A friend recently asked what I consider to be differentiators for venture capital funds. Here was my answer, copied and pasted below:
Network/Access: An investor needs a unique angle on this to source new companies with a higher likelihood of venture-return potential, given the portfolios will ultimately be heavier on losses.
Motivation: When there’s an imbalance between prior accomplishments and compensation that keeps an investor fighting for that network/access as they build a repeatable strategy. And, whether they want to generate carry (from performance) or management fees (from gathering assets).
Unrealized Returns: I’ve never seen a venture investor’s deck show off bad unrealized returns.
Stage: I really dislike the nomenclature around funding rounds, especially because some investors heavily rely upon stage as a risk management signal, when not all seeds (or A’s/B’s/etc.) are de-risked from their prior round. There are also some late-stage investors I consider much less risky than some early-stage ones. And vice versa.
Valuation Discipline: I understand why it’s important to negotiate but when we’re predicting outcomes of new companies 10+ years in advance, it’s a sort of moot point if the outcomes are strong. On the flip-side, for private equity investors I consider this the most important differentiator.
Re-reading my response, I’d probably update it to say that I’ve never seen a venture investor’s deck show off bad returns in a vacuum (without some sort of creative caveat). And, late stage venture investors would take extreme issue with the valuation discipline point — maybe the early stage ones as well. Fair enough.
There is a differentiation problem in venture capital though. At the RAISE Conference in May, I was struck by the sheer number of seed-stage funds there. If one were to think (or agree) there were too many there, the chart below wouldn’t be very surprising.
Not all 2,348 of those venture funds in market around the world actually attended — but it felt like it. The conference to me raised the following questions: why do all of these funds need to exist? What angles could each of these funds have? What actually differentiates any of these funds from each other?
To be fair, I could direct that question at a large swath of the alternative investment world (e.g. reactive generalist buyout firms). But, when over half of the funds currently in market are within venture capital, it necessitates the harsh look. In a space where several investments per year generate the overwhelming majority of that entire year’s returns, the vast majority of those 2,348 funds all won’t gain exposure. Maybe some will gain exposure to fast-growing yet lower-returning companies — though they’ll need to adjust their own portfolio construction approach, trading lower loss ratios for lower expected returns. Which may not interest the institutional investors seeking to allocate within venture.
Those 2,348 are located all around the world, and being unable to compare that figure to the past decade of global fundraising data, that very large number has no context. Specifically in the US though, 262 venture capital funds in aggregate raised $53.9 billion in 2018, with just over half of those funds each closing on less than $100 million.
Granted, the proportion of funds raising more than $500 million increased from 2017, while those raising less than $100 million decreased year-over-year. When you factor in the growth in the number of funds that have raised since 2013, we’re in a world with an ever-increasing number of venture firms, and they’re raising (or trying to raise) even larger pools of capital.
For that matter, the number of first-time funds continues to grow, and comprising a larger proportion of funds raised: 20% in 2018 compared to 15% in 2017. In an already saturated market, there are more newcomers to the space.
It may not be fair to single out venture capital, but I follow the space closely (overflowing my Twitter feed). And when I see more and more funds entering the fray, many of which are being raised by teams with limited track records investing together, I have to further strengthen my filter for new opportunities. Like I mentioned to my friend, many funds without the differentiated angles on network/access and motivation are going to have a hard time surviving the next downturn in venture, whenever that happens. Or if. Maybe I’m just spooked, and this time is just really different.