Limited partners need to pay close attention not to dilute venture into private equity. Especially because technology and its impact on the world are at the beginning of their evolution.
The more I look into the complete value-chain that makes up Venture (from Limited Partner all the way to Entrepreneur), the more I see the origination of its gaping dysfunction. My conversations with a $3 Trillion, a $20 Billion, and a $1 Billion Limited Partner (LP) with some of its asset-under-management (generally between 10-15%) committed to Venture, yields the same fundamental conclusion.
Lack of general investment discipline
It appears that many of these LPs in Venture deployed money frankly too lazily and too hastily to a sector that was once booming, as they rushed to get in to reap similarly projected upside. Without any specific Venture expertise, they quickly deployed a me-too investment model to Venture (copied from its elderly Private Equity PE brother) that was supposed to outperform its other asset classes significantly, but it didn’t. And those LPs now wonder in disappointment whether Venture scales, to which of course my answer is:
No investment strategy without discipline scales.
Most surprising in my conversations with LPs who are eager to improve Venture performance is that almost all of them seem to expect me to roll out a more dark and deep “Voodoo plan of Venture investing”, with more complex detail and nuance combined with alternative exit structures.
I do quite the opposite, as I prefer to simplify things dramatically. As an “outsider”-looking in, my role is not just to absorb the way investing works today but more importantly, identify the way a better financial system for Venture should work. As if today is the first day of Venture investing.
So rather than with a submissive attitude akin to the usual money-hungry cast of characters that approach LPs, I challenge them on the fundamentals of the assessment of investment risk to benefit us all and to come up with the proper investment structure to curtail excessive risk. Because the only risk LPs should incur is the market risk of the startup companies that are invested in, not bear incremental risk because of the sizable financial system that sits on top.
Au contraire, LPs have deployed unnecessary risk in Venture that “by design” underperforms:
– Deflation and fragmentation of risk
As one can glean from our The State of Venture Capital presentation, LPs have allowed the deployment of no less than ten levels of diversification (and fragmentation), before the money reaches the startup it invests in. And that means the underlying instruments are deploying excessive risk aversion and downside protection, a source of comfort (perhaps) but not indicative of a great understanding of risk nor a consistent process of the great performance by the supposed investment professionals.
– Lack of focus and accountability
LPs should have deployed an upside-down pyramid in the deployment of risk, meaning they get to deploy diversification of assets and below its diversification should be dramatically reduced or (ideally) zero. So, while top-heavy diversification may be meaningful, bottom-heavy diversification is destructive and leads to a lack of accountability to the investment thesis. Many Fund-of-funds that deploy Venture money for LPs, themselves have their diversification strategy, as they also invest in PE, buyouts, pipes. So do some Venture Capital firms (VCs) who also diversify in different instruments, sectors, stages, industries sometimes aided by investment networks that can “uniquely smooth out investment commitments,” clouding the performance of a specific investment thesis and the merit of the people attached to them even more.
– Mediocre Private Placement Memorandums
The composition and content of many of the Private Placement Memorandums (PPM) from VC firms I have seen is an absolute joke, and many of them are a straight copy of the plan from one of the first brand-name VCs on Sand Hill Road. No business plan from an entrepreneur with such a vague description of the ability to execute would make it past the first meeting with a VC. LPs even go as far as defending why no PPM commits to a target return; “the lawyers will not allow it.” But without a baseline performance index, LPs who invest in multiple VC firms have no simple way of holding VC firms to their promise, except to try to assess whether the VC firm “did their best.” No startup gets sued over not making its target revenue numbers, and I am sure we can find a legally acceptable way to hold VC firms accountable for their bottom-line.
Lack of Venture specific discipline
But Venture requires a few crucially different disciplines than its elderly “brother” PE. The significant difference is in the nature, and the risk associated with the asset LPs (indirectly) invest in. Simply put, PE relies on more hindsight (ability-to-execute) than foresight to become successful, while Venture requires more foresight than hindsight to cross a chasm (Geoffrey Moore) that is so unique to that disruptive innovation.
– Lack of relevant GP experience
We have hit on the general lack of relevant entrepreneurial experience of GPs (that passed LP scrutiny), which is essential in helping plot the risk associated with an early stage investment and with the identification of how much money an investment requires to create disruptive market value and subsequent public value. Many GPs came from PE, Wall Street or other finance positions, or came out of a late-stage technology company that made money in the hay-days, and have now slid into the aforementioned unaccountable GP role with a comfortable income, plus no downside but upside for the next ten years. Very few of them have proven that they have what it takes to take a company from the left side of the chasm to the right side of the chasm successfully, and therefore lack the necessary foresight that is so pertinent to Venture.
– Lack of expectations
Many LPs in Venture allow GPs to hide behind the notion that startup success is impossible to predict. It is indeed when GPs have only hindsight as the instrument to project foresight. But as an experienced entrepreneur who wants to change the world, and being born with such characteristics and subsequently honed and monetized those skills for 30 to 40 years, your odds as that entrepreneur are much better than you can often articulate, and certainly much better than many of the current GPs can evaluate. Every company or product line I ran became successful beyond its expectations, and I would not even engage when my next venture (which is to rebuild venture) would not have a higher success rate than 50%. So, GPs who are comfortable with two successes out of a portfolio of ten demonstrate what they are made of. They gamble instead of having their relevant experience and foresight play the crucial role in setting a higher (disruptive) bar. LPs should demand more than a 50% success rate from their GPs.
You get what you put in: put in $x, get $x. In Venture, put in $x + foresight, get $x times foresight.
Lack of discipline turned VC subprime
Smart entrepreneurs, who do not let themselves be “abused” by unfavorable terms or partnerships that do not match the authentic experience and merit of the entrepreneur, are not engaging with the predominantly subprime VCs, waiting instead patiently until conditions improve.
For the last 10 (I believe 20) years VC have treated entrepreneurs like a cheap commodity, that subsequently has overwhelmingly answered subprime VC mating calls. Subprime VC now attracts hordes of subprime entrepreneurs, convening in flashy technology flea-markets where each matchmaking applies ill-advised risk analysis in a quick dating scheme to make a buck. They deserve each others company.
But the lack of relevant public value (through IPO) has deflated trust not just with the public – and thus output, but now also with those LPs managing public money to fund venture – and thus input.
To fix Venture
So, to repair Venture, we need to implement a mechanism that marries the needs of those with money, the LPs, with the requirements of those with disruptive ideas, entrepreneurs, in a more effective fashion. We need to treat Venture as an economic marketplace, in which not syndication perpetuates mediocrity but real competition amongst GPs emphasizes their merit and demonstrates their unique ability to find outliers of disruptive innovation.
We are blessed in this country with brilliant entrepreneurs who have found refuge from the Venture malaise in as many ways as entrepreneurs can. They will come out of the woodwork again when the appropriate marketplace for disruptive innovation presents itself.
All LPs need to do is treat Venture as a particular sector that can create, with the right market model and incentive structure, better returns than any other asset class. Because technology, along with its immediate impact on the world, is at the beginning of its evolution.
But Venture requires discipline and devotion many LPs do not have today. So, dear LP: stock up on experience, knowledge, and discipline, and let’s rock-and-roll again soon.
