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How does Hedgeable’s venture capital investing work?

As Master Sensei of Hedgeable I can address how the venture investing works, what we are investing in, and how selections are made –


Executive Summary

Hedgeable was the first digital wealth manager (Robo-Advisors) to offer venture capital investing to clients. As of the time of this writing (early 2016), all Accredited Investors that are Hedgeable clients are eligible for any venture fund. There is no additional fee for this feature, and the minimum investment in the fund is $1. Hedgeable mainly relies on top crowdfunding platforms like AngelList (company) to source investments, typically co-investing with the top venture capital firms in Silicon Valley.


Fund Structure & Investor Status

Hedgeable’s Venture Capital funds are formed in Delaware as Partnerships. They have a distinct Tax ID and registered agent in Delaware that is separate from the Hedgeable corporate entity. Hedgeable serves as the General Partner, while all investors are Limited Partners. The General Partner makes investment decisions and handles the fund administration, while the Limited Partners may contribute capital and own a stake in the fund. Limited Partners do not need to be involved in the ongoing operation of the fund, but are able to benefit from any profits made.

Private partnerships like Hedgeable’s are excluded from the definition of an investment company, and are not registered under the U.S. Investment Company Act of 1940. Instead, these partnerships fall under the U.S. Securities Act of 1933. According to this law, Hedgeable can offer its fund to accredited investors as long as they meet the standards that were described prior. Under Section 3(c)(1) of the Investment Company Act of 1940, partnerships like Hedgeable’s are compliant as long as no more than 99 individuals own it. Because of these restrictions, each Hedgeable fund is limited to accredited investors, and only 99 investors can allocate capital to each fund. When the 99 accredited investor limit is breached, Hedgeable opens a new fund.

As of the time of this writing, we do not believe there is a sufficient number of quality offerings on the market that meet the criteria for non-accredited investors under Title III of the JOBS Act of 2012. We will continue to explore if, and how, we will offer venture capital to our non-accredited clients via the new Title III provisions. As a fiduciary, it is our duty to take a cautious approach to new regulation, as effects are typically not seen in markets for years after implementation.

Fund Costs & Taxes

As part of our overall mission to democratize the investment process, we provide venture capital investing to our clients with no additional fee. That means the Hedgeable venture funds do not charge any management fee or performance fee, and any administrative costs are covered by Hedgeable. Any member of the Hedgeable platform that meets the regulatory requirements is eligible to invest in our venture capital offering with no added cost. Hedgeable charges one fee for all platform features, based on the total assets under management for each client.

Similar to publicly-traded ETF portfolios, some of the investments in venture capital funds that Hedgeable makes may have costs associated with them. However, Hedgeable’s fund does not charge a fee for its services.

Funds will be administered by Assure Services in Utah. The administrator is responsible for issuing an annual Schedule K-1 to all investors in the funds. All clients will be responsible for filing their own taxes. Hedgeable will not file or handle tax documents for any Limited Partners.

Fund Performance Benchmarking

Performance will be shown on the Hedgeable platform as data becomes available, utilizing updates provided by the index funds or individual companies and following standard mark-to-market practices.

The benchmark that Hedgeable uses for the Hedgeable Venture Funds is the iShares Micro-Cap Index. This index tracks publicly-traded securities in the bottom tier of the Russell 2000 Index, with market capitalizations generally below $1 billion. This is a serviceable proxy, as the majority of Hedgeable’s venture capital investments are made in firms valued below $1 billion.

Fund Liquidity & Timing

Currently, there is no secondary market for shares in any Hedgeable venture fund. Therefore, commitments cannot be redeemed until a fund liquidates, which is estimated to occur 7-10 years after investments are made. Investors should be comfortable with this lockup period before committing assets, and must qualify as accredited investors to be eligible. Ongoing distributions may be made to fund investors if an underlying company has an exit or another liquidity event occurs over the course of the fund.

Hedgeable intends to launch at least one venture fund each year, closing on or before December 31st of the calendar year, or when 99 accredited investors have successfully committed to a fund (whichever happens first). The graphic below shows projected timeframes for Hedgeable fund investments:

As shown above, there will be some overlap across funds, as investments for each will be spread over a period of roughly two years. For clients seeking greater vintage diversification, an investment in multiple Hedgeable funds is possible.


Fund Allocations

When clients hire Hedgeable as their investment advisor, we use proprietary data science to construct customized portfolios, in line with their long-term goals and objectives. We target a 0%-5% recommended allocation of a client’s overall portfolio to venture capital. The precise amount is tied to a client’s overall profile and goals. Our proprietary algorithms analyze the risk appetite and liquidity tolerance of each client, both of which are instrumental factors in determining a recommended venture capital allocation.

The chart below demonstrates what a typical portfolio might look like, including Hedgeable’s recommended venture capital allocation:


Hedgeable Venture Capital Methodology

In this section, we will go over the methodology that underlies Hedgeable’s venture capital investing. Our venture capital exposure mirrors the core-satellite approach we utilize for clients’ broader stock and ETF portfolios.

Core Investments

At least 65% of the venture capital exposure is invested in index fund offerings from leading venture platforms such as AngelList (company), CircleUp, and OurCrowd. These investments will form the “core” portion of the venture portfolio. The index funds provide exposure to a wide array of consumer technology, enterprise technology, food & beverage, retail, and healthcare companies.

The core exposure aims to have diversification across both sectors and geographies. For example, with core public equity exposure, most clients are invested in the U.S. stock market, international developed markets, and emerging markets. Each of these investments may be represented by an ETF that has exposure to hundreds of underlying companies from all sectors of the market.

Hedgeable venture capital portfolios make investments in approximately five index funds, each of which invests in an estimated 25-100 underlying startup companies. We consider a diverse range of platforms through which we can obtain the core exposure, including but not limited to CircleUp, AngelList, and OurCrowd. CircleUp is a platform focused on the consumer and retail startups, while AngelList focuses on high-growth companies in the consumer technology and enterprise technology spaces. To increase geographical diversification, we also leverage high quality platforms like OurCrowd that invest in Israel and across Asia.

Why Crowdfunding Platforms?

Hedgeable leverages equity crowdfunding platforms for core investments because of the vast array of investment opportunities they offer.

Equity crowdfunding is a new way for companies to raise capital that started in the wake of the 2008 financial crisis. As credit markets tightened, less capital was available from banks and other traditional sources. This coincided with an explosion in the use of social networks like Facebook. When you combine the social power of the crowd with the demand for capital, you end up with the emergence of crowdfunding platforms.

Some of the earliest crowdfunding platforms were Kickstarter or Indiegogo. Investors who fund projects on these platforms can contribute capital to something they want to support, but they do not receive an equity stake in the project or company. A new batch of crowdfunding platforms sprouted up in 2009-2011 to solve this problem, including AngelList, CircleUp, and OurCrowd.

These equity crowdfunding platforms offer a great way to see which companies are raising money in the first place. For example, in 2010, a little known company called UberCab listed itself on AngelList and gathered an impressive $1.25 million in capital from the crowd. Little did anyone know, just five years later, UberCab would be the $60 billion phenom that we now know as Uber (company)! Equity crowdfunding played a role in making Uber what it is today.

Companies listed on equity crowdfunding platforms often have large institutional investors backing them as well, or have been incubated by top accelerators like Y Combinator. Not only do equity crowdfunding platforms provide great marketing tools to learn about new companies, but they also serve as a filter for the hundreds of thousands of companies that start every year.

A Venture Capital ETF

In our core stock and ETF portfolios, we typically allocate to ETFs like the Vanguard Total Stock Market Index (VTI) for U.S. exposure or the iShares MSCI EAFE Index (EFA) for international exposure. Using these two investments as an example, investors get exposure to over 4,000 underlying companies. Since these ETFs are weighted by market capitalization, they include exposure to small-cap companies across the world.

Remember the iShares Micro-Cap Index that we use as a benchmarking for venture capital? The challenge for investors is getting access to small, upstart companies before they reach the public markets. Our venture index fund methodology acts as a proxy for the performance of micro-cap stocks before they reach IPO status. We look to diversify the core venture index exposure in the same way that we would the core public index exposure in the rest of your portfolio, by considering both sector and geographic diversification. So, while no such publicly-traded security exists, Hedgeable’s venture capital exposure serves as a Venture Capital ETF proxy with its hundreds of underlying investments.


Satellite Investments

Outside of the core index piece, the Hedgeable venture funds also make “satellite” investments into individual companies. Up to 35% of a fund’s capital may be used for the satellite portion, with a target of 15-35 companies across different areas of the market. Satellite investments in individual companies mirror the satellite allocations we make to individual stocks for clients’ publicly-traded portfolios.

Satellite investing increases diversification in the funds by boosting exposure to lower correlation sub-sectors. By separating out some of the sectors within the index, we can also overweight the most attractive sectors given the vintage year. To understand this concept, consider the following data from Cambridge Associates:

The return dispersion in the chart above is striking. Earlier, we noted that venture capital, as a whole, produced a 14.6% annualized return from 1984-2014. Yet, some sectors deviate substantially from that overall movement and provide much higher returns. The primary goal of satellite investing is to best isolate those sectors, providing increased diversification and also greater opportunity for return.

Lead Investing vs. Follow-On Investing

When startups raise capital after a friends and family round, they typically have what is called a lead investor for a funding round. The lead investor sets the terms (provided in a term sheet), including the pre-investment valuation of the company, the percentage of equity being offered, and the board seats offered. The lead investor, in turn, can bring other investors into the round at the same set terms. A lead investor can also act as a cheerleader for the company, helping and guiding founders through the fundraising process. The lead investor is generally the largest shareholder in the round and is typically granted a seat on the company’s board.

Hedgeable does not act as the lead investor for any satellite investments. Instead, we participate as a follow-on investor. This means we only get involved in a deal once terms are set by a lead investor. The Hedgeable venture funds will always represent a small portion of any fundraising round and any investment will result in a minor economic stake in the company.

Deal Sourcing

Hedgeable finds individual deals for satellite investments in one of two primary ways: (1) by utilizing syndicates, or (2) by sourcing deals directly.

Syndicates

One way to get deal flow for satellite investments is through a syndicate, including those listed on the AngelList platform. In a syndicate, a lead individual or firm will bring forward deals to the syndicate backers. The backers rely on the lead’s connections or deep knowledge of the industry to gain access to quality investing opportunities. Due to the lead’s track record, syndicate backers will pay the lead of the syndicate a percentage of the profits, known as a carry, and in some cases, a management fee on the asset invested via the syndicate. Investments made using AngelList are currently only subject to carry and operational costs, and are not charged an annual management fee.

The backers of a syndicate reserve the right to not participate in any of the deals sourced by the lead. Participating in syndicates not only allows Hedgeable to make very specific and themed investments, but also enables us to leverage the insight of the lead, which is typically an established venture fund or investor with a proven track record and deep domain expertise in the syndicate’s focus area.

Direct Investment

Outside of deals that are syndicating by leading VC firms, Hedgeable may opportunistically invest in individual deals outside of any online platforms. These opportunities may come from connections of the Hedgeable management team, referrals from knowledgeable individuals in the startup space, attendance at incubator demo days from Y Combinator, TechStars, and other leading programs, or events hosted by Hedgeable to incubate companies internally.

Categorizing Deals

We divide our potential investment universe into 16 distinct sectors:

  1. Artificial Intelligence
  2. Biotechnology
  3. Blockchain Technology
  4. Unmanned Aerial Vehicles and Drones
  5. Financial Technology
  6. Alternative Energy
  7. Healthcare Technology
  8. Internet of Things (IoT)
  9. Marketplaces
  10. Media
  11. Restaurants
  12. Robotics
  13. Software-as-a-Service
  14. Collaborative Consumption (Sharing Economy)
  15. Virtual Reality (VR) & Artificial Reality
  16. Wearable Technology

Each sector is described below:

Artificial Intelligence (AI) – Artificial Intelligence involves the creation of machines that are capable of replicating human cognitive functions like speech recognition, learning, planning, and problem solving. According to reports published by Markets and Markets, the AI market will grow at a 53.65% Compound Annual Growth Rate (CAGR) to $5.05 billion by 2020.

Biotechnology – Biotechnology companies develop drugs and conduct clinical research aimed at treating diseases and medical conditions by using live organisms or their products, such as bacteria or enzymes. Hexa Research expects the biotech market to grow at a 12.3% CAGR through 2020.

Blockchain – Blockchains are distributed databases that record and maintain data, without the potential for tampering or revision. This new form of technology became popularized with the advent of bitcoin, and many platforms have emerged since. One example of blockchain technology is Ethereum, which is a platform for the development and distribution of business applications on the blockchain. According to Aite Group, blockchain spending by banks & other players in capital markets is set to grow at a 52% CAGR through 2019.

Drones – The drone sector builds hardware and software for unmanned aerial vehicles for consumer, commercial, or military purposes. TechSci forecasts the commercial drone market will grow at a CAGR of 27% through 2021.

FinTech – FinTech companies operate in traditional finance industries by utilizing technology to improve data collection and dissemination. According to Research and Markets, the FinTech sector is expected to grow at a 54.83% CAGR from 2016-2020.

Green Energy – Green startups attempt to more efficiently utilize existing energy consumption and production, or focus on developing new ways to generate energy while minimizing environmental harm. BCC Research forecasts that the green energy market will grow by an 8% CAGR through 2019.

HealthTech – HealthTech companies use mobile apps, cloud storage, and other information technology to collect, store, and evaluate health data. These companies have goals of preventing, diagnosing, and treating diseases, improving rehabilitation, or improving long-term care. According to Statista, the HealthTech market will grow at a 36% CAGR until 2020 when it will reach a total addressable market of $223 billion.

Internet of Things (IoT) – The Internet of Things is a network of electronic devices that collects and exchanges data without human involvement. According to IDC, the IoT market will grow at a 17% CAGR, to nearly $1.3 trillion by 2019.

Marketplaces – Online marketplaces bring together and process transactions between buyers and sellers who are looking to exchange value in the form of a product or a service. Marketplaces can be B2B or B2C, and generally seek to improve availability, pricing, and/or liquidity for a given market. Forrester expects marketplace sales in the US to grow at a 10% CAGR from 2015-2019, hitting $480 billion by 2019.

Media – Digital media is the distribution of entertainment and informational content using the web and mobile platforms over traditional distribution sources such as television and newspapers. PwC expects the sector to grow at a 5.9% CAGR through 2019.

Restaurants – Venture investing in the restaurant sector typically focuses on funding companies that target an underserved segment of the market, those with proven concepts looking to expand into new markets, or capitalizing on new dietary habits or eating trends. For example, Infiniti Research forecasts that fast casual restaurants will grow at a 6% CAGR until 2019.

Robotics – The robotics industry designs, manufactures, and operates machines that assist or replace humans in the workplace. According to Boston Consulting Group, the robotics industry could grow 10.4% annually and reach $66.9 billion in revenue by 2025.

Software as a Service (SaaS) – SaaS companies create software that is distributed over the internet using a third-party provider, removing the need for customers to install and run applications on their own computers or in their own data centers. IDC forecasts the SaaS market will grow past $112.8 billion in revenue by 2019 at an 18.3% CAGR.

Sharing Economy – The sharing economy connects people with spare capital or resources with those who need it. The two biggest players in the sharing economy are currently Uber and AirBnB. According to PwC, the sharing economy is expected to grow at a 29.5% CAGR to reach $335 billion in revenue by 2025.

Virtual Reality (VR) & Augmented Reality (AR)Virtual reality technology creates holistic interactive environments for users, in which senses are stimulated as they would be in the physical world. Augmented reality technology creates interactive environments that are not holistic, but instead are overlaid on a user’s physical surroundings. According to ABI research, VR and AR technology is expected to grow 78% annually from 2015 to 2020, reaching a total addressable market of $100 billion.

Wearables – Wearables are electronic devices that are worn on the body to track information and collect data. According to Markets and Markets, the wearable device market will grow to $8.36 billion in revenue by 2018, with a 17.7% CAGR.


Sector Selection

For satellite investing, our methodology involves targeting specific sectors. In order to assess the opportunity presented by a given sector, we analyze the growth potential and the risk profile of each. Growth factors are consolidated into a Sector Growth Score, risk factors are consolidated into a Sector Risk Score, and these two metrics contribute to an overall Sector Rating.

Growth Score

The two key data points that influence the Sector Growth Score are growth rate and valuation. For growth rates, we utilize projected CAGRs (compound annual growth rates) from leading industry experts such as IDC, BCG, and PwC:

To measure sector valuations, we consider known valuations from a sample of existing companies across each sector. For example, the following is valuation data for early stage companies that have raised money on AngelList:

Sector Growth Scores are calculated as growth-to-valuation ratios. This is analogous to a PEG (Price to Earnings to Growth) ratio. PEG ratios are commonly used to measure the value offered by publicly-listed securities, considering a security’s value in relation to its expected growth. A low PEG ratio indicates that a security may be undervalued. Hedgeable’s Sector Growth Score is calculated in the reverse, measuring a sector’s growth prospects adjusted for value. A high Sector Growth Score suggests a compelling case for future growth given a sector’s current valuation level. The primary objective of the Sector Growth Score is to identify areas of the private market in which companies have ample room left to grow, which is a crucial barometer for early-stage investing.

For the purposes of standardization, the ratio is interpolated onto a scale.

Risk Score

The two key data points that affect the Sector Risk Score are burn rate and sector age. Both of these metrics can vary drastically across sectors.

In order to incorporate these two very different measures into one score, we interpolate each on a standardized scale. Lower burn rates and longer sector histories lead to higher scaled values, as they indicate a more favorable risk profile. The numbers are then equally weighted to arrive at the Sector Risk Score, which is also standardized because it is derived from scaled values.

Sector Rating

The Hedgeable Sector Rating is a weighted average of the Sector Growth Score and the Sector Risk Score. Considering the individual components of the Scores, it is calculated as:

The variables w1 and w2 represent weights assigned to the Growth Score and the Risk Score, respectively, where w1 and w2 sum to one. These weights provide our model with flexibility to accommodate different market environments across fund vintages. At the end of an economic cycle, for example, growth prospects may play a slightly more important role than a sector’s risk profile. In other economic environments, the two factors may contribute to the Sector Rating equally.

For example, in 2015, the top sectors as measured by Hedgeable’s Sector Rating were:

Artificial Intelligence (AI)

Biotechnology

Blockchain

FinTech

HealthTech

Restaurants

Robotics

Sharing Economy

Software as a Service (SaaS)

Virtual Reality (VR) & Augmented Reality (AR)

Those sectors with high Sector Ratings are given top priority when evaluating satellite investment opportunities. Investments that do not fall into a sector with a high Rating are still considered on a case-by-case basis, dependent upon the individual security selection methodology outlined later in this paper.

Interacting with the Core

One additional layer of analysis when considering satellite investments is the relationship between satellite exposure and core exposure. Companies in sectors that are already well-represented in one or more of the core index funds are given lower priority, in order to optimize the core-satellite structure of the venture portfolio. Similarly, if there is a large amount of overlap between the market catalysts that drive a sector and the catalysts that drive part of the core exposure, said sector is also given lower priority as a satellite. For example, if a core portion of the venture portfolio has substantial exposure to investments that depend on the decline in traditional energy markets or the transition to clean energy, potential satellite investments in the Green Energy sector may be given lower priority than other investment opportunities, all else being equal.

Security Selection

While identifying attractive sectors to target for satellite exposure is important, it is also imperative that individual companies be analyzed thoroughly. We use a proprietary two-tiered framework to assess a company’s health and potential. This includes both a quantitative screen and a qualitative screen.


Quantitative Screen

Companies must pass our quantitative screen, which judges the competitiveness of the company in relation to its peers on factors like valuation, financials, and revenue growth. For earlier stage companies, product success – in the form of sales or customer growth rates – are weighted more heavily than the other measures.

Qualitative Screen

All companies are also subject to a qualitative screen, which judges the market potential of the business, the quality of the product or service, and the strength of the founding team. For earlier stage companies, the strength of the founding team and the potential for market disruption are most important.

Conclusion

Venture capital has long been the domain of the ultra-wealthy. Historically, allocation to this asset class has helped the wealthy to outpace their retail counterparts. With the advent of new technology platforms and more education, we believe this will change for the better. To that end, we are proud to offer a robust venture capital investing feature that curates a venture portfolio for our clients, with commitments as low as $1 and no added fees.

Disclaimer: This is not a solicitation to buy or sell securities or an offer of personal financial advice or legal advice. Past performance is not indicative of future performance. It is suggested you seek out the help of a financial professional before making any investing or personal financial management decision.