Chapter 4 — Solving for the Human Capital Challenge in Venture Capital

So if we haven’t found a strong argument why we should not try and build a fund from scratch as there appears no structural barrier to entry that cannot be overcome — how do we therefore do this? How do we solve the human capital challenge of identifying the top performing venture capitalists and founders!

Photo by Olav Ahrens Røtne

Where to look first?

The churn in top tier performance is drastically increasing as the VC market matures and alpha is dispersed due to the inherent inefficiencies. Only the best funds plan for succession.

Ultimately, VCs firms are small partnerships. Behavioural challenges in investment partnerships include:

  • economic allocation
  • shared decision making
  • diffused responsibility
  • personal risk minimisation
  • go-along-to-get-along interaction

There is a long history of successful spin-outs, driven by:

  • poor inter-generational carry allocations with the allocation of fund economics to individual partners being divorced from past success as an investor;
  • younger generations being closer to age of entrepreneurs; and
  • Legacy questions as the retirement of senior partners have negative effects on the ability of funds to raise additional capital.

Therefore, the way to remotely access top tier funds with persistent performance is through a meticulous assessment of the successful VC’s network with the hope of finding the “next generation” managers.

Source: PitchBook Data, Inc.

The Venture Capitalist Mindset — The Fox

In the seminal essay by philosopher Isaiah BerlinThe Hedgehog and the Fox”, a title referring to a fragment of the ancient Greek poet Archilochus, Berlin divides writers and thinkers into two categories: hedgehogs, who view the world through the lens of a single defining idea, and foxes, who draw on a wide variety of experiences and for whom the world cannot be boiled down to a single idea.

Photo by Ray Hennessy

In the context of venture capital, my view is that mentality is imperative: Hedgehogs are belief-driven; foxes are discovery-driven so VCs must be foxes!. As with any investment field, unconventionality is required for superior investment results. This means VC managers must be able to identify an “edge” and in this asset class the available edges are found truly looking at “frontier” technologies that other investors are not willing to evaluate; looking at industries where previously technology has had limited application; or investing in geographies that have a scarcity of competition.

The analysis at the edge must be supported by a polymath approach with broad peripheral vision to understand and create a probabilistic view on the impact of converging technologies. The best VC’s are ones that construct methodologies that continually tilt the odds in their favour.

Ability to identify outlier founders and have a working model that determine the outcome of certain behaviours, their interaction with the market and wider environment and how best to drive the best from working with them seems to be the holy grail.

Convergent Investing

Testing for Alpha

If we have isolated that individual manager hustle, investment analysis and strategic skill is the driver of returns supported by an auto-correlation of brand, network and fundraising then we need to solve for all these elements in individuals. Returns are a trailing indicator — so how do you evaluate performance of managers (whether new or existing)?

GPs show us your data!

As the best entrepreneurs will know, VCs are very partial to KPIs, metrics and any other performance indicators that might provide insight into whether a nascent business is likely to become a bigger business. I consider that LPs do not require the same from GPs and I am not advocating burdensome reporting, I believe efficient technology enabled reporting can provide a great deal of information (privately and confidentially) that will enable LPs to make a much more informed decision about the performance of GPs.

Traditional approaches to solving the human capital problem in venture capital by LPs have largely been focused purely on track record and qualitative referencing, which I consider a lagging indicator given the time horizon of the asset class.

As such some ideas below on how early stage investing can be better attributed — I share this with tremendous humbleness as I am aware that many of the smart LP’s are already using more real-time and granular metrics and this is just a small illustration to encourage further debate, in an endeavour to make this asset class mature from a cottage industry!

With this, the penultimate chapter, I want to thank all of you for reading and hope that at least some of you found it insightful. Sadly there is no segway into the final chapter, as I continue to focus on my core business! But I will share some preliminary rumblings shortly and what I do hope is that the final chapter/s write themselves with all your help.

Many Thanks!

Disclaimer: All the opinions are my own and do not reflect those of Jetstone Asset Management (UK) LLP. This document is provided for informational and discussion purposes only. It is not a solicitation or an offer to buy or sell any security or other financial instrument. Any information including facts, opinions or quotations, may be condensed or summarised and is expressed as of the date of writing. The information may change without notice. It may not be reproduced either in whole, or in part, without my permission. This document is not marketing material or is not used for the purposes of marketing. Copyright Ahmad Butt © 2018.