New Expectations For Limited Partners In Venture

Georges van Hoegaerden
Georges van Hoegaerden
Founder, Author, and Managing Director of methodEVA.

The tables have turned on Venture. Only 35 out of 790 Venture Capital firms (VCs) have allegedly made any consistent money for their Limited Partners and so recommitting to the desperate cries of Venture Capitalists for more money is the dumbest thing they can do. And the stupidest thing entrepreneurs can do is to continue to listen to the current VC arbitrage.

Venture will not be “stolen” by the oxymoron of Angels who perform on average worse than VCs and appear to use the same cartel practices. What can fix Venture is the proper deployment of risk, not escapism.

Today, Venture is at a stalemate.

Subprime VC maelstrom

The reason why VCs have not performed is not that of the dismal state of the economy but because of their fuzzy investment thesis (read some of their Private Placement Memorandums), insufficient relevant experience, and improper self-induced deployment of risk.

Many Limited Partners, spurred by attractive returns from an era when turkeys could fly, rushed in twenty years ago without paying too close attention to the deployment of risk either and allowing thirteen levels of bottom-heavy diversification to develop, which proliferated an investment cartel (through ad-hoc syndicates) and thus propelled the mediocrity that we coin subprime VC today. Rather than eliminate unnecessary risk, Limited Partners, by their lack of investment discipline, allowed for the creation of new risk on top of an already risky startup business exacerbated by extreme fragmentation of assets-to-risk ratios.

So now, Venture is poised to slide further down the subprime maelstrom and, without fundamental change, will artificially restrict the birth of groundbreaking innovation to the limited scope of a handful of VC firms. Contrast that with the 80% greenfield in technology penetration, and you realize how a defunct financial system can systemically erode our role as the most innovative country in the world.

Despite desperate attempts from a few who ignore the importance of the innovation intake and instead seek alternative exits for valuations without value, Limited Partners have no other alternative than to stay in and pray for better times or to get out altogether. Until now.

The solution

The solution to fix Venture is not to optimize its problems downstream but to set the methods of deployment of Venture right at the source. I mention various of those gating elements in this blog (see The State of Venture Capital), yet a cohesive Venture model consisting of those economic ingredients is disclosed only to Limited Partners who demonstrate a different commitment to Venture.

A new model with the same despondent Limited Partner involvement from the past will not yield the critical commitment to innovation we aim to secure. Our goal is to achieve prime relationships with select Limited Partners, which will lead to establishing relations with prime new General Partners and prime entrepreneurs. We eradicate subprime at every level of the investment pyramid and therefore attract genuinely groundbreaking innovation that carries considerable socioeconomic value and instills public trust.

We know the decision to turn the table where access will not be “easy” means fewer Limited Partners will be interested, and fewer will be able to demonstrate their authentic commitment. And that is okay with us since the further proliferation of subprime Venture helps no one.

There will be plenty of General Partners who, for more selfish reasons, will still take their “Evergreen” money for a spin. But subprime Venture hurts innovation, and to us, there is no other option than to eradicate the Limited Partners from the Venture ecosystem who, intentionally or not, deploy subprime. Prime returns can only be generated by prime Limited Partners who build relationships with prime General Partners who attract prime entrepreneurs.

Limited Partners commit different

To enable new discipline in Venture Limited Partners need to do nothing but commit anew. Commit to a new regimen that flattens the distribution of assets, removes derivatives, and emphasizes the merit of individual General Partners, each with their unique investment thesis and deployment of risk compatible with Venture.

We built a new economic model for Venture at the beginning of this year. The way we designed the model is that Limited Partners do not need to spend more time than their limited allocation in Venture as part of their overall portfolio warrants. Limited Partners need to spend less time on Venture. No longer do they need to worry about the inherent deficiencies of the improper deployment of risk, its current incompatible, indefinite diversification and overly complicated market model that built the ongoing Venture fallout.

But that new commitment requires Limited Partners to unlearn some behavior from their current practices that have proven not to deliver viable Venture returns in the past anyway.

So change should come easy:

Value future more than past

Just like CalPERS admitted to using every statistical (trailing & predictive) analysis known to man, returns in Venture do not come from hanging on to conventional wisdom and endless fine-tuning of what our schooling has told us. Venture returns depend on the recognition of dependable foresight and thus require an economic and financial system different from what we have currently deployed in Venture and different from the macroeconomic models that prove time and time again to spiral down to mediocrity. Eighty percent of the world’s population is currently not served with a viable technology application. That statistic should be enough to lead Limited Partner interest in a new future for Venture.

Commit to Venture specialization

Venture is a unique sector. While it is considered part of Private Equity in financial terms, the unique behavior and risks require that those managing the deployment of assets are a particular breed too. So, a fund-of-fund with multiple alternative assets cannot adequately serve and be the master of Venture Capital, nor is a Private Equity firm with risk diversification in other financial instruments the appropriate venue for the unique focus and emphasis Venture requires. We are creating a new Venture specialization in which all interests are aligned to serve the unique requirements of innovation and therefore spawn its greenfield opportunity. By doing so, we dramatically reduce diversification at the bottom of the pyramid and increase accountability.

You should not select General Partners

Let’s face it. As a Limited Partner, you have not succeeded in picking the winners from the losers. No surprise there, your expertise is to assess risk horizontal across multiple assets, not to evaluate the vertical skills needed to determine GP’s on their merit of the Venture domain. Limited Partners generally do not have the depth to understand which Venture strategy does or does not make sense, as we witnessed from the wildly copied private placement from a prominent VC firm in Silicon Valley and subsequently accepted by many Limited Partners “carte blanche.” We can take over that role and act as the intermediary who, with a new investment thesis in hand, will find GPs with the demonstrable merit to participate.

Ditch proven for passion

Most “proven” investment strategies from the past have not produced and will not lead to viable investment strategies tomorrow. The world has changed, and Limited Partners should invest in people who have learned a few lessons in life over those that have been riding the oh-so-comfortable bandwagon for too long and conniving with their friends and colleagues on how to extract rather than produce money in a socially acceptable fashion. Venture returns are dependent on the flourishing of outliers, recognizable only by similarly outlier General Partners. Unique foresight remains the only investable attribute that can make Venture businesses take off (technology development and cost is a commodity), and whatever is proven is unlikely to generate the returns Limited Partners are looking for.

Focus on upside versus downside

I understand it is hard for many to see the forest through the trees in Venture. Dismal returns have and will scare many investors off, but the appropriate response to Venture should be calibrated against the massive adoption greenfield that still lies ahead.

Contrary to popular (but underperforming) belief, “Capital efficiency is a protectionist trap”. Technology companies that shoot for significant disruption statistically still require no less than $25M in funding. That means that the original premise of Venture, to deploy considerable risk to yield substantial returns (when targeting socioeconomic value), remains valid. Most successes in Silicon Valley are from those companies that have been able to dodge the Venture cartel and shake the money tree for upside support (Google, Facebook, Twitter). So, as a Limited Partner, you can deploy $250M and up to Venture and still create very viable returns, albeit this time with a more diligent deployment of risk.

The race to produce upside belongs to Venture, and the efforts to protect downside belong to Private Equity. The distinction is where we separate the “men from the mice.”

Commit to invention

Venture, the way it is deployed and popularized currently, cannot produce viable returns because of the incompatibility of risk deployed. Limited Partners need to learn one lesson of innovation, it is the following:

If you want similar success to the iPhone in the mobile phone business, you better reinvent the phone. If you want significant success in the Venture business you need to reinvent Venture.

We look forward to testing your commitment to the unique access to Venture Capital we aim to provide.

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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