Well, we promised. This is a follow-up to our last piece on expected returns for a private portfolio. This time we are going to illustrate a variety of portfolio outcomes with some numbers. However, there IS a catch. Humans are not good at forecasting the future so these returns outcomes are just a guide. A bit like a US-NATO promise to Estonia – we might send military forces to fight off an attack from Russia, but then again we might not. The good news for investors (for Estonia not so much) is that history can provide some confidence but no guarantees. History, in this instance, is the long-run return on private assets which we referenced in last week’s article. As a refresher, here is the reference table we used (Source: Pitchbook):
We noted the various categories of assets and concluded that Spark investors would be mostly invested in private equity and venture capital type assets. Then we decided to use 12% as a conservative ‘base case’ annual growth hurdle (IRR) expected of a portfolio with that mix of assets and quantified that growth over 10 years:
“In real terms (and compounding those rates [12%] of return) that equates to an initial investment of €10,000 growing to €31,000 over 10 years. For context, a fund with publicly listed equities would be expected (by financial planners) to generate 7% returns per annum and thus turn €10,000 into €19,600”
However, many of the Spark investment opportunities are very early-stage (higher risk) so it would be reasonable to expect something in excess of this 12% base case growth/returns scenario. Rather than use another headline number, we thought this article would be an opportunity to build a returns scenario from the bottom up. In other words, we would use illustrative portfolios of 25 investments each and explore three different mixes of outcomes. Our reasoning for using a portfolio of 25 investments is that this approximates to what many of our Private Portfolio (service) investors are currently trying to target/build as a personal portfolio over three years. The other assumptions used across the different illustrative portfolios are as follows:
Total investment cost = €50,000
Position size = €2,000 equally invested across 25 companies
EIIS tax rebate rate = 37%*
Holding period = 10 years
*The EIIS tax rebate rate is a ‘blend’ of the new standard rate of 35% and the higher rate of 50% applied to pre-operational businesses.
Now, let’s consider our first portfolio. According to the US Bureau of Labour Statistics, 65% of start-ups go out of business within 10 years. So let’s use that historic 65% failure rate as a future outcome for our first portfolio. In other words, 16 of our 25 portfolio companies will end up being worth zero. With the remaining 9 companies, we are going to assume that 5 of them become unspectacularly profitable and grind out a typical equity return of doubling every ten years(7% per annum). The final 4 companies are expected to be successful exits or ‘wins’ generating returns of between 7x and 15x. The table below illustrates those outcomes with an overall portfolio rate of return (IRR) of just over 13%. This equates to a multiple of 3.4x of the initial investment cost MINUS your EIIS tax rebate.
Portfolio 1:
The above example shows how important tax is to the initial cost or valuation multiple paid for your investments ie a 50% tax rebate cuts in half the valuation multiple paid. This portfolio generates a respectable 13% return but in the next example we’d like to demonstrate the importance of “winners”. So, in Portfolio 2 we raise the failure rate to 20 companies (80%) and model the impact of two big exits of 20x and 40x. This scenario delivers a superior IRR (vs Portfolio 1) of 15.4% and a multiple of 4.2x your initial cost of investment:
Portfolio 2:
Clearly, a return of 40x on a single investment would be huge but for ‘unicorn’ followers of companies reaching billion dollar valuation status this is the equivalent of a €25m company growing to €1 billion. Rare, but increasingly possible given the research team at Dealroom estimate 100 ‘unicorns’ have entered the billion dollar club every year since 2018. However, if the mention of unicorns smacks of fantasy territory let’s look at a more ‘diversified’ mix of outcomes in a portfolio. In particular, we want to model a portfolio reflecting some of the themes (including Spark’s risk management process) we touched upon in our first article of this series. Portfolio 3 is a mix of the following themes:
Recovery: Failure of ‘asset lite’ businesses could actually deliver some recovery values due to the data base built, team domain expertise, customer relationship assets etc.
B2B: Almost 70% of Spark investments are business-to-business (B2B) companies in a world where corporate VCs (CVC) are increasingly active eg Google has acquired more than 200 start-ups over the years.
Taxation: Due to higher capital gains (CGT) and income tax (dividend taxation) regimes in Europe and particularly Ireland the ‘hurdle’ or exit/return expected of a young company must be commensurately higher to compensate institutional investors.
Quality: Start-up funding is, bluntly, more scarce in this part of the world and Spark probably turns down 9 out of every 10 investment opportunities. In theory, we are already investing in the top quality decile of opportunity.
So, in Portfolio 3 the failure rate will be lower than previous examples (60%) and will also not amount to a ZERO return but include a recovery value of 20%. However, as demonstrated above, the key swing factor is the ‘winner’ category of investments. In Portfolio 3 we ‘diversify’ the outcomes of the surviving 10 companies with 6 actual exits. The following table outlines those outcomes across the portfolio:
Portfolio 3:
Clearly, diversification of outcomes and a higher number of more moderate exits does move the returns (IRR) dial. Any investor with a portfolio delivering 14.7% annual returns for an almost 4 X return on initial investment cost should be happy. Of course, these are merely estimates of the future anchored to historic data. We, like all forecasters, will get it wrong. However, it is reasonable to think a portfolio of mainly B2B assets with varying levels of maturity (along the start-up to private equity buy-out spectrum) operating in busy corporate VC activity sectors will achieve some exit success. You’ve read it here many times before… the future is private. But… there’s an additional Spark Private mantra to get to know – the process is portfolio. Private investors should build a sufficient opportunity set by holding multiple investments in a portfolio. As a small aside, this writer’s personal view is that exit valuations in the private asset world will surprise on the upside compared to even the multiples used in the portfolios above. Again, no promises!
Writer’s Note: The above is just a basis for discussion and exploring the long-run drivers of portfolio returns. I would be more than happy to talk through our investment pipeline and deal-types with anyone interested in building a diversified portfolio of private assets over the next 2-3 years.
