What VC Can Learn From PE And Vice-Versa? (Part II) — Fit To Lead

Discover what Venture Capital (VC) and Private Equity (PE) can learn from each other — is there a best of both worlds?

I’m imagining a conference with CEOs from both VC- and PE-backed businesses. What would they be talking about? What would they be learning from each other? What topics would be alien to each other? What blind spots will be revealed?

My motivation for writing about what each world can learn from each other is whether it is possible to have the best of both worlds.

My first essay looked at the similarities and differences between the two worlds and the life of a CEO within each world. Let’s dig into my second essay on the topic of VCs vs PEs.

So What Can VC Learn From PE

VCs Should Do More Thorough Management Due Diligence

This may seem like an odd place to start but I am gobsmacked by the lack of management due diligence (“DD”) most VCs do.

“We don’t have the funds or the time for management DD.”

“We should focus on other areas such as the tech or the market opportunity.”

One partner I talked to of a billion-pound fund told me he thinks his partners are good judges of people and don’t need others to tell him what makes a good founder. Welcome to the world of bias! And depressingly they were a team of largely middle-aged white men!

Management DD is even more important at the VC stage because you don’t have much else to grab hold of. Of course, there are many different types of successful founders but at the very least I think VCs should be taking a view of what good likes like (hard and soft skills) and use data to help them make better-informed decisions.

Management DD is always done by PE firms and this is symptomatic of their desire not to make a mistake, and to reduce risk.

Majority Owner’s Mindset Vs Minority Shareholder

VCs have many children. But unlike us perfect parents in the world, they have favourites! They don’t spread their love to all their children equally. They focus on the star performers. The VCs want to see results quickly — if you are not composing a new symphony, playing five instruments at grade 8 level or running a four-minute mile within 12 months of their investment you are largely ignored.

PE firms on the other hand take a longer view, spreading their love equally across their children. They still want you to be writing your second symphony by the time you are 28 but they will not write you off if you take a bit longer to be a star. They will focus a lot of their own energy on you and give you more resources to support you on your growth journey.

I get why VCs do what they do but I just think they are missing a trick. If they took more responsibility and acted with a majority shareholder mindset for more of their portfolio companies they might discover some late developers who go on to be big stars!

VCs Should Focus More On Operational Excellence

Most VCs rarely become operational involved and if they do they are usually responding to putting out fires rather than systematically improving and building processes and value.

The world is changing to some degree and you see more VCs offering help beyond raising capital and exiting. One great example is Frog Capital who have an Operating Partner model which, according to companies I have invested in alongside Frog, works well. Frog is offering a diverse range of support for their companies. They are utilising the best of both VC and PE. And their returns are as a result top quartile.

Better Governance

Governance is not a word many entrepreneurs get excited about. Governance to them feels like people getting in the way with bureaucracy or accountability.

Governance might mean you have to appoint a board of directors. Many of the founder CEOs I coach are not very positive about their boards. “Too many investors on it” or “They don’t add any value” or “Waste of time, board meetings are something I just need to get through” are comments I often hear. It doesn’t have to be that way as you will find out in a previous essay I wrote on boards.

However, if I told you governance meant you are more likely to make better decisions, you will get better advice, make fewer mistakes, make the most of the opportunities and become a better leader. You might think this governance might have some legs after all!

I think to get the best out of anyone you need some accountability. A good board will coach and mentor you and support you to become a better leader. A diverse board will challenge your ideas and force you (in a good way) to think differently and see other perspectives.

Good governance should mean everything gets sharper, not duller.

Dysfunctional Syndicates

As I mentioned earlier VCs often invest in syndicates. There is usually a lead investor who takes the reins and gets the deal over the line and then a few other VCs essentially follow the leader.

Sounds fine, everyone starting at the same stage on the same terms but it’s more complex than that. As time goes on new VCs come on board as the company hopefully grows and raises more funds. This occurs because most VCs rarely have the ability or desire to fund a business from startup to breakeven and beyond.

You end up with lots of different shareholders with different needs.

For example, one fund may need to get an exit sooner than another to help with its own new fundraise. Frictions between syndicate members can have material effects on the growth, survival and direction of companies.

This compares to a typical PE deal where there is one PE house.

How to mitigate these potential sources of friction within a syndicate?

• Choose syndicate partners who share the same characteristics and hence whose incentives are more likely to be aligned e.g. VCs who can invest throughout the stages of growth resulting in fewer VCs on the cap table
• Designate a lead investor — they have more on the line financially and reputationally and hence put in the greatest effort in terms of monitoring, advice and governance
• Pay-to-Play clause in the legals makes it costly to go against the crowd in the syndicate

Better Financial Discipline

Maybe it’s because I trained as a Chartered Accountant or maybe it’s something my entrepreneurial father and mother instilled in me but I am shocked by the lack of focus on cash in a start-up or scale-up.

Not many startup CEOs come from accountancy backgrounds, many however do come from technical backgrounds which is great for the technology-led world we live in. Whatever your background and whatever the stage of your business, if you don’t know how much cash is in your business, how long it’s going to last, what your working capital cycle is and/or what the levers are to generate cash, you are very likely to get into trouble.

So What Can PE Learn From VC

More Explore Less Exploit

I’m generalising here but PE-backed (i.e. more mature) businesses tend to double down on what they already know. Rinse and repeat. They do more of what they’re doing today, but more efficiently, believing this will lead to more success tomorrow. They look to exploit using existing tools and technologies in existing markets, with existing capabilities.

This recipe of doing more of what you do today tomorrow is no longer viable. Exploring has to be on the menu. Trying something new. Exploring can be in three main areas — product & https://www.sbs.ox.ac.uk/Said Business School of Oxford says in this video, “…what becomes really interesting is that tension, that ratio between exploit and explore. What we do for today, and what we do today for tomorrow.”

What’s the right ratio? No right answer but given the economic conditions today, innovation is not just an endeavour for business growth, it’s just as much a survival strategy.

To borrow two questions from Marc again.

“How much of today is about today?”

“How much of today is about tomorrow?”

You may think you can stay on the explore side of the equation but remember in five years when you come to sell, the buyer will need to believe in the next stage of growth i.e. the explore side.

As the legendary Clayton Christensen says in Innovator’s Dilemma the role of a leader is to lay a foundation for growth.

Don’t Just Innovate Learn How To Innovate

One of the skills of a VC firm is not only their ability to innovate but how they innovate.

Larger more mature companies may take risks but often they will either not put proper resources or time into innovation or they fail to kill new ideas quickly enough resulting in unnecessary big bets.

Whereas early-stage companies typically backed by VCs capture ideas quickly as there are no walls preventing ideas from surfacing, the ideas are tested, learnings are recorded, the good ones survive and the bad ones are killed.

Watch and wait vs act and adjust.

More Offence Than Defense

The world is more volatile. “We haven’t seen anything like this before,” is a comment I hear more and more. The problem is the seismic shocks keep coming. As I write, spot shipping costs have tripled in a week. And the smart people who have hedged against these rises are predicting the contracts will be reneged by the shipping giants (because they can!). The new normal is the increase in the number of unusual events outside normal ranges.

In the past, as a CEO of a PE-backed business you could afford to be generally cautious, and do all the right things on efficiencies and planning but not make any material strategic changes i.e. more on the defence.

Research from McKinsey shows that the more resilient (and hence valuable) companies have ambidextrous leaders who play on the offence and defence. They continue to be conservative in managing the downside but are more actively looking to capture the upside.

CEOs within PE need to develop the ability to ‘perform’ and ‘transform’ at the same time and stay ahead as a result.

Ability To Learn More Important Than Today’s Skills Or Experience

CEOs who have progressed through stable business units will have developed key skills for this type of environment: operational and process improvement, controlling costs etc.. But when it comes to running a growth business and innovation they may struggle.

PE likes to back experienced CEOs which makes sense although evidence of whether this is the right strategy is mixed. I would argue it’s better to find a leader who is a quick learner than someone who relies on decades of experience. A strong operator or executor can develop the skills or aptitude of an innovator and hence shift the balance of the company from exploiting to exploring.

“It is not as important that managers have succeeded with the problems as it is for them to have wrestled with it and developed the skills and intuition for how to meet the challenge successfully the next time around … Failure and bouncing back from failure can be critical courses in the school of experience.”

Clayton Christensen, Innovator’s Solution.

Can You Achieve The Best Of Both Worlds?

In the nuanced realms of Venture Capital and Private Equity, the aspiration to merge the strengths of both worlds poses a compelling challenge. Can the relentless drive for innovation and market disruption from VC be harmoniously integrated with the operational rigour and strategic foresight of PE?

I believe that each world will become stronger if they imbibe wisdom from the other and discover the Third Way through Polarity Thinking.

Where VCs learn to love more of their children, not just their star performers and PE houses learn to let their children play and innovate with more freedom.

Where VCs properly assess the strengths and weaknesses of the management teams not only to figure out whether they want to invest in them but also to inform them of areas of development going forward. Where PE firms value the ability to learn and adapt more than experience.

Where VC firms align their needs over the short and long term to prevent conflict. Where PEs collaborate with other PE firms to gain a diversity of knowledge, expertise and thinking for the benefit of the portfolio companies.

Where discipline and accountability are embraced in the VC world and flexibility and adaptability are embraced in the PE world.

Most PE and VC funds fail to make a return on their investments for their investors and themselves. So maybe it’s time to rethink the VC and PE models not just to improve the financial returns but to build better, more sustainable businesses (which will benefit wider society too).

Maybe it’s time for The Ambidextrous Fund which takes both defensive measures (efficient in managing the current capabilities for profit) and offensive measures (adaptable to explore new opportunities for growth) ultimately leading to sustainable competitive advantage for their portfolio companies and their own fund.

If you would like help on how to get the most out of the VC or PE world or a combination thereof please email me at mark@fittolead.net or contact me via the Fit to Lead website.

Originally published at https://www.fittolead.net on February 4, 2024.