About one year ago, I attended a great session with Limited Partners (LPs) to VC firms, the Carlyle Group’s Bob Grady, and fund managers from Hamilton Lane and SFERS in San Francisco.
At the time, I was impressed with the rationale behind a deliberate slowdown in new VC fund investments. Yet, every fund manager assured that the technology asset class remained an interesting one that LPs cannot afford not to participate in. Moreover, the group as a whole emphasized that the new VC funds being deployed must prove substantial differentiation in its investment strategy, not unlike an entrepreneur who needs to demonstrate a similar aggressive differentiation to win market share.
With that in mind, you may be as amused as I am to see the “duh” investment strategy explained in this private placement memorandum (PPM) from a triple-digit fund in early 2000:
- Market capitalization at IPO of $1 billion or more
- Rapid growth and huge potential market size
- Leveraged customer acquisition strategies: the business can take advantage of established customer bases, “network” economics, or powerful “viral” strategies to acquire customers at a modest up-front cost
- Scalable business models
- Robust economic models: significant margin generation with potential for self-funding in year three or before.
- Significant competitive advantages based on such factors as proprietary technology, the establishment of industry standards, customer investment in applications and user interfaces, or winner-take-all economics (i.e., the market is a natural monopoly)
- The opportunity to create leverage vis-à-vis suppliers and customers by efficiency advantage, neutrality, the scope of the business, and hard-to-replicate investments
I have seen quite a few other PPMs since, and the resemblance is remarkable. No surprise that VCs have had the flexibility to latch on to every new technology acronym, using whatever allocation per company they desire and invest in virtually any technology company that comes their way. And so they did.
They all did. In pretty much the same way, as lemmings are known to do. So now, we are over-invested in the same deal constructs (deep, see the investment atrophy described here) and under-invested in the full scope of technology innovation. As a result, large technology companies (such as Apple) are eating early-stage disruptive innovation for lunch, leaving the little deals for the bottom-feeder (subprime) VCs that count themselves blessed investing in “capital efficient” deals with little disruptive value, let alone IPO prospects.
No longer can fund investments be made using a single yardstick
LPs need to better control the segmentation in the technology asset class, especially since maturing technology evolution will have its feet in every market segment, including crossovers to other asset classes.
VC funds need to be pushed apart to yield less overlap and provide complementary investment strategies rather than an 80% overlap. That, with the requirement to start new VC funds with GPs who have had early-stage CEO operating success, allows VCs to better align with the needs of the entrepreneur and fundamentally improve the chances for high-yield returns.
