What Determines VC Returns

Today: VCs, LPs, firms, individuals, sectors, ecosystems, additional thoughts, and a comprehensive reading list.

The Agenda 👇

• Is it about the firm or individual investors?

• Is it about the sectors where you deploy capital?

• Is it about the underlying ecosystem?

• A few additional thoughts, and a reading list

We’ve all heard (or read) the discussions about what determines a company’s success: is it the market, the founding team, the product, the timing? 

Less discussed, however, is the question of what determines a venture capital fund’s returns—probably because the relationship between VCs and their limited partners largely remains a matter of secrecy. Nevertheless, I’ve opened about 25 tabs from my Evernote with the ‘VC-Returns’ tag, and here’s a first round of thoughts on the matter.

I assume the idea of the ‘power law’ in venture capital is well known. If you’re familiar with this notion, just keep reading. If that’s not the case, feel free to explore the following articles to get a grip on the ‘power law’ (or ‘skewed returns’) in VC:

• Performance Data and the 'Babe Ruth' Effect in Venture Capital (Chris Dixon, a16z, 2015)

• Power Laws in Venture (Jerry Neuman, Reaction Wheel, 2015) 

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Firm or Individual Investor?

An opening question is whether returns are determined by the firm managing the fund or the individual investors in charge of making the deals. Here we have ambivalent conclusions. On one hand, in his landmark 2014 article Mortal Inspiration from the Gods of Venture Capital, Ashby Monk (a researcher specialized in asset allocation in the realm of sovereign funds) writes the following:

Small (or even random) differences in investment capabilities within GPs are magnified over time through the emergence of structural advantages… With a good [enough] team and a great structural advantage, you can end up doing something legendary.

On the other hand, Ahmad M. Butt, a hedge fund manager with Jetstone Asset Management in London, published a thorough piece of research on alpha in VC in 2018 (compiled here):

Venture is undoubtedly still all about Human Capital. It is a game of hustle where individual partners drive superior returns over firm capital, with estimates of partner value being in the order of 6x more valuable as a predictor of future performance versus firm organizational capital. This is a business where experience matters as evidence asserts that companies funded by more experienced VCs are more likely to go public. But given the weight placed on lists like the Midas List and other individual partner rankings, it is hard to argue that this is a business where a great deal of value is tied in the firm. The brand of the individual VC trumps that of the firm, in general, save some truly “celebrity” firms like Sequoia, a16z, Benchmark.

What Ahmad suggests is that it’s mostly individual investors that determine returns. As for Ashby, he suggests that the firm can make a big difference with returns if it secures what he calls a “structural advantage”—that is, a premium brand, a wide network, access to the right persons and companies, setting up the organization to better support portfolio companies and maximizing returns, etc.

As is often the case in such things, the correct answer is: ‘A little bit of both’ (firms and individuals). As Bill Janeway wrote in Doing Capitalism in the Innovation Economy (p. 95-96):

A widely recognized stylized fact is the extraordinary skew in venture capital: a very small number of venture capital funds and firms drive the aggregate returns for the industry as a whole... [Another stylized fact] is that—in contrast with all other asset categories—persistence can be detected in the returns of individual managers. 

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What About Sectors?

We should be cautious when conducting retrospective research. There are so many things in the future that won’t resemble the past. Let’s start with these:

• Software eating the world means “Silicon Valley-style startups” entering more industries, including those where tangible assets and regulations force companies to be “default local”, thus degrading the returns (more capital deployed + smaller/more fragmented market). There’s less of a Babe Ruth effect in real estate, healthcare, and financial services (or ride-hailing) than in online search or social media!

• Those lesser returns, however, can be compensated with a reduced exposure to risks. For instance, less scalable businesses are typically easier to defend with traditional moats (regulatory barriers, tangible assets). Hence the risk-adjusted returns are on par with what exists in more scalable businesses: lesser returns, yes, but also lesser risks.

• In addition, businesses that are more tangible/regulated are more predictable, thus reducing the information asymmetry at the frontier. Not only does it make it possible to fund such businesses with debt rather than risk equity, it also diminishes one of the main differentiation factors of traditional VCs: their unique ability to maneuver in a world ridden with uncertainty.  

And so there’s a feedback loop linking back to the previous question: the more time goes by, the more it’s about deploying venture capital in tangible/regulated sectors, which in turn tweaks how dealmakers and a firm’s structural advantage should be assessed—notably by LPs. As I wrote in The Diffraction of Venture Capital, the further we advance in the Entrepreneurial Age, the more venture capital is bound to be Taylorized, just like good old investment banking.

The corollary is that firms willing to play the capitalist game of scaling up and diversifying will matter more and more, and the individuals populating them will matter less and less:

Boutiques of craftspeople will each remain focused on one narrow segment. [Meanwhile] we’ll witness the rise of large, generalist firms integrating the different lines of financing (“interference between the wave forms produced”) as they will discover synergies either on the marketing side (same target with different needs along the way) or the financial side (like between equities and fixed-income in every large investment bank that serve clients with capital to deploy). As I wrote back in May last year, Andreessen Horowitz is clearly on that path.

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What About the Entrepreneurial Ecosystem?

There’s something else, however, and that’s the ecosystem to which a given investor belongs. As Brad Feld and Ian Hathaway wrote in The Startup Community Way,

Entrepreneurs must acquire more than innovative ideas, technologies, or industry-specific information. They must also amass a team of skilled employees, customers, and suppliers, and support them with the startup funding and know-how that are specific to the venture-building process. The traditional market mechanism, where buyers and sellers exchange goods, services, or information at a specified price and set of terms, doesn’t work well in this context. For startups, this presents two acute challenges. They are especially reliant on the external environment vis-a-vis most other businesses, and they are often deficient in critical resources.

This, I think, is what explains the results of AngelList’s research on returns in early-stage VC investments. They write about investing in every “credible deal” in a given context, rather than trying to pick the best startups. Obviously, it means deploying capital within a geographical perimeter that’s a healthy/thriving ecosystem such as Silicon Valley, Israel, even London. That makes all the difference:

• More secondary opportunities (which are important as explained in VC strategy: managing risk & securing wins with secondaries ⚠️🏆)

• Easier to fund the next rounds for fast-growing startups—listen to Alex Danco’s inspiring conversation with David Perell.

• Easier to hire world-class employees who will make a difference when it comes to excelling at engineering, operations, and sales.

• Easier to find an acquirer if the startup doesn’t make it all the way to the IPO! 

And so at the upper level, LPs want to allocate to VC firms to be exposed to a given ecosystem. You want your money to be secure and your asset to accrue value at the same pace at which the underlying entrepreneurial ecosystem grows. Where’s the research on that one?

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A Few Additional Thoughts on the State of Things

LPs being LPs (that is, cautious, conservative, and largely hidden from sight), I think individual investors are bound to be confronted with a situation like that told many times by Steve Schwarzman. They’ll tend to stick to a firm rather than following individual GPs in their career moves, thus accelerating the polarization of the VC landscape: large-scale financial powerhouses on one end, boutique, artisans and solo capitalists on the other. Here’s Schwarzman leaving Lehman Brothers to build Blackstone:

Despite setbacks, we were still confident enough to think that our reputations, our experience, and those hundreds of letters would bring in a flood of business. Weeks passed. Nothing… I felt like watching an hourglass, the money just draining out as the business never came. Not so long ago, people fought to have us work for them. Pete [Peterson] and I hadn’t changed, but now that we were out on our own, no one cared about us. Here, I realized, was a great truth. For all that we had accomplished, we were a start-up. There would be no easy jobs.

Once the ball is rolling, a successful VC firm will tend to raise capital at an increased frequency (until it ends up raising on a constant basis, just like a large brokerage—hence, rolling funds!). This means that the quality of the more recent segment in the portfolio cannot be taken into account as an LP decides whether to allocate more capital to the fund. Here’s VC Starter Kit in How VCs Make Money: 

As long as VCs can continue to raise from new funds LPs, they get another shot. Because VCs raise a new fund every two to three years, the return profiles of their old funds are not always clear. LPs are inclined to stick around with VCs for a long time, because of their own FOMO (fear of missing out) on a particularly great vintage (the year in which a fund started making investments).

In addition, research suggests firms that are blessed with high returns can afford to demand higher fees, which in turn can translate into what Ashby Monk calls a “structural advantage”: strengthening whatever matters (brand/network/access/operations). Indeed, Fred Destin of Stride VC writes here that “top funds charge 3/30” rather than the customary 2/20.

This is a mixed bag:

• On one hand, contrary to what many are suggesting these days, it means that track record will matter more and more and that emerging managers will have fewer opportunities to raise their own fund (consistent with what I wrote above 👆). Be prepared to have to build a track record as an angel investor, investing your own money!

• On the other hand, it also means established VC firms can afford to take more risks over the short term, perhaps losing money on new trends but also burnishing their brand and deepening their moat—which, hopefully, will be rewarded with higher returns in the future.

This is an idea I’m borrowing from my colleague Balthazar de Lavergne, which I already discussed in At What Stage Stage Should You Invest in European Startups?

Some firms are so successful, they can afford to lose money making early bets on entrepreneurs interested in the new technology of the day. It is highly improbable that even some of those bets pay off (although there are exceptions). But investing early still makes perfect sense: It trains a generation of entrepreneurs who will come back for more when the dust settles, and it sends a signal of early interest that later makes it possible to attract the best deals on the market.

Another idea: Maybe it’s all about portfolio management and reinvesting in every round, as Byrne Hobart argues in this mind-blowing article: Judging VC Skill: The Hardest Open Problem in Finance?. 

Final idea: LPs are protected by hurdle rates and VCs by liquidation preferences, and you end up with what resembles a pretty ordinary asset class: not that much downside (because of favorable terms re: hurdle rate & liquid pref); not that much upside (because more tangible/regulated); but overall, a rather good correlation with the value added as part of the paradigm shift toward the Entrepreneurial Age.

Here’s the complete list: 

• Mortal Inspiration from the Gods of Venture Capital (Ashby Monk, Institutional Investor, 2014)

• Performance Data and the 'Babe Ruth' Effect in Venture Capital (Chris Dixon, a16z, 2015)

• Power Laws in Venture (Jerry Neumann, Reaction Wheel, 2015) 

• Micro-VC — Smaller is better, but the math is still really hard (Samir Kaji, GVCdium, 2017)

• Judging VC Skill: The Hardest Open Problem in Finance? (Byrne Hobart, Medium, 2018)

• Unpacking Alpha in Venture Capital (Ahmad M. Butt, Medium, 2018)

• How to Win in Venture Capital: Focus on the Fat Tails (The Quantified VC, Noteworthy, 2018)

• Startup Growth and Venture Returns: What We Found When We Analyzed Thousands of VC Deals (Abe Othman, AngelList, 2019)

• A Review of Risk and Returns and the Future of VC Allocations (Going VC, 2020)

• Ventureball: A Primer on Venture Capital for Hedge Fund Managers (David Siegel, Data-Driven Investor, January 2020)

• Late-Night Musings On Portfolio Construction (Semil Shah, February 2020)

• The Venture Capital Math Problem Revisited (aka How Could You Be So Wrong?) (Fred Wilson, AVC, February 2020)

• VCs should play bridge (Alex Danco, Two Truths and a Take, March 2020)

• Why VCs are obsessed with Unicorn companies? (HINT: let’s do the math together) (Elizabeth Yin, May 2020)

• Venture Capital’s Role in Financing Innovation: What We Know and How Much We Still Need to Learn (Josh Lerner and Ramana Nanda, Journal of Economic Perspectives, Summer 2020)

• The Venture Capital Flowchart (Nikhil Basu Trivedi, Next Big Thing, July 2020)

• Know Your Edge As A VC, The Complete Series (Ha Duong, Cambrial Capital, July 2020)

• Do Emerging Fund Managers Outperform More Established VCs? (Chris Harvey, Law of VC, August 2020)

• Let's revisit the basic math managers must go think through (Samir Kaji, Twitter, August 2020)

• How LPs Can Generate Alpha in 2020 (Conrad Shang, Collin West, Nihar Neelakanti, Kauffman Fellows, August 2020)

• Venture Capital Is Faring Better Than Other Parts of the Economy (Christine Idzelis, Institutional Investor, August 2020)

🎧 And two podcasts:

• How to Invest in VC Funds (Thomas Kristensen with Carlos Espinal, This Much I Know, 2018)

• Why Venture Is Hard (Jerry Neumann with Patrick O’Shaughnessy, Invest Like the Best, 2019)

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From Normandy, France 🇫🇷

Nicolas