Ventureball

A Primer on Venture Capital for Hedge-Fund Investors

David Siegel
Jan 15, 2020 · 7 min read
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Start-up stock certificates are lottery tickets. How many do you want?

hy invest in venture funds? Startups mostly fail, they suck up huge amounts of resources, and VC funds generally don’t outperform the S&P 500. Sure, a small number of companies and funds are wildly successful, but you can’t tell them ahead of time. No one can.

Smart investors look for inefficient markets where they can use data to gain an edge. In this short essay, I’ll describe three trends driving venture capital now and a unique approach to generating manager alpha.

How We Measure Success

Hedge funds report monthly returns (after fees). Most hedge funds can be redeemed either quarterly or at the end of the year.

Venture capital is different. A venture fund invests typically over 3–5 years, calling capital in stages. Often, they hold back a large percentage of their capital for follow-on investments. The value of the portfolio always goes down in the first few years then catches up in years 5–7.

In venture capital, we measure the multiple of cash returned to cash invested. While the fund is still maturing, we use TVPI — Total Value to Paid In multiple — which is essentially the value on paper. It becomes more meaningful as more exits provide real returns back to investors. After the fund is over, we use a single number — the return multiple.

The median VC fund returns 1.9 times capital invested over 7–10 years, which is good reason not to invest. To compensate for the risk, VCs must return at least 2.5x to break even, and 3x or more to be considered a worthwhile investment.

However, in the US, the top quartile of VC funds do beat the S&P 500.

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In this graph, 1.0 is the public-market index benchmark; above the line is positive alpha, below the line is negative alpha.

Top-decile (dark blue line) returns are driven by luck — most of them don’t repeat, and you can’t identify them in advance. Inside the 25–10 percent band (above the teal-colored line), there have been some consistent performers. However, three trends are changing the landscape, and investors must understand them.

1: A Lot of Money Has Flowed into Venture Capital

The year 2018 saw a total of $254 billion invested globally into ~18,000 startups via venture capital financing — a 46% leap from 2017’s figures — with 52% ($131 billion) landing in the US alone. Despite the industry appearing relatively healthy, an unprecedented trend of fewer funded companies, but larger round sizes has emerged.
Toptal, State of Venture Capital 2018

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Record amounts of money are flowing into venture capital, as deal sizes increase and the number of deals goes down. More money forces everyone downstream: Series A is now $10–20 million, while the median “seed” stage deal is now $2 million. Samir Kaji is now tracking over 900 active US micro-VC (seed) funds. This is a huge advantage for entrepreneurs: venture firms no longer partner with other funds, they compete against them. Many $1-billion funds have set aside money for seed investing, so they can get a piece of the upstream pie. The seed market is crowded.

Bottom line: tons of funds trying to load the same number of companies with a lot more money is a recipe for disaster.

2: It’s Getting Cheaper and Cheaper to Start a Software Company

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My estimate of the general cost to create a new product. I believe costs will continue to decline.

Just ten years ago, it would have cost at least $1 million to get a software product ready for market testing. Today it costs so much less that many coders are able to hack a first product together over a weekend and spend the next few months getting it ready for market. Many consulting companies are now “productizing” their offerings and taking them to their existing customers.

The growth of open-source code, and the millions of APIs available now let app developers incorporate sophisticated payment and banking tools, maps, weather, communication, logins, security, and other services instantly. Entrepreneurs can now create a working mobile app in a week or less. It won’t be long before they will create apps with no coding at all.

These new companies don’t need huge amounts of capital. Rather than spending a lot of their money on product, they can listen to customers to keep adapting to their needs. By focusing on customers and building recurring revenues, they reduce their risk of failure. Many more companies have revenues within 4–12 months than ever before.

Bottom line: Just at the time when huge amounts of capital have entered the market, the next generation of companies doesn’t need as much.

3: Everyone Now Has Data

From seed investment through series F, all venture capitalists now report their deal figures and subscribe to several databases that give them everyone else’s data. That makes these markets very efficient. Everyone knows what market price is. Because there’s an oversupply of cash, valuations are higher than they would be otherwise.

Not surprisingly, VCs complain there are few “good deals” to be found. Venture capitalists have always been herd animals, chasing the “sexy” deals that everyone wants to get into.

Thirty years ago, baseball decisions were made by gut feel. Today, data and computer models make most of the decisions, not just in baseball but in most professional sports. These days, the majority of VCs claim to be “data driven.” All VCs now have several data dashboards that give them an overview of what everyone is doing:

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As Michael Mauboussin noted in his essay The Paradox of Skill, when the general level of skill goes up across the board, luck plays an increasing role in determining outcomes.

Bottom line: as venture capital becomes more data-driven, picking managers becomes more of a roll of the dice.

A New Asset Class

We can view the world of corporate equity as a pyramid, where more information and data creates more efficient markets:

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Now we can take a lesson from Nassim Taleb: A large number of uncorrelated, high-convexity investments creates an antifragile portfolio that provides strong returns in most macro environments. If you think about it, stock in early-stage companies is really an option. Most options expire worthless, but a few pay off and can make up for the rest.

Robert Wiltbank points out that, in aggregate, angel returns consistently beat the major indexes. But it takes a disciplined approach. The more risk you take, the more diversification you need.

Investors have mostly been left out of a critical asset class — companies seeking their first round of outside funding. Three US funds are working at this level today: 500 startups, Hustle, and Right Side Capital (disclaimer — I am a venture partner with Right Side Capital). These funds do as many as four deals a week. These funds build their own database of deals to understand better what market price really is. They provide various services for their companies, and they have far more data than anyone else in this “pre-VC” asset class.

I don’t have access to other funds’ performance figures, but the Right Side team targets 3x+ net return to investors for each fund. Each of their three funds is on target (they are raising their fourth fund now). Massive diversification limits the downside (low chance of losing capital) and also limits the upside (no chance of 10x returns).

Tax Considerations

These super-early-stage funds pass on huge tax advantages to US investors. The Qualifying Small Business Stock rule means that investors will likely pay no capital-gains tax. And losses are passed through — investors can take up to $100k per year against their ordinary income.

More than 90 percent of Right Side Capital’s investments qualify, meaning investors will pay little or no federal tax on their gains. They also provide 3–5 years of losses that can be offset by ordinary income (for example, via rents or royalties). This is likely true of the other two funds as well.

Summary

As venture capital becomes more efficient, as it gets cheaper and cheaper to launch a new company, most VCs find themselves with more and more money fighting over fewer and fewer companies. But a smart, quantitative approach gives an edge to those with data where others have none. A 3x+ return with extreme tax advantages should be on the radar of any “antifragile” investor.

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David Siegel is a serial entrepreneur, start-up investor, blockchain expert, and a venture partner with Right Side Capital. He is the author of Global Beta Ventures. You can contact him and see all his writing at dsiegel.com.

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David Siegel

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Provocateur, professional heretic, slayer of myths, speaker of truthiness to powerfulness, and defender of the Oxford comma.

Data Driven Investor

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David Siegel

Written by

Provocateur, professional heretic, slayer of myths, speaker of truthiness to powerfulness, and defender of the Oxford comma.

Data Driven Investor

empower you with data, knowledge, and expertise

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