Despite their common focus on smaller companies and bias towards tech, listed small-cap funds and VC funds have a fundamentally different approach to risk.  On the listed funds side, investors can try to reduce risk through portfolio mix and construction, and variable amounts of due diligence. On the private side, risk is also addressed through the structure of the investment, typically using preference shares and other downside protection, a lot more due diligence and board representation.

So, I thought it would be interesting to see what happens if we press a small-cap portfolio into a preference share mould.

This is very much an illustrative exercise: the results do not provide anything more than ‘context’ on how venture funds compare to small-cap funds, and for that matter how some small-cap funds compare to each other. Most micro-cap investments are substantially further along than VC investments; micro-cap funds can (usually) sell their investments and don’t have to reserve funds for follow-ons. The list goes on probably for longer than either side appreciates.

Preference shares give VCs unappreciated downside protection

As a reminder, the debt-like element and legals of preference shares mean that as a company struggles, and maybe heads towards its end, the preference shareholders extract value ahead of the ordinary shareholders (the founders, and 3Fs). There are typically no intentional traditional lenders involved in the companies the VC funds invest in.

If the company dawdles along surviving, then the preference shares provide a debt-like yield, and what upside there might be is taken by the ordinary shareholders.

If the company takes off, the yield on the prefs almost becomes irrelevant as the holders share in the exponential valuation growth that the equity element of the preference may provide – for example, rights to convert from preference into ordinary shares.

The chart below is the ‘illustrative example’ used by Molten Ventures at its 2024 Investor Day. It is not a reflection of any particular investment, and valuation nerds may observe that there’s rarely a straight line in valuation. Preference shares give protection such that even if the Enterprise Value of the business falls to 50% of the level when the investment was made, the fund still gets the full value of its investment back, while it only shares in the upside once the Enterprise Value has exceeded 250% of the figure when the investment was made.

Take two micro-cap funds – round pegs through the square holes

We take two UK micro-cap portfolios’ top-30 shareholdings as at their 2022 year-ends. One is managed, using what a marketeer might describe as a diversified value/recovery methodology. The other could be described as more conservative, and growth and due diligence oriented.

Obviously, we can’t revisit the valuation of every listed share within these portfolios and value them as preference shares. But we can take the share price to provide the equivalent of the VC’s calculated enterprise value.

Using the example above as guidance, but noting that this is all in broad terms, where the share price drops below 50% of the initial investment, we take a valuation of 40% of the investment for the faux pref shares.  When the share price is within the range of 50% to 250% of initial investment price, then the valuation for the faux pref is held at the initial investment level. And when the EV extends beyond the 250% point, the faux pref valuation goes up in line with the share price.

Our prices are set at end-March 2022 – clearly not reflecting the reality of a VC fund built up over time and probably not the timing that many funds would choose as a reference point.

Surprising results, not really

For the conservative growth fund, the faux preference structure does little to alter the performance of the top-30 holdings.

For the more aggressively managed fund, the faux preference structure makes a significant difference in limiting the losses seen with the top-30 holdings.

Mindful of not reading too much into these results, it is interesting to see that the results of the VC fund and diversified micro-cap fund are closer than those of the two micro-cap funds. It’s important to remember that Molten is no more typical of a VC fund than either of the two selected micro-cap funds are of their universe.

While not proving anything, perhaps clarifying some of the differences between VC and small-cap investments helps to highlight some of the similarities, and to provide a kind of transit or sight line between the two worlds.

VC funds are not as risky as those who look at the underlying businesses they investment in might assume. Then again, perhaps micro-cap companies are simply not as safe as the sheen of a listing and a broker’s note might suggest.

Ian Robertson
irobertson@progressive-research
07768 276595