The inevitability of sector specific Venture firms

Many new venture funds are becoming increasingly specialized in order to better access startups

(this article was originally published for VentureBeat: https://venturebeat.com/2017/08/07/get-ready-to-see-more-sector-specific-venture-firms/)

We have witnessed a marked rise in the amount of venture investment dollars over the last decade. Capital has become near-ubiquitous, it may seem.

These capital inflows have had a number of different effects, though most pertinently for investors they have, often inflated round pricing and increased the amount of capital competing for access to tier 1 startups.

As we continue to near the tail-end of the mobile technology cycle, we have seen the near saturation of many business models and sectors. Capital is being pushed towards frontier technologies as they seek the disintermediation of current technology incumbents. Opportunities in new protocols and technologies such as blockchain, AR/MR, drones, autonomous vehicles and conversational interfaces are surfacing — with many VCs placing their chips as to which platform wave to ride next.

Going narrow

We can generally classify venture funds as generalist, thematic, thesis-driven or sector focused. The early days of venture investing, until relatively recently, firms were predominantly generalist with a significant technological white space to attack and specializations found within specific individual VCs within the firms — allowing flexibility. In the last decade, we’ve seen thesis and theme focused funds — helping investors to bring concision to their thoughts and sanity to their deal flow funnels. Thematically-driven firms include Foundry Group, DFJ and betaworks and thesis-driven firms like USV and Bessemer, are leading examples of how to correctly execute on these investing disciplines.

The further evolution of technology venture investing has now lead us to seeing an uprising in sector specific funds. Funds which are expressly targeting a specific, related technology sector. The primary benefits of doing so are two fold:

• Knowledge is power: deep sector-specific domain expertise allows VCs to attract higher quality deal flow, due to an assumed ability to drive a flywheel of value-add to founders. The flywheel consisting of domain knowledge-> related portfolio companies -> industry specific relationships.
• Marketing: new VC firms raising assets need to be able to demonstrate to LPs that they have a relevant edge in sourcing companies versus established peers. Sector specialism and focus also gives LPs comfort that investors will be disciplined and not profligate with their capital.

It seems like the term FOMO was coined for venture investing — investors often clamor for hype-cycle du jour startups. This (irrational) exuberance extends also, as a second order reaction, to LPs — who increasingly seek novel technology investments and ‘momentum’ industries and sectors.

investors seeking an ‘edge’ + LP appetite for narrow investment focus + search for the next technology platform = increase in sector specific funds

The last few years have seen a number of new investors differentiating by sector, such as:

• SaaS: SaaStr, Point Nine Capital, Notion Capital, Scale Venture Partners
• FinTech: Ribbit Capital, Fintech Collective
• Blockchain: Blockchain Capital, Digital Currency Group, Pantera Capital, Fenbushi
• AR/VR/MR: The Venture Reality Fund, Super Ventures, Presence Capital
• Real Estate: Fifth Wall Ventures, Pi Labs, Concrete
• Automotive: AutoTech Ventures, FM Cap
• Artificial Intelligence: Y Combinator AI, Gradient Ventures, AI VC

Venture returns, sometimes

Venture returns are largely predicated on the power law of outliers: this means outsized fund returns (more than 3x) generally consist of a few big winners in any one portfolio. With this in mind, an ability to access outliers is often important for early (seed/Series A) investors . This becomes increasingly important as fund size increases, with economics unlikely to allow for larger funds (>$150m) to drive outsized returns whilst operating within small sector specific concentrations.

The reality is that few can predict which industries, technologies or indeed companies are going to take off. Few saw the outliers of Google, Airbnb and Uber — few were clamoring for more search engines post Yahoo!, more accommodation booking sites or black car chauffeur services. These mythical black swans are near impossible to predict in terms of sector, probability, size and impact — though arguably easier in terms of themes (mobile, social, network effects) or theses (‘software eats everything’). As venture investors anti-portfolios demonstrate, successful technology outliers are non-obvious.

Limiting one’s investment focus decrease the chances of hitting on one of these outliers, though trading this off may secure generally higher quality deal flow — sector allowing. As a sector specific firm it’s conceivable that the space you play in only produces a number of breakout hits — missing any one of these can be fatal. Ultimately, it will remain a challenge for insurgent investors to take scalps from tier 1 venture firms, though going sector specific may give them the best chance in doing so.

Conclusion

As the industry grows and the search for outliers becomes more competitive, expect to see more sector specific venture firms looking to target narrow slices to attract deal flow and ultimately scale both capital and returns wise.

Founders need to choose their investors based on their ability to drive specific value to your startup. They should not conflate a VCs deep understanding of a sector with a proven ability to drive wins for your company. Company building and investing are very humanistic, look for VCs who feels as passionate about your startup as you do and have a proven track record in providing value.