How a hedge fund manager launches a venture fund.
In certain parts of the world (and if your area code starts with 510, 415, or 408, you’re absolutely in that part of the world)… you can easily conclude venture is the only way to build a business. Promising founders raise money to pursue a mind-blowing market opportunity, design a giant competitive moat, and create new industries from scratch.
And of course, venture funds appear to meet that need. VCs take high risk / high reward bets in companies — knowing that most will fail, and perhaps 10% will return sky-high returns that justify the funds’ overall existence.
And in this world, the firm with a few billion in assets under management (AUM) rule supreme on Olympus — they realize the dreams of a few, and crush the dreams of others. And they’re in turn surrounded by demi-gods, smaller funds with “only” a few hundred million in AUM.
But what if I told you, many venture capital funds have no reason to exist?
I’m familiar with the venture world as a venture investor, but I’m also intimately familiar with a different world — and in that larger asset management world, it turns out venture is only a tiny, almost insignificant piece of a much larger pie.
For larger institutional investors, venture capital represent < 5% of their overall allocation. And it’s these larger institutional investors who really define success in our capitalist society — they’re the ones who decide which managers are able to raise multi-billion dollar funds, and which managers struggle along with nothing.
I formerly launched and ran a quant fund called Junzi Capital Engineering, and I would’ve fit in the “hedge fund” category in the chart above. But in reality, almost all asset managers across all of these buckets fight for the right to exist, and it’s a highly competitive battle in which the spoils are tens of millions of dollars in annual management fees, and hundreds of millions of dollars in performance fees for often passive investments.
And no matter what your strategy, you have to demonstrate what’s called alpha in portfolio management speak — it’s essentially “out-performance” (above what might be expected from a passive investment in the broader market). And for my quant fund to thrive, I had to convince sophisticated institutional investors that I had a meaningful edge — in my case, it was through a carefully designed vol-arb trade paired with a fully automated, high frequency intra-day hedging strategy.
And without that clear definition of alpha, without a clear performance edge backed up by decades of back-testing and years of live trades, I knew I had no chance of success versus the incumbents — funds with tens of billions in AUM, some spending tens of millions annually on research, staffed with the best applied math researchers and mathematicians from around.
So when my career led me to consider launching a venture fund… I approached the problem set in exactly the same way.
What’s my edge? Why am I better than every other fund in existence? What is my raison d’etre?
All VC investors should go through the same mental exercise, and make the same arguments — after all, we ask founders to do precisely that — but many aspiring / struggling managers don’t. And unfortunately, we can’t back-test venture strategies, nor do we know the result of investment decisions for close to a decade.
Instead… venture investors have to differentiate in other ways. After hitting the fund-raising trail with hundreds of fellow new funds + collaborating with many others, it seems almost everyone claims variations around a few themes:
- superior access to deal flow — former operators from Facebook and Google are best buddies with the founders of tomorrow’s unicorns… or a former professor/student is tightly connected with bleeding-edge research coming from a specific lab;
- superior access to resources — some funds (like Slow Ventures) only accept investment from top executives / founders, and you can expect help from that unique network as you go to market;
- superior domain expertise — by studying a specific vertical in great detail, a fund like Basis Set Ventures (for AI) or Eclipse (for hardware) argue they understand the nuances of every product / customer / management team in this space.
- and finally, sheer management talent. A fund manager who is just smarter and harder working than everyone else in the room, and will simply be a better deal picker by virtue of their brilliance.
It’s that last category which I, as an experienced asset manager, believe shouldn’t have a place in venture.
I’m not a believer in venture capital brilliance, if only because none of us can ever objectively test it. To put it in computer science terms, I’d argue the ability to pre-emptively detect brilliance in a VC is NP-complete (and even retrospectively — it’s hard to distinguish between a great VC, and a lucky VC).
I simply don’t think there’s any way to distinguish between a brilliant deal-picking venture capital investor, and an extremely charismatic (or perhaps merely deluded) charlatan. Or as I heard Chris Douvos of VIA once say …
Every manager claims to be an unique snowflake — but for a venture fund investor, it sure looks like a snowstorm.
I had been asked to join / launch funds before Berkeley SkyDeck, but I passed on every opportunity. But Berkeley SkyDeck represented a truly unique opportunity — with the resources of the UC Berkeley community behind me, and with UC Berkeley’s global presence, I knew we had a strong structural advantage as we built SkyDeck into the world’s Global Accelerator.
My favorite phrase on the fund-raising trail?
Pretend I’m the world’s worst dumbest person, and no better a deal-picker than randomly throwing a dart at a board— and understand that we will still succeed.
Apparently our investors didn’t have a hard time imagining that I’m the world’s dumbest person, because we were able to close our Fund I in record time.
Now, I go into work every morning filled with excitement because I know that I’ve built the only kind of venture fund that should exist — one that has true alpha.
Berkeley SkyDeck’s Spring 2018 cohort holds its Demo Day on May 15th; apply to attend.
