In equity crowdfunding, large number of individual investors finance startup companies buy taking a partial ownership of the companies or at least making a contract to participate into the success of the companies. There are nowadays dozens of equity crowdfunding platforms such as SeedInvest, AngelList and Companisto that make the investment process easy for the projects and the people financing the projects. Investing in startups in the early phase may offer significant benefits. Participating into a successful company that one day will be sold to another company or is listed in the stock market will multiply your investment.
The question for the investor of equity crowdfunding is, how to model the investments in Adaquant Asset Allocation Suite. The Suite has a pre-configured asset class “Private Equity Venture Capital” that is based on a private equity index that measures performance of US based venture capital funds. The long-term return of this index is 12.8% per annum, while S&P 500 index has returned 11.2% per annum at the same time period. The venture capital investments have also been very risky, maximum drawdown of the index is -70% and volatility 15.1%.
There are couple of problems in using the venture capital index returns as such to model the equity crowdfunding returns:
- There are hundreds of investments in the venture capital index, so it is extremely diversified. When individual investor invests in equity crowdfunding projects, there are usually only a handful of investments made. This means less diversification and higher risk.
- The return distribution of a single (or even handful of) equity crowdfunding investment does not follow normal distribution but is closer to a binary distribution. Either the investment more or less fails and the initial investment is lost, or the start-up succeeds and the payout is huge.
- The measurement of investment performance during the investing period is not necessarily even possible; you only know your returns when the start-up company is sold or listed in the stock market. There is rarely a good idea of the start-up company valuation before that.
- The venture capital funds have full-time professionals analyzing the investments and they also have resources to support and guide the start-up companies. Individual investors cannot make a similar due diligence and they cannot give similar help to start-ups in order to make them succeed. Therefore it is unlikely that the long-term average returns for individual investors would be the same level as the venture capital index returns.
Taking all this into consideration, my recommendations are:
- You can use the pre-configured “Private Equity Venture Capital” to model your investments. The distribution of this index is very skewed so it takes into account the volatile expected outcomes of the start-up investments.
- You should set the estimated return of this asset class depending on the type of investments and your confidence level. If the investments that you make are being co-invested by venture capital funds or other financial professionals and you have very high confidence level, the maximum estimated return could be 1.6% + estimate for Large Cap Equities asset class return. This is the long-term alpha that investing into start-up companies has been offering. If your confidence level is lower and/or the quality of the investments is lower, then you should adjust your return estimate lower.
- If you invest into small amount of start-up companies, you need to have the estimated standard deviation higher than the 15.1% of the venture capital index. I have made a simulation with small cap equity companies to study how concentrated portfolios affect the volatility of the portfolio and came up with the following volatility multiplier table:
|No Holdings||Volatility Multiplier|
So if you would have only one single start-up investment, your estimated volatility would be 2.37 * 15.1% = 35.8%.
In general, I think the best approach is to be very conservative in the estimates. It is better to underestimate the returns and overestimate the volatility than other way around. There is no escape from the fact that investing in start-ups is very risky and there are no guarantees of any kind of positive outcome.