How Top-Quartile Runs Out Of Merit

Top-quartile wins my proclamation as the most delusional way to measure VC performance or any financial firm. And none of us should be surprised that innovation cannot reach maximum potential with such meritless accountability of its arbitrage.

When a swaggering private-equity reporter of an unfortunate finance publication attempts to soften the blow of how yet another Silicon Valley venture capital emperor is losing its clothes by stating “the emperor” may still perform in the so-called top-quartile, it becomes clear how he and those who feel comfortable in this argument know nothing about math, finance, its investable attribute and the business of innovation.

Change must come

Even the venture firm in question, KPCB – to their credit – appears unsatisfied with the reporter’s rationale, given their purported apologetic confession, not worthy of grand excuses to their limited partners. Being among the best subprime venture capital (99.4%) is not a badge of great honor. KPCB appears to and should be ashamed of itself for not producing outlier venture-style returns amidst a young and gaping 80% adoption greenfield of innovation.

KPCB is not the only top-brand venture firm in Silicon Valley losing steam; we have similar indications to believe others, including Draper Fisher Jurvetson, with massive stacked and parallel fund diversification, suffer from the same fate. So, how many more heads of the state of venture capital need to roll before limited partners realize the Silicon Valley emperor has genuinely lost its clothes (as I wrote back in August of 2009)?

When will most limited partners realize that the many problems in venture are not merely incidental but systemic? As in deploying the vast embedded risk of old-school asset management, Systemic is incompatible with the needs of innovation.

When will we all realize that to allow venture capital firms to deploy greater-fool economics is to erode the 20% of GDP innovation can generate steadily? And that if – and only if – we fix the flawed deployment of ten levels of embedded risk (regardless of private placement investment thesis) in venture capital, we have a chance to once again successfully tap into the unique entrepreneurial culture and capacity this country has to offer.

We should not be surprised that if the arbitrage of innovation does not fundamentally renew itself from time to time (along with the innovation it selects), its performance will mimic that of a gold-winning Olympian: very hard to replicate as time goes by.

Define top-quartile

The term quartile is commonly used in finance to qualify an investment firm’s past performance. As such, “top-quartile” is used to denominate the best-performing venture capital firms by past (and sometimes trace current) cumulative performance of all funds under management.

In descriptive statistics, three quartiles divide a data set into four equally populated groups. In finance precisely, the quartiles of a population delineate the four subpopulations (defined by classifying individuals) according to whether the value concerned falls below or above the three delineating values. Thus, an individual venture capital fund is described as “in the top quartile” merely when all venture capital firms are considered. Cumulative fund performance tops the performance of 3/4 of other firms.

To simplify the above a little, in the Olympics, the gold and silver medal winners of the 100-meter sprint can be considered top-quartile, representing the best 25% of all performers (of that race). The bronze medal winner is near the edge of the top quartile.

The morass of top-quartile

There are many problems with the top-quartile definition, indicative of the foolishness that has permeated much of the financial world.

Let’s pull a few of the many fallacies out:

Fallacy #1: The meaning of top-quartile population is relative to the sample size and composition of the active population measured. If limited partners know all venture firms’ performance, that sample may be complete at one point. Most limited partners do not have access to the entire live selection nor the refreshment of the population needed to stay aligned with the changing nature of innovation. Not all venture firms raise money from institutional investors, and not all do from private investors, and they are not all inclined to share. So, what population subset defines the top quartile?

In Olympic-runner terms: the question should be asked if the ten runners lined up at the starting line are all the best runners one can find today. How do you source new talent who still qualifies – where are the pre-trials of fresh blood?

Fallacy #2: Regardless of sample composition, there is no universal method of choosing quartile measurement values. The low and high bar and standard deviation fluctuate dramatically based on the performance criteria you intend to measure the population. The plot thickens when some firms use the ever-so-popular but nebulous, internal-rate-of-return (IRR) metrics. And many venture firms even get away with establishing their metrics, er excuses. Some can use stock-market indices, including shares of 100-year-old asset classes with highly commoditized characteristics and almost depleted greenfield, to be compared with an emerging asset class of technology innovation with opposite traits.

Again, in Olympic terms: how relevant is the performance of one of the ten runners? If one or each runner gets to define what it means to be a winner during or after the race?

Fallacy #3: Relative performance of the sample population deployed to highly untapped and thus still inefficient markets, such as an 80% greenfield of technology innovation, is a highly non-representative metric for how it will perform. Even the best venture capital performer, using today’s investment model chockfull of collusion and price-fixing, may produce an occasional venture-style return for limited partners yet never propel a meaningful adoption of innovation. Thereby questioning its renewable value, the trust it needs to earn from the public, and its merit as an asset class.

In Olympic terms: the best runners may win the race now and then, yet perhaps never secure a world or Olympic record to write home about. Conversely, people like Lance Armstrong (he is not alone) can rig a system by which the winner’s proclamation gets a whole new meaning.

We are fools

There are many more reasons why the top-quartile denomination earns my proclamation as a ridiculous way to measure venture firm performance or any financial firm. None of us should be surprised that innovation cannot reach maximum potential, with a financial arbitrage atop held accountable for such meritless and meaningless definitions as top-quartile.

We must look seriously at the foundational economics that allows this nonsense to erode everything we stand for and produce. Or we, as entrepreneurs, will continue to succumb to the failed policies derived from that nonsense.

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