For the majority of individual investors, a portfolio of low cost index funds such as for S&P 500 is prudent. Most of us do not have the time, resources, or industry expertise to perform the diligence necessary to have chance of beating stock market indexes with an actively managed portfolio. When you consider that majority of professional fund managers do not beat the market either, this point becomes even clearer.
However, there are some markets that index funds do not have access to, and thus an accredited investor who wishes exposure to power tail governed returns must hold his nose and jump into the murky waters of active investing. Venture capital is one such arena. Although the institutions of venture capital such as the incubators, premium firms, and startup hubs have been around long enough to establish some norms of behavior, the startup economy has seen considerable evolution since the heyday of the late 90's, with examples including the advent of micro investments as pioneered by A16Z, the establishment of premium incubators such as Y-Combinator, and the trend away from IPO’s to acquisitions for firms that successfully exit.
The world of venture investing is different than the public markets in most every way. While the average security holding period on public markets is well under a year, venture investments are intended much longer, sometimes even approaching a decade. While investors in public markets are predominately passive / not actively engaging with company management, in the venture space it is expected that an investor’s backing includes access to resources and support. While in public markets shareholders can number in the thousands or more, in the venture arena a startup typically only takes on a select few investors in any given round. Most importantly, the world of venture remains strongly rooted in the active arena for all who participate, there is simply no avenue to passive investing.
What would an index fund look like in the venture arena? One avenue would be a “fund of funds”, a vehicle that passively invests in all active venture funds as they become available, potentially even as an ETF / exchange traded fund. This approach would be problematic however, primarily because of the sustained outperformance of the overall venture market by a handful of premium firms — a phenomenon that can be traced to the investor selectivity that is afforded to startups with demonstrated success and momentum. Much like how a student’s professional prospects are improved by enrollment into a MIT or Stanford caliber university, an investment in a startup by a premium VC firm is a strong form of signaling that opens many doors, encouraging startups with options to veer toward those firms with name recognition. Thus, any fund of funds that does not overweight allocation into premium funds would be expected to underperform the overall venture market, with determination of such weighting putting a fund right back into the active management camp. This approach is further stymied by the fact that these very premium funds have the benefit of selectivity not only of their portfolio companies but also of whom they allow to invest with them in the first place.
Thus the only way to enable a passive vehicle in the venture market would be to enter the picture prior to full venture rounds — essentially in the very beginning. Of course the problem with this approach is that you lose the benefit the selectivity and diligence of the venture firms. A real estate investor is wise to seek homes within proximity of a new Starbucks franchise to piggy back off of their siting group’s expectation of neighborhood prospects / avoid the bad parts of town. Any passive investment prior to a venture round would get exposure to a whole bucket of firms with reduced prospects, those whose external funding has traditionally come from friends, family, or angels. Fortunately, there is a middle ground that is increasingly taking space between these two thresholds — that of the incubator. While not affording anywhere near the diligence that is performed by a venture fund, an incubator does have a level of selectivity to weed out bad apples or the incompetent. While it is true that not all startup firms take the path of the incubator for early stages, I assume there is no outsized weighting of unicorns amongst those who take that route, an assumption that is probably worth investigating further.
Having identified the appropriate stage for a passive vehicle to enter the picture, the next question is how. Incubators traditionally encourage applicants through a guaranteed seed investment and timeline of support in exchange for a portion of equity. Just as there are varying tiers of venture capital firms, there are likewise tiers of incubators including those of different industry specialization, those partnered with different research hubs or universities, and with a wide band of resources and prospects — each with their own standard of terms for seed funding of applicants. Convincing a majority of these incubators that incorporation of additional funding into seed rounds for benefit of a passive vehicle could present some obstacles. The vehicle could either attempt a standard multiplier and terms globally or alternatively tailor their terms to align with those of individual institutions — the latter an approach that would definitely prove more challenging and resource intensive but one that may be necessary until such time of adequate scale. Vanguard, the pioneer of the index fund, is known for streamlining their organization to ensure market leading cost basis — I would suggest that any passive vehicle in the venture arena should attempt likewise.
The venture capital industry, as opposed to say private equity, is unique in that the volume of early stage transactions could prove sufficient to support a cross industry passive indexing vehicle. It was the purpose of this post to explore how such a vehicle could be enabled and suggest practices to ensure success.
Albums that were referenced here or otherwise inspired this post:
Saint of Circumstance — Grateful Dead
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