The lack of control limited partners have over the capital they put to work is palpable and disturbing. But more power is not what saves the bacon; only better preselection will.
The statement in the title of this article was posited by a limited partner on our website recently and made me think about similar discussions I have had with other asset managers. Such a sense of helplessness indicates how limited partners (for example, the investor in Venture Capital funds) feel a lack of control over the capital they put to work after a commitment for a ten-year vintage investment cycle is agreed upon.
Legally, of course, there is little intervention that can take place beyond the investment committee construct agreed to in the closing agreement. But even with more frequent investment committee meetings, the question remains as to what pertinent topics they should cover. Because any General Partner with half a brain can douse the curiosity of a Limited Partner with the complicated and mysterious “voodoo of innovation,” or temper it with soothing references to the me-too of hot potatoes in the industry.
So, the real question for a Limited Partner is not how to become more informed but better informed considering the asset manager’s holistic area of expertise.
The deep-dive temptation
Since the Venture Capital sector has underperformed for the last twelve years (it shouldn’t have) and produced negative returns for most, the natural attraction of many Limited Partners who righteously still believe in the massive greenfield for innovation is to become more involved and interject themselves into the investment decisions more aggressively. In the same way, a Venture Capitalist will request more board meetings from the CEO of a portfolio company when things do not go well. But Limited Partners do not have the same expertise as General Partners. In the same way, most Venture Capitalists have no experience or merit to question a CEO of a portfolio company adequately to induce corrective measures.
So, to maximize the quality of information a Limited Partner receives to judge the performance of his asset management portfolio, we need to go back to the original premise of the relationship structure between Limited Partner and General Partner and the roles and responsibilities of each.
We need to go back to the start.
A lousy start makes for a worse ending
Almost fifty years of life experience has taught me that a bad start practically always leads to an even worse conclusion.
Having seen many a Private Placement Memorandum (PPM) of Venture funds on Sand Hill Road, void of tangible performance metrics, void of detailed risk deployment parameters, the omission of a contrarian investment thesis, and the omission of lasting socioeconomic impact in the “business plan” of many a Venture Capital fund screams at my experience that many are doomed to fail. And they have. Only about a handful of the 790 Venture Capital firms (post 911) make any(!) Venture money monolithically and consistently for Limited Partners. The remainder is embroiled in cunning and in-transparent risk escapism.
The engagement in such an investment plan says something about the time in which the plan was blueprinted. Pre-911 many new Limited Partners were desperate to expand their asset management strategy with a piece of the significant returns produced by the pioneers of Venture Capital. Subsequently, General Partners of virtually any descent obliged and jumped in to take their money and become “the expert” of the sector’s newfound glory.
Since then, not the lack of greenfield but the overwhelming subprime nature perpetuated by these uniform agreements deflated the arbitrage needed to detect outlier innovation and stopped it from producing promised prime investment returns. Only a handful of innovations that escaped the wrath of subprime Venture Capital continue to prove their value worth – despite not because – the “best practices” of Venture Capital.
So, with these ill-formed agreements in the market, how do we now correct the distant relationship between Limited Partner and General Partner? How do we realign the Limited Partners and General Partners from subprime to prime?
New rules of engagement
As explained in our innovation primer, the Limited Partners and the entrepreneurs are the primary asset holders in the innovation marketplace. And money from Limited Partners is exchanged with innovative ideas from entrepreneurs by Venture Capital as the judge.
The public has spoken; deliver tangible socioeconomic value post IPO, or you will lose my trust and support. And support for the Venture sector is already waning, not just by the public as a public investor.
Innovation can only remain a renewable asset class if the public agrees with the purported value assessment, and some delivered, by the Venture Capitalists. And thus, the public as a consumer (user), public investor (stock market), and private investor (institutional fund allocation) needs to agree with and be a beneficiary of the realization and upside of an innovative idea.
Hence, the merit of innovation arbitrage (Venture Capital) is a direct analogy to the ecosystem’s health that can feed the returns achieved to Limited Partners and entrepreneurs. Mistreat either asset holders and their assets, money, and outlier ideas will start to diminish in quality even further. For great Limited Partners and entrepreneurs always have other options.
The above realization sets some new standards to which Limited Partners can hold Venture Capitalists accountable, even if the formal agreements are already locked in place. Renewable innovation is the only way for Venture Capitalists (with merit) to stay in business.
So, the above-identified uninformed Limited Partner should not indulge in and become an accomplice to the decision-making by a General Partner for a specific innovation. The Limited Partner has no credentials to do so. He should instead validate that any investment made by the General Partner complies with the asset management philosophy that generates and perpetuates a renewable investment sector, secures a valuable long-term investment commitment, and warrants the investment of developing the necessary experience associated with its unique risk profile.
The only reason why a Limited Partner would engage in Venture, to begin with, is to reap the massive rewards available to no other asset class but Venture, with its underlying 80% technology adoption greenfield, and thus worthy of incurring well-tuned and proportionate risk.
The economics of risk
Successful investing in Venture Capital rests on a simple economic principle: prime risk can produce prime returns, subprime risk can only deliver subprime returns. Lest risk not by default be money.
We know what constitutes subprime investing. We coined the term and diligently spelled out its discovery in Silicon Valley with its trending attributes. And since the majority of Venture Capitalists have deployed subprime risk for quite a long time, subprime returns and a subprime pipeline should come as no surprise.
Beyond the damage caused to Limited Partner assets and confidence, subprime investing severely hurts the underlying asset. Just imagine the number of false negatives underperforming Venture Capitalists have left in their wake. Some forty years of Venture Capital investing has not made a severe dent in the size of available technology adoption greenfield. And frequently, corporate innovation beats Venture driven innovation, proving its arbitrage wrong time and time again.
Venture’s success is directly related to the fundamentals of investing and the pursuit of a prime thesis therein.
The pursuit of prime
While subprime investing is easily identifiable, prime investing is not. Outlier innovation can only establish the opportunity for a prime investment, driven by the agreement on the possible upside between the investor and the entrepreneur. The merit of that upside ultimately validated by the public will determine whether the arbitrage and marriage constituted by the Venture Capitalist are indeed recognized as prime.
So, the uninformed Limited Partner must act as the referee in a football game. He can establish what violates the rules of football, but he cannot preempt who wins. Conversely, subprime investing in violation of the economic principles needed to drive outlier innovation should, therefore, be aggressively ruled out by the Limited Partner as the referee. And then, following the financial rules of innovation, clear the way for the best prime Venture Capitalists to win.
The merit of the Venture Capitalist is no longer based on meaningless quartile accreditations meant to reward the one-eyed in the land of the blind. Still, it is ultimately determined by the public’s more relevant and absolute standard and whether the early investments consistently produce the returns promised. Only then can Limited Partners consider Venture prime and a renewable asset class worth investing in.
Three new disciplines
So, the most critical role of a Limited Partner post-close is to ensure the investments made by Venture Capitalists do not default to subprime and predicate the deployment of a prime risk profile (that earns the classification of Venture) that can produce outlier performance.
Below are three new disciplines aligned to meet the core competency of an asset manager that enables him to make a start in becoming better informed about the degree of prime economic risk deployed in Venture.
The disciplines below do not protect the economic outcome of Venture as a whole. For we need to apply a more fundamental change in the workings of our financial systems we alluded to elsewhere on our site.
1. Establish socioeconomic upside
Regardless of the opportunity for intermediate exits, every investment must have the potential to produce tangible socioeconomic value independently. This meaning Venture Capital investments must have economic upside asset-managers can grasp, unfazed by the complexity of underlying technology du-jour. Keep questioning innovation’s upside supported by technological elasticity and the financial requirement to do so.
2. Measure contribution to the runway
Investments by Venture Capitalists must be made to contribute to the upside, not merely as a way to protect the downside. To avoid the mediocrity of investment socialism, Venture Capitalists must demonstrate how they can contribute to building the economic upside and its runway without heavy dependencies. The spray and pray of “capital efficiency” is a well-known investor methodology that frankly is responsible for much of the negative trailing performance in Venture. The reality is that the production of any socioeconomic value worth Venturing into still requires some $25M to build. Ensure the planned contribution to each portfolio company is at least half of that ballpark to avoid excessive fragmentation and collusion.
3. Validate non-uniformity
Outlier performance is non-uniform, and hence the risk deployment and investment staging cannot be uniform. Meaning if the investments by Venture Capitalists are staged the same, relying on the same technological trending and use the same syndicates, they violate their unique investment thesis. They have submitted to uniform (and thus subprime) conformity. Measure, instead, how and why non-uniform investments in innovation contribute to the individual risk profile associated with the economic objective of every portfolio company.
Exercise your right to become informed
Limited Partners with their Venture Capital funds already deployed in-market may not be able to affect the change required to turn the majority of Venture Capital from subprime to prime. In the same way, a portfolio company, if doomed, can seldom be rescued.
People’s unique foresight, the crucial attribute of differentiation for a Venture Capitalist, does not change because they are managed more closely or even when their monetary incentives are turned (up or down).
But close monitoring of Venture Capitalists based on the economic criteria mentioned above will explain why some of them succeed and many don’t. And it offers valuable clues as to which Venture Capitalist has the innate spirit and proven merit to produce the renewable returns at the horizon of a still massive technology adoption greenfield.