What’s happening to the Venture Capital scene today is ironic. As an industry whose aim is to search for new innovation frontiers and scalable models, little has been done to scale itself. Despite creating more value and economic impact than any other sector, Venture Capital remains a niche asset class, with all the limitations stemming from it. Why has VC remained niche, despite more capital being allocated to it than ever in history? And what would it take to grow it further?
Why bigger VCs are not the answer
In the eyes of an LP, institutional or not, a fund represents a vehicle of exposure to a diversified portfolio of a very specific asset class. This type of asset class is one of the riskiest in the realm of privately-held companies and, for the risk-reward principle, is expected to have a high ROI. The expected return is so high that it’s often measured in “x’s” rather than %. A common industry benchmark is returning 3x the capital invested. I will not enter the discussion on how much of the LPs’ net wealth is allocated in such a class: that varies greatly. The common patterns here are:
- diversification: LPs are investing in a portfolio
- domain expertise: LPs are entrusting their capital to managers with superior market knowledge to perform investment decisions
Funds have a lifespan, usually 10 to 12 years, which makes them fairly illiquid. This illiquidity is discounted in the expected returns: LPs are fully conscious of the restrictions imposed.
In recent years it became increasingly easy to raise an early stage micro fund (<$50m) thanks to expansive central monetary policies. This meant experienced fund managers were able raise even bigger funds, but the expected return (i.e 3X) remained the same. Funds became bigger and took on a even higher ($$-wise) responsibility in terms of expected returns. The perceived risk remain high, despite the fact that LPs’ capital is cheap. Illiquidity remains a problem. Those who hoped for a cascade effect on the startup ecosystem may have been disappointed when they found out that more capital available simply meant more capital allocated to few deals. All investors seem to be chasing the same (high-expected-return) deals, while plenty of companies remain un- or under-funded. VC’s portfolios are often skewed because most are built on the basis of the power law. Of course they are, because that’s the most efficient strategy a VC can follow given the current state of things. But I don’t see how this structure can hope to scale. There are only so few deals that can aim at billion-dollar exits, but there are tons more that can aim at lowers ones. The problem is, the bigger the fund the bigger the target exit, but the lower the chances to find one.
I wondered for a long time what’s the incentive of raising a bigger fund, so I started to research into that. What I have found is that:
- first-time or unproven GPs tend increase the size of the follow-on funds, which are substantially bigger than the previous ones (often even before returning the capital to early investors)
- Proven GPs (at tier-I firms) tend to be more consistent in fund size the raise.
What one would expect is that Tier-I firms can count of their reputation to close a fund at any time, thus removing the incentive to raise bigger funds. Lower-tier firms, on the other hand, have the incentive to be more risk-taking and make a big splash. Few will, many won’t.
This is my biggest remark to the entire industry. The current structure rewards herding behaviour and momentum investments, while the most successful decisions were often strongly thesis-oriented. It’s like comparing day-trading and TA with fundamental analysis: one chases the short-term spikes and the other long-term value creation.
I argue that accountability, transparency and liquidity are the key elements to foster thesis-oriented investments.
Diversified liquidity in bits: ETVCF (Exchange Traded VC Funds)
ETF’s (Exchange Traded Funds) are a relatively new invention. For as simple as they may sound, they are a marvel of financial engineering that, from their first inception in 1993, grew exponentially to today’s $4 trillion. I call them a marvel because for the first time a security was offered with built-in diversification, based on the principle of a passive market-following strategy. Regardless of personal opinions or debates on their efficiency over mutual funds or other actively-managed funds, ETF’s shook the fundamental principle that portfolio management could not be innovated. The very belief that active management was better passive management was challenged, as ETF’s seemed to perform better than most managers.
We all saw what ETF’s meant in terms of market accessibility for retail investors: they opened up a brand new field of investment opportunities previously choked by the existing investment fund framework. For the first time a (share in a) diversified portfolio became a liquid, tradable security. Was is the doom of mutual funds? It wasn’t, but it forced a reconsideration of their own strategy and market positioning. The two approaches came to co-existing, with the advantage that more capital can be efficiently invested by a larger pool of investors.
VC funds are just like mutual funds in the 80’s and early 90’s. They offer a service to a restricted audience and, when trying to expand, clash with the limitations of their own structure. Every fund manager goes through the same frustrating process of a) raising a fund b) investing c) waiting and hoping while d) raising a new fund on a track-record built on unrealized returns, which are often shaky at best.
The current structure is not only illiquid, increasingly hard to sustain and restricted: it’s also detrimental to performance transparency.
The lack performance transparency determines that:
a. funds are allocated all at once upfront, creating an opportunity cost for LPs and an incentive for managers to raise larger funds;
b. reputation is built only over the very long term: the results of today’s work will manifest only at the closing the of the fund.
What would mean to make VC funds tradable just like ETF’s?
I see three main positive externalities to the theme of “liquidity” for LP’s stakes:
- end of the fund lifetime issue: GPs will finally be able to invest fundamentally, not based on momentum. This is something that only the top-tier individuals, those who built reputation and pedigree, have the luxury to do. New GPs will always be tied to a lifetime, which might lead them to invest on “what grows faster” rather than necessarily “what’s ground breaking for tomorrow”.
- inclusion: de-risking such an illiquid asset class will make it more accessible to the entire financial market
- extended network: theoretically speaking, a larger audience of LP’s should also create a network of ambassadors similar to Venture Partners.
- accountability: GPs will be under the scrutiny of the market, thus preserving the incentives intrinsic to the current legal framework.
There are few example of publicly-listed VCs, like DraperEsprit, but IPO’ing a fund is a very expensive and tedious process and the stocks refer to the entirety of funds being managed. What I suggest is creating trading units of each of the funds, in a way that investors can pick their preferences based on the portfolio companies.
Currently the closest example of an ETVCF are tokenized funds, like the DAO and Blockchain capital. The DAO is GP-less: decisions are made by the holders of the DAO token, who decide which projections/companies to fund. Blockchain capital works like a traditional VC, but recently raised a fund where LPs could contribute only with cryptoassets. Blockchain capital invests exclusively in blockchain-related companies.
The ideal scenario is a company that combines both approaches, where GPs can count on the votes of their LPs to make better decisions, but being able to invest in all sort of companies, and LPs can trade their stake at any time. Likewise, the voting system can also be applied to a referral one, where deal suggestions are submitted and voted on before reaching the review stage by GPs. Such structure would make venture investing more like a flow, rather than a process made of interval and phases, removing the bottlenecks to the market for early-stage companies. We all have to gain from it, especially in terms of distribution exit outcomes.
It’s an hypothetical scenario, but one I like to toy with.
Update: while drafting this post, a very, very interesting article came out on avc.com (Fred Wilson) on the importance of the second quartile exits, which further reinforce the point I’m making here.
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