Does Venture Scale?

Marketplace models in violation of free-market principles never scale.

Last week, through a long string of conversations with a CalPERS board member and some trusted peers, I ended up speaking with Joe Dear (Chief Investment Officer) and other members of his Venture team at CalPERS in Sacramento, the largest pension fund in the United States with $200 Billion in total Assets Under Management and single largest investor in the Venture sector (as a Limited Partner, or LP), with an allocation of around $20 Billion in direct and indirect (fund-of-funds) alternative investments (which includes venture).

Joe expressed specific concern about the ailing venture sector, a message we as participants in the Venture ecosystem should all take very seriously. I do because I hear it all the time, and it worries me how devastating withdrawal of CalPERS (10% or so of all U.S. Venture and the consequent ripple) from Venture would be to Silicon Valley and our country.

Such withdrawal would be devastating to our entrepreneurial capacity and drive to which we owe our statue in the world. We still have many parasites (some quite well-known, and not too anxious to be found out) who are too busy deploying ingenious methods to suck this ecosystem dry while it lasts, unable and unwilling to see the dark clouds forming above their heads.

We all need to pay attention to the discomfort of LPs, and resolve those – not with a new set of lies and promises – but with a breakthrough systemic solution to improve the performance of Venture Capital.

Late to the table in 1988 as portfolio manager Jesús Argüelles explains, CalPERS made up for it in the 90s followed by disappointing performance today. Joe questioned the sector’s viability as a whole, by rhetorically asking me (amongst other topics):

Before I answer that question, it is important to note how ignorant the many players in Venture are to the impending threat this question poses.

At this public event, I recognized only two Venture Capital (VC) firms that were present. If as a VC I wanted to make money for my LP in these turbulent times, I would show up to offer whatever support I can muster. I did: to represent the unwavering value of disruptive innovation.
No-one of note from the National Venture Capital Association (NVCA) was present according to the attendee listing handed out at the event. Rather than to focus on helping CalPERS generate upside, I guess it prefers to spend its time protecting its members’ downside to lawmakers. The VC lobbyist needs to rethink its leadership focus.
The dismay of LPs in the Venture sector is in sharp contrast to the incessant, blind, self-serving and false optimism of many Venture participants, journalists and investors who continue to suck entrepreneurs dry and leave a subprime Venture pool behind that clouds the opportunity for serious investors and serious entrepreneurs.
No-one (except we) in the Venture community is genuinely acknowledging, with a plan of change, how the performance in Venture can systemically be improved. Better times, with more of the same, is what many wait for, but hope is not a plan.
If we do not take the subtle message from CalPERS serious, more than 10% of Venture investments in the United States could suddenly disappear, with many other LPs quickly following suit. And that means that (once again) the deployment of an incompatible financial system destroys the innovative capacity of those that deserve better.

My answer

So, my short answer to Joe’s loaded question was:

“Sub-prime venture does not scale, but prime venture does”.

The currently deployed economic model of Venture will never scale, and here is why:

Ten levels of diversification with multiple (hybrid) relationships from LP to startup investment makes it impossible to identify the real merit and performance of VCs and the validity of their investment thesis.
A (loosely coupled) commoditized investment thesis can never outgrow its peers, and thus is incapable of generating significant alpha.
Sub-prime VC systemically destroys the trust of Public Markets by pushing so-called innovations through the funnel, soiling the opportunity for more discretionary value.

The necessity to produce public value

It is a bad idea to ignore the public’s perception of Venture Capital. With a large sum of Venture money (roughly $1.9 Trillion) over the last 10 years producing no substantial public value by way of IPO, sub-prime VC has lost the confidence of the public that does not only supply the money to VC (indirectly through the public pension funds, endowments etc.) but is also expected to buy post-IPO stock on the public stock market.

So, rather than to continue with “the models for success that have worked for our industry in past decades” as many of the NVCA cohorts continue to preach, we need to rely on a new economic model that fundamentally changes Venture Capital to its core.

Our proposal in the presentation “The State of Venture Capital” will do so and it scales because:

Our Venture model removes the diversification at the bottom of the Venture equation, exposing VC matchmaker merit and accountability.
Our Venture model employes dynamic marketplace merit, not static institutional merit.
Our Venture model attracts unique investment theses that can find the outliers of innovation.

Incompatible financial systems

The problem with Venture is that traditional financial systems (stemming from more conservative asset classes and times) are incompatible with the risk and returns that early stage Venture has to offer. Over time the old financial system has steadily suffocated, and worse alienated disruptive innovation, by forcing sub-prime innovation through an exit funnel that as a result left a trail of eroded trust.

Venture has lost trust in public markets, but even more so with the outlier entrepreneur. Genuinely disruptive ideas do not even show up at the doorsteps of many VCs anymore, because certain corporations have become better custodians of innovation than venture capital (remember those ridiculous buyers/sellers-market arguments of VCs).

Change the dating service

But just because VC is broken does not mean innovation is. We need to re-establish the merit and definition of disruptive innovation and stimulate the creative and intelligent minds that can spawn it. The Internet provides a massive opportunity to tap into the buying power of 5/6th of the world population that is still technologically disenfranchised.

But if we leave the innovation marketplace functioning the way it does today, less money-in will not change the alpha (portfolio returns) for Limited Partners. Survival of the fittest in a dysfunctional market is a worthless asset.

Superior Economics

Smart Limited Partners stay committed and realize that Technology Venture has superior economics, which with the right economic construct can outperform any other asset class.

Technology feeds the brain in the same way water feeds the body. Technology can be served up in many ways to produce, share and monetize knowledge, just like water can be used to produce soup, coffee, tea or anything else you can think of. We have all the ingredients in this country to make lovely dishes, all we need is a better economic system to attract the right chefs with scrumptious recipes.

The new size of Venture Capital

So, stop making statements about whether Venture Capital should be smaller or larger. It’s a futile discussion. The size of an inefficient marketplace is irrelevant and thus by definition wrong. First, we need to deploy an efficient marketplace (that is designed to find the real merit of innovation), before we can make educated guesses about how to best support it with a proper financial system and size. Lowering the commitment to Venture Capital does not create more efficiency, changing the marketplace does.

So, LPs need to deploy a new economic system that systemically roots out sub-prime. The solution that scales to its authentic potential is here today.

Does Venture Scale?