Why Venture Capital Will Not Simply Recover When The Economy Does

I saw an article a few days ago from an enthusiastic young General Partner (GP) declaring that “Venture is Back,” and it reminded me how frighteningly naive some people in the venture business are.

A naiveté that gives entrepreneurs (and Limited Partners) false hope. And we do not need more false promises in the venture business.

I want nothing more than to leave this horrible decennium of venture behind and start a new one again, but I cannot get excited about the mere sound of a spinning engine that gets the car rocking back and forth. Frankly, the car is still stuck in the sand with spring breakers drinking the kool-aid and cheering it on.

Spinning the wrong wheels
I, too, see the statistics on the venture pace going up and down and depending on whose reporting of an in-transparent venture business, you believe. You can pick your pill of the day.

But how fast Venture Capitalists spin their wheels is irrelevant to the performance of the venture business. And even how many deals are done and how many exits are produced is irrelevant. Short of any transparency in the venture business, those metrics are poor derivatives to report on its ups and downs.

What matters is fund returns
But what matters to Limited Partners is how much money goes into the VC fund and how much comes out at a vintage (after the 7-10 year life-cycle of the fund). Only a fund return that outscores any other asset class a Limited Partner (LP) invests in can count on receiving continued commitments that add to the growth of the venture sector. And the venture sector is far from growing.

Why venture remains broken
There are many more fundamental reasons as to why in the years between 9/11 and the economic crisis of 2009, venture funds have not shown dramatically better performance while the wind was blowing in the sails of VC who had their LP commitments lined up (see how we counter the hope-and-pray philosophy).

Here is my top 3:

– Flawed deployment of risk
The majority of VCs today rely solely on what I call “technology grazing” as the method to extract greater business value. While that not only reduces potential upside, it also deploys a flawed risk profile to the creation of early-stage companies.

Venture Capital has died and resurfaced as micro-PE (Private Equity) that deploys an inappropriate risk model to innovations that are supposed to set the world on fire. To the many VC funds larger than $100M, chasing companies that have access to less than $1B in monolithic revenue opportunity and less than a $300M exit opportunity is simply a waste of time.

But the GPs have done so in droves anyway because God forbid if they would have to give the money back to LPs unable to find genuinely disruptive innovation and forgo some of their management fees.

– Too many cooks who can’t cook
The vast majority of VCs in the venture business today have never themselves crossed the chasm that would allow them to find the outliers and arbitrate innovation accurately. While GPs in Private Equity may get away with fundamental skills to accelerate growth, the venture sector relies on specialist GP skills to turn early ideas into highly relevant innovations.

And even then, outliers are usually detected by outliers themselves, not by people who merely followed an educational trajectory cum laude. From a dissection of their bios on their websites, you will find the evidence that most General Partners have no merit in judging how and when an early-stage company should make the transition from an early adopter to a mass market and with what kind of investment.

Experienced entrepreneurs are like discerning food lovers; they have a choice and stay away from bad restaurants.

– Endless diversification without accountability
Excessive multi-level diversification does not work and leads to more fog than clarity of purpose. Everyone and everything becomes a derivative, with no line-of-sight to accountability.

First, the LPs diversify their risk by deploying a mere 10-15% to alternative assets (which includes venture, relying on other assets to produce the majority of LP returns), then they diversify to commitments in a multitude of venture firms, who then diversify into multiple funds, that then diversify to multiple GPs, who then diversify in multiple startups, who then diversify investments in multiple rounds, and then syndicate with multiple VC peers.

Hence my reference to a venture soup. And the asset holders, LPs, and entrepreneurs are not liking the way it tastes.

The real fix
The underperformance in venture is similar to the car driving in the sand with the wrong tires and without locking differentials. The size of the engine (VC fund) does not matter, nor does it matter how fast you sped away on other roads. Only the way you apply the power to the current surface does. And so what matters is to what risk the amounts of money of a VC fund are applied.

So, unless the VC funds are set up and mandated to chase different risks, I do not expect to see any positive, sustainable change in venture performance.

Yes, macroeconomic confidence will increase investment pace and even improve the speed of mergers and acquisitions, but as long as we keep filling the pipe with sub-prime investments, we will not see more than sub-prime returns. We merely keep producing insufficient innovative disruption to outpace other prime LP asset classes significantly.

Over the next couple of months, our government should instill free-market principles to the financial industry that, through transparency, can expose the real merit of investors in the venture business. But before that, each LP can make immediate changes to their VC commitments now, to stave off the lingering curse of subprime VC.

The good news is that the future of the venture business is solely in the hands of the LPs, who, by virtue of more discretionary VC selection can enthuse the outliers of innovation which, because they have more options, are currently patiently lying in wait.

The sign of an intelligent nation is its willingness and ability to reinvent itself, upstream. Let’s inspire the world with new rigors of excellence we first and successfully apply to ourselves.

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