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How to Get Superior Returns in Venture Capital

All That Money Wants

A friend of mine interviewed for a job with massively successful hedge fund manager Steven A. Cohen.  My friend sat in the conference room, and Cohen walked in. He looked at his resume, and asked just one question: “What’s your edge?”  My friend got the job because his answer was differentiated, credible, and backed up by a history of investing success.

Traditional venture investing is challenging. The good news is that past high performance is predictive of future high returns.  But, the industry is consistently cyclical and quite competitive.  

So what edge do VCs have?  They fall into 3 buckets: the standard advantages, the unsaid standard advantages, and emerging new tactics to give an advantage.

 

THE STANDARD ADVANTAGES

The traditional answer of most VCs to the question of “edge” is a combination of the said and the unsaid.  What VCs most typically talk about are:

Industry expertise.  Many VCs focus on specific verticals, usually based on the sector in which a VC initially made her reputation. This model certainly makes sense.  That said, one limitation in early-stage investing particularly is that 2022’s growth sectors probably don’t fit neatly into a vertical we can define today. If you define yourself as a specialist in narrow and well-known theme X (e.g., a “Bitcoin Fund”, a “Social Media Fund”, a “Nanotech Fund”), you’re going to raise capital from Limited Partners who are very focused on Theme X.  The logical challenge there is that LPs are typically not ahead of the already competitive VC industry in identifying the next great theme.

Network. Social media tools like Linkedin and FullContact increases the value of network currency (reputation and access), because people with currency can spend their currency getting to a wider array of influencers. At the same time, they reduce the value of knowledge about people in your network; now anyone can find out who, for example, are the M&A decision-makers at Cisco.

Proprietary sourcing.  VCs used to emphasize their proprietary sourcing, but tools like AngelList, CB Insights, Gust, and Crunchbase now make the whole industry significantly more transparent. That said, we’re in an opaque industry compared with the public markets, and having the real scoop about what’s going on at a private company, and who are raising now, will be a meaningful edge for a long time. Our industry is highly noisy, and VCs use their networks to filter for signal amidst the noise.

Reputation. VC is one of the very few asset classes where past performance is predictive of future results, so reputation does have a meaningful impact on returns.  The importance of reputation is why, for example, Andreessen Horowitz invested early and heavily in their own PR, adding PR guru Margit Wennmachers as a Partner.  

Thesis. My HOF Capital colleague Victor Wang observes that Union Square Ventures is a particularly good example of the power of a correct thesis. Historically, USV has been an order of magnitude better at picking winners than almost every other VC in the industry. However, unlike most of the other elite VC firms with a substantial track record, USV is based solely in NYC (no office at all in Silicon Valley, where a substantial percentage of the world’s best startups are based); is relatively new (founded in 2003); didn’t have decades of reputation behind it at the time that it first invested in most of its current unicorns; has only a 8-person full-time investment team (even smaller previously); and is well-known for being an especially top-down thesis-driven investment firm. Most of the other VC firms with a history of picking unicorns have significantly benefited from being based in Silicon Valley, having much larger investment teams, and having multi-decade Tier-1 reputations, which has led to them seeing most of the best deals in the market. It seems reasonable to assume that USV’s investment strategy (i.e., top-down, thesis-driven, with investment theses that in hindsight have proven to be correct) must be especially efficient and effective if the firm has been able to substantially out-perform everyone else despite what might appear from the outside to be several limitations.

THE UNSAID STANDARD ADVANTAGES

In addition, VC funds benefit by some differentiators that they rarely talk about publicly, but are actually arguably even more important than the differentiators above.  

Execution. It is unexciting and hard to prove, but in fact “We execute better” is a critical differentiator. Amar Bhide, my former professor, wrote in Harvard Business Review, “Strategy is Bunk.”  He points out that Morgan Stanley and Goldman Sachs have virtually identical strategies. They win or lose against one another in various businesses based mainly on their skill in executing. If you can just execute competently, you will outperform a lot of people who might have a theoretically superior strategy.  

Thoughtful fund management.  When I talk with non-founding insiders at many alternative investment firms, I regularly hear complaints about the quality of firm management. The people who run investment firms usually got there because they’re good investors/dealmakers. Investing is a completely different skillset from being a good manager.  The leaders follow the normal human tendency of focusing on what they understand, and spending less energy on the domains in which they are less competent. Worse: the way you get rich as an investor is when you think orthogonally to everyone else.  This then leads successful investors to sometimes think that whenever they are pursuing a non-standard management decision, they’re geniuses, and everyone else is foolish.  The result is a poorly managed organization. The recent sexual harassment scandals in a number of VC firms only highlight this issue; they are a canary alerting outsiders that the fund has substantive management weaknesses.  If your fund is led effectively and transparently with clear decision-making, that itself is a differentiator.  

 

EMERGING NEW ADVANTAGES

As our industry has become more transparent and competitive, the traditional levers I list above have become less differentiated. Some VCs have identified a number of new advantages that distinguish them in the marketplace:

Portfolio acceleration. In a prior life, I served as a consultant to Goldman Sachs Special Situations Group, Carl Icahn’s organization, and some other very large private equity investors. I saw “portfolio operations,” i.e., levers to enhance the operations efficacy of portfolio companies, become a standard part of the private equity toolkit.  Private equity firms used to be composed almost entirely of ex-bankers; now it is much more common for them to include former CEOs and consultants. Similarly, firms like my alma mater ff Venture Capital and Andreessen Horowitz have executed this strategy in VC.  My experience has been this lever brings three benefits: it lowers origination costs because more founders want to raise capital from you; it enhances your leverage in negotiating with the CEO; and it lowers your failure rate.  

Incubating companies.  An extreme example of portfolio acceleration is the approach of Y Combinator and the other accelerators. They get in early and cheap with very attractive economics. They offer “Community as a Service,” by tapping the community (which is scalable), not just their own staff to support their companies.

Technology stack.  I have published a series of research papers on how VCs are using technology to improve returns. VCs tout themselves as tech-savvy, but most are using the same infrastructure tools they have used for the past 20+ years: Excel and recent college grads searching Google. We’ve seen some modest progress in people upgrading from Excel to Google Sheets; use of some CRM; and a cloud-based storage service.  But, according to Knowledge.VC, under 5% of US VCs have a full-time team member focused on technology. We think there are a lot of opportunities to differentiate by using technology aggressively, e.g., Totem, an investor operating system built by some of my past colleagues at ff Venture Capital.  

Quantitative investing. A quant approach is common in the public markets, but used by few in the private company investing space. Among the VC firms which are pursuing a more quantitative approach are Correlation Ventures, Google Ventures, Right Side Capital, Signalfire, Ulu Ventures, Y Combinator, WR Hambrecht+Co, and Venture Science.  The obvious challenge of this approach is poor data quality and relatively few success stories against which you can run regressions. Quantitative, technology-enabled investing in private companies makes sense, but is structurally very difficult. In venture capital, in particular, early-stage companies are often operating in frontier industries, where the rules are unpredictable and conventional analytic frameworks may be misleading. Even for later-stage companies with predictable financials, the lack of liquidity, audited financials, and standardized metrics creates real challenges to scaling quantitative investing.  

Internal diversity.  According to the National Venture Capital Association/Dow Jones VentureSource, the VC industry is dominated by men (89% of VC Partners), specifically white men (76% of the total).  Of all VC Partners studied, just 10% identified as Asian, 1% as African-American, and less than 1% as Latino.  Many research studies have shown the value of a diverse management team.  In VC in particular, our job is to understand the diverse future, not the present.  America will be a “majority minority” country by 2040; I suggest it’s helpful to have a diverse team which looks like the future of America, not our past.   [Chamath] Palihapitiya observes, “the firms that embrace diversity and inclusion in a systemic way will change venture capital for the better … because the minority leaders who rise up inside those firms will “rip them apart from the inside.”   

Portfolio company diversity.  The companies receiving venture capital do not look like the rest of America.  CB Insights found that companies headed by male executives received 98% of all venture investments, totaling nearly $1.88 billion. In addition, 83% of companies had a racial composition that was entirely Caucasian, while only 12% of founders were Asian and less than 1% of founders were African-American.  Social Capital is an example of a firm specifically seeking exposure to the emerging domestic market and reducing their reliance on traditional gated VC networks. Their recently launched Capital-as-a-Service (CaaS) arm allows them to make small investments in startup applicants anywhere in the world, sight unseen.  

VCs which can build out expertise in portfolio acceleration, use of technology, and investing in diversity are rare and will have a significant advantage over time.

Initially posted at PEHub.  Photo credit: Wikipedia

 

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