A couple of years back, we first coined the phrase “subprime Venture Capital” (short: subprime VC), and many of our blogs since have followed, describing its foolishness and demise. Recently Limited Partners, the investors in VC, have become more interested in the definition of “subprime VC” jazzed up by the temporal resurgence of IPOs (remember: IPOs are just another promise of value) juxtaposed with reduced access to an even smaller group of Venture Capital firms that seems to benefit from them. The pool of confidence for LPs, driven by negative 10-year average VC returns, has become smaller.
So, I get the question more often about what exactly “subprime VC” is, how to recognize it, and how to steer clear from it as an LP. Obviously, “subprime VC” is more than a simple curse to describe the more than 95% of the Venture Capital firms that do not produce consistent Venture Capital returns for their LPs and the destructive effect the creation of many false-positives and false-negatives has on the perceived state of innovation.
The Venture Capital sector and the asset class (or sector) returns are only meaningful to LPs when they scale and consistently outperform others. And after many years of financial tinkering, the question for many LPs remains why the financial system of Venture Capital, which is supposed to support the still massive 80% greenfield of technology adoption, cannot scale along with it.
The term subprime
Wikipedia describes the term subprime in great length in relationship to the subprime mortgage crisis, in which many mortgages were doled out to subprime borrowers who, under financial duress, ended up in default. However, the problem with the subprime mortgage crisis was not as much of the quality of its borrowers as with the massive deployment of uniform risk to those borrowers.
In financial terms, subprime simply refers to the uniform deployment of risk.
The mortgage crisis would have been avoided if the investments of a mortgage bank were not uniformly deployed, and investment risk would have been deployed proportionately to the variety of borrowers and a range of assets. So, the mortgage crisis results from flawed risk management in the asset diversification strategy of banks rather than the cumulative fault of borrowers who were made to believe in the “American Dream.”
Subprime VC explained
Venture Capital suffers from the same uniform risk deployment discovered in the mortgage crisis. We are blowing the whistle on Venture Capital to secure viable LP returns and prevent further damage to the detection and monetization of groundbreaking innovation. We believe outlier entrepreneurs deserve better than to be shoved through a uniform funnel of risk arbitrage.
As a former (part-time) Venture Partner operating in Silicon Valley, I could divulge many stories about specific investors and companies. Still, I care more about working on a fix than embarrassing those who take it for a selfish ride. Thus, my focus in explaining subprime VC here is its structural incompetence and deficiencies.
Subprime VC refers to the uniform deployment of investment risk in the arbitrage of innovation.
- Uniform compliance with economic principles in Private Equity that are not free. A financial system that is not free-market, in-transparent to all marketplace participants, and violates many other free-market principles by economic principle gravitates to the deployment of uniform risk.
- Uniformly unaccountable Private Placement Memorandums (PPM). Most Private Placement Memorandums from VCs fall short in the analysis of plausible investment risk, contain no tangible performance metrics, nor a well-defined investment strategy that sets them apart. Many PPMs (we’ve seen) are a carbon copy or a personalized version of the PPM from one of the few prominent VC firms on Sand Hill Road. The newly proposed Private Equity principles by the ILPA are an excellent step to tighten up some of the controls, yet do not touch the flawed economic principle underlying private equity and, as such, is effectively not more than dining room etiquette.
- Uniform investment structuring. Every groundbreaking idea has a unique path to the upside and, therefore, a unique funding trajectory. The investment staging applied by VCs reflects nothing but uniform protection against downside risk.
- Uniform valuations. Every idea unique enough to obtain funding requires a valuation calibrated to the upside unique to the idea. Funding companies based on relative valuations by default classify every investment as a commodity and therefore apply uniform risk.
- Investor collusion. The uniform freedom of VC firms to deflate risk, freely fragment and syndicate investment stages, and engage in the excessive investment socialization (and price-setting) we can all witness at the popular innovation conferences is opposite to the fundamental discovery of outliers and uniformly applies attraction to those who are not.
- Uniform technology risk assessment. The majority of VCs deploy risk associated with technology waves we can all see in our rearview mirror, while technology production is far from the most precious risk of a technology company.
- Years of funding small first rounds attract only entrepreneurs with predominantly trial-and-error technology ideas, of which only a few can produce $1B companies. Thus, the financial rewards of Venture are artificially restricted by its self-induced uniform investment thesis. Big thinkers are encouraged to find refuge for their ideas elsewhere. No surprise corporations have become better custodians of innovation. Uniform wannabes (on either side of the investment equation) comprise the remaining maelstrom.
Venture Capital risk should be deployed non-uniform and, thus, in the opposite way it functions today to attract, find, and recognize the prime talent that can build lasting socioeconomic value the public can trust again.
Great time to be an LP in Venture
New institutional investors in Venture have the opportunity to quickly recognize and avoid subprime VC by – for the first time – deploying economic principles that are compatible with the needs of the underlying asset, innovation.
Innovation relies on discovering outliers to which only a free-market financial system can assign merit. So, now with still a massive adoption of green fields on the horizon and the internet as the technology foundation for free-markets is a great time to benefit from the innovation subprime VCs with their socialistic capitalism will never be able to discover.