figured out on their own, without the studies, how much more that added management value may be worth. As Seraphima Ventures is focusing on international investments that investment management philosophy can only improve performance from European investments as well.


Management is both art and science. It is the art of making people more effective than they would have been without you. The science is in how you do that. A manager's most important and most difficult job is to manage people. You must lead, motivate, inspire, and encourage them. And sometimes you will have to hire, fire, discipline or evaluate employees. Investors are encouraged to increase their understanding of management and assessing its value since it is not straightforward.


Hence the ability and skill of a VC to understand these resu
lts, management and market dynamics and to translate it into an investment strategy for his or her portfolio of companies, could potentially directly translate into significantly higher returns than the public equity markets. Investors are strongly encouraged to do their due diligence on profiling the capability of the management team members of any fund.
A key takeaway is that these conclusions apply to any industry where venture capital investment internationally is possible, not only to nanotechnology. However, it would be best to implement these strategies now to optimize returns investing in nanotechnology and to avoid a nanotechnology bubble.

Seraphima Ventures
90 John St., 6th Fl.
New York, NY 10038

US: +1-212-861-3298
US: +1-212-656-1481 Fax

UK: +44(0)7986 807 580
UK: +44 (0)20 76812390 Fax
www.seraphimaventures.com

 

The contents of this page, including the views expressed above, are the responsibility of the author. They do not represent the views or policies of Nano Tsunami Dot Com, except where explicitly stated.

 

Dr. Pearl Chin
PhD, MBA

 


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