Manager Selection in Venture Capital
The Power Law, popularized by investor Peter Thiel and then immortalized into the eponymous book title by author Sebastian Mallaby , drives venture capital returns. Venture capital empirically operates according to this principle, with singular outliers in most portfolios returning more capital than the entire portfolio’s remainder. Those VC managers who wish to outperform are therefore almost entirely beholden to not only the existence of the outlier, but to its amplitude.
“The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined. This implies two very strange rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. This is a scary rule, because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more humble scale.) This leads to rule number two: because rule number one is so restrictive, there can’t be any other rules.” - Peter Thiel
The other great truth, called out by Level Ventures’s Jake Kupperman in his comprehensive piece which we’ll further explore below is the notion from Michael Mauboussin that, “A lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters.” Even though many if not most of pre-seed investments will go to zero, the log-normal, or long tail distribution of outcomes means that Power Law, and the magnitude of that outlier, is really what matters in early-stage investing.?
Pundits also point to the rising nominal interest rate environment and pose the rather drab and predictable question, “with risk-free returns going up, why would anyone invest in venture capital?” The answer I usually give first points out that the risk-free interest rate is actually the nominal rate minus the inflation premium, and at least based on my own experience of CPI it’s a rather glib figure that factors out the real costs of life in a policy-convenient way. So the real risk free rate of return isn’t as large a plate of free lunch as one might think.
The second point I make is that there is very little dispersion in the risk-free rate of return, in other words mean and median are identical, but the dispersion in venture capital returns is massive. The difference between an under-performing and an over-performing VC manager can be significant (as seen in the graph below). Moreover, the distribution of venture returns is not Gaussian or “Normal.” It’s positively skewed, with outlier managers significantly outperforming the median managers. In other words, the Mean performance is many levels higher than the Median performance in venture capital.
Abe Othman, head of Data Science at AngelList published a study in 2019 demonstrating that by making a higher (n) number of bets significantly increased the chance of getting mean , rather than median returns, in venture capital. So if you’re a manager trying to outperform, taking more shots on goal is an effective strategy. My co-founder Jenny Fielding and I have discussed this for years, and this is the reason why we’ve written one check every five days for the last half decade. This is a cadence that indexes around 8 percent of companies we’re introduced to by a founder in our community. We’ve invested about 400 times out of about 5,000 total opportunities. You have a greater chance of finding a successful company, and the amplitude of that winner will determine the extent to which the Power Law holds true, with that one winner being more valuable than the remainder of your venture portfolio.?
For LPs, particularly funds of funds backing numerous managers, they also focus on this notion of differentiating between Median and Mean managers. By looking at what differentiates a manager insofar as how they Source, Select, and Support, LPs can determine if a manager has some, or many, characteristics to outperform others. LPs need not have to predict the future of which managers will perform best; they simply need to back a portfolio of managers who have the right characteristics to outperform. Performance dispersion is so wide, and the positive skew so great that the Mean performance is multiples of the Median. In fact, Morgan Creek has done research that suggests that the mean performance of the Top 50% of venture funds exceeds the top-quartile of all VC funds. This again, is because of the skewness, and how much top performing managers outperform. The average of their performance is better than the bottom 75% of firms. The argument for “why invest in venture capital” is clear if LPs can identify a few key characteristics to identify and isolate better managers. Then they only need the average of those managers to outperform the top quartile of firms. And top quartile venture capital returns far outpace alternatives in equities or fixed income, making VC a worthy allocation strategy. Of course if you’re unable to access or select for outlier manager performance, you’re also probably better off consolidating your capital in asset classes barely-shielded from inflation. As with many things, it comes down manager selection access, process, and execution.
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The team at Hummingbird VC have titled these fund outliers “nomads,” and built a fund of funds around it to target funds that look distinctly different. These are decidedly not your household names, because to find true alpha you need to be non-consensus, meaning you stick out. And you need to be correct. So outlier funds will, by definition, be the odd balls, those that come across as a bit strange. As entrepreneurs ourselves, the best fund managers probably won’t shy away from this. At Everywhere Ventures , for one, I recently heard a panelist state, “we would never back a global generalist pre-seed fund,” and the room broke into laughter. This is exactly what we do, and we’re not afraid to be contrarian. That statement didn't give me self-doubt; it bolstered my confidence because we have a model that uniquely allows us to do this unlike just about any other firm. This irreverence, and self-belief is what we look for in startup founders, and it’s certain to be a characteristic in nomadic, truly differentiated fund managers. Jordan Nel at Nomads / Hummingbird has written an excellent piece on this .
So if you’re a VC manager what should you do?
And if you’re an asset manager or LP making fund investments?
The question of what characteristics drive alpha is well trodden, and Heather Hartnett, founder of Human Ventures, has done a good job laying it out in her recent Forbes piece on “alpha generators. ” There are over 2,700 VC managers with under $100 million AUM, predominately focused on the early stage. Many of them are known as “emerging,” but she makes the point that these managers who have deep networks, access to accelerators, and a core proposition for why they are accretive to the industry, providing something different, might be better called “alpha generators.” After all, if LPs can identify such characteristics to select top half managers, because of the highly skewed distribution this fact alone will allow them to isolate and consistently achieve top quartile venture returns outperforming other asset classes.
For more astute thinking on this subject I’d recommend reading works by Morgan Creek, and particularly Frank Tanner. Morgan Creek has decades of venture capital fund of funds and asset management experience from across the endowment worlds of UNC Chapel Hill, Duke, Stanford, and the Kauffman Foundation. They are one of the pre-eminent voices on VC asset allocation and manager selection. Many thanks also to Kate Simpson at TrueBridge for helping me refine these ideas, to Kelli Fontaine at Cendana Capital for our conversations on this at Collision 2023, and Eric Woo at Revere for continuing to build community around emerging manager development. This post also builds off the great research done by fund of funds investor Jake Kupperman at Level Ventures , research done by Jordan Nel and team at Nomads and Hummingbird VC, and writings by Heather Hartnett of Human Ventures.?
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More posts at www.ScottHartley.com , specifically on Venture Capital , and our weekly founder spotlights from Everywhere Ventures .
Asset Based Finance, Specialty Finance, Crypto, Private Markets. Financial Advisor and Head of Alternative Investments at Gramercy Park Wealth Advisors. Host of ATLalts and Asset Backed Podcasts.
11 个月Terrific article Scott, much appreciated. Reviewing opportunities in VCs with industry specialization investing out of Funds I-III and this really helps. I look forward to following you and your firm for great insights in the future.
Fund Founder I Investor I Capital Markets Expert
1 年Scott - love the piece! A number of great points here, from the risk-free rate discussion to return skew to being comfortable sticking out from the expected industry norm.
CEO at 50/50 Foods, Inc
1 年Great read. Appreciate the sentiment. For those of us in the fox hole, “pre-seed” usually means $1m-$5m+ in revenue. What’s your definition of pre-seed?
Entrepreneur | General Manager | Board Member | Investor | Strategy to Execution | Growth to M&A
1 年Flavio Pripas
Advisor | Entrepreneur | Arsenal FC | NBA | IMG
1 年Really enjoyed the read Scott, great piece!