Why does Venture Capital exist?
Going beyond risk capture
NB: If you just jumped into this note without checking out some of my previous posts, I need to clarify something upfront. In our discussion of venture capital so far I have defined it very broadly as “the funding of long-tail risk”. This means that I go far beyond venture capital general partnerships to encompass things like government science grants and corporate R&D budgets as examples of venture funders. We will, shortly, go back to the exciting world of venture capital firms, but for the time being please indulge this slightly different perspective.
If we were to follow the logic from “What is Venture Capital?” then the answer to “Why does Venture Capital exist?” should be self-evident — there are endeavors with a long-tail return probability in the market, there is value in capturing that risk premium, and if you are particularly good at underwriting that risk, there is (relatively) a lot of money to be made. There is also the fact that most venture capital investments are earlier stage, private, and take a while to result in an exit, so there should be an extra illiquidity premium in there somewhere. Presto change-o: venture capital!
Venture capital funds will construct a portfolio of investments, knowing that the majority will be losing some money (if you take into account time, effort, and opportunity cost), but hope that the proceeds from the few outliers will compensate for that. If this makes venture capital sound like a strange, reversed version of the good old boring insurance industry — I am sorry; but somewhere deep inside it kind of is. Insurance companies will construct a portfolio of policies, knowing that the majority will have small, positive contributions, and hope that in aggregate those contributions will outweigh the big payout outliers. This is not to say that the two operate the same way. For one, insurance companies are heavily regulated to ensure that they take responsible bets and are built and managed to last for a long time. Venture firms are… well, not that. But this is still kind of a weird parallel.
Let’s stick with this for a minute. If we look at the types of companies that are naturally most attractive to venture capital, it might actually make sense to see venture capital as an insurance against something. Change? Progress? The future? This could work.
Let’s say we are the corporate development arm of a large public pharmaceutical company whose blockbuster drug is an ongoing treatment for a chronic disease. We don’t know it yet, but a few years down the line an obscure little startup will have a scientific breakthrough and come up with an actual cure for a bunch of diseases (including the one we are treating) and become a behemoth in the space. As you can imagine, this will us and a bunch of other companies into oblivion. Clearly this is great for society at large, but very, very bad for our shareholders. If, however, we placed a venture bet on that company and owned a small stake in it… maybe we are fine. Society still benefits from the great advance in science, our core business is still likely obsolete, but we just made so much money from our investment that we might be worth more than ever before. This is, of course, a hypothetical and unlikely scenario. But there are examples when things work out just like that — like when South African Naspers took a stake in obscure Chinese internet startup Tencent. There are a bunch of practical issues and even a dash of moral hazard here, but it does make sense that one can use venture capital to dampen the effects of an unfavorable (to them) future, or at the very least use it to see that future developing slightly before everyone else.
On that note, the “seeing around the corner” may seem like a minor benefit, but it does point to an interesting trick that venture capital takes advantage of (and may be another reason for its existence) — information arbitrage. The obvious (and benign) example here is information arbitrage over the course of time. If we have, over time, backed several successful supply chain software companies, we likely have a better idea about the opportunities and challenges ahead than any individual management team. Industry dynamics, customer behavior, governance pitfalls, exit paths — we know more because we have seen more. This can hold true even if we ignore time and assume we are a first-time fund. Just by having a portfolio of multiple assets gives us a better idea of what the world looks like than any individual company — we get to see how different marketing strategies, compensation schemas, and financing structures play out, and then propagate any best practices. Now, if we can push the logic, we can actually have an information arbitrage even before we have done a single investment (and this is where things get less benign). We might, for instance, have access to industry knowledge that our potential investment does not — the corporate development roadmap of key potential acquirers, the planned legislation that is about to change up the industry, the weak bargaining position of certain suppliers. Or, even more simply, we might just have spoken to all of the company’s competitors as we were learning about the space. Assuming we are upstanding investors who strictly abide by our NDAs (as we should!) and never mutter even a word of what we learned from the competition, that still does not negate the fact that we have a much clearer view of the industry. We know how everybody stacks up and have a better-informed opinion of how things will play out. This is information arbitrage, and it has value.
In sum, I’d argue that venture capital’s existence is explained by three factors — intrinsic (the ability to capture certain risk premiums), extrinsic (the ability to provide a natural hedge against a nebulous future), and structural (the ability to capitalize on information arbitrage). Don’t get me wrong; even if only the first, intrinsic, one were true there would still be venture capital investors. They might just have careers that are more similar to insurance underwriters.
