Venture Capital 2.0: Not So Separate, But Still Equal

A 1900 word finale in the series.  Part 1 is here. Part 2 is here.

The separation theorem is the foundation of Modern Finance.   Among other things, it is used by investors to construct optimal portfolios of investments based on underlying assumptions of risk, return, and correlation.  Limited partners (LPs) use this rationale to compute allocations of public versus private equities. Within private equity alternatives they further allocate between venture capital, LBOs, distressed debt, etc.  And within venture capital they allocate between early and late stage, market segment, national and local geographies, etc. 

Of course, each dissection introduces more random measurement variance as the analysis gets increasingly refined.  At some level, as I suggested in the prior post, the noise overwhelms the signal.  Funds of funds provide a very useful function in aggregating the volatility of individual private equity firms.  The theory is a Fund of funds can provide a lower beta than a direct VC fund investment.  The theory relies on reliable and persistent investment strategies of the underlying components – the VC funds themselves.

Many investors (pension funds, insurance companies, unions, etc.) also want to construct their own ‘optimal portfolios’ from private equity instruments.  So they overweight certain segments, such as buyouts, and underweight others, such as late stage technology venture capital funds. They, too, want the “pure plays” that portfolio theory demands.

Most VC funds, especially the newest ones, encounter an investors’ paradox.   They market themselves to LPs on a specific investment thesis (stage, sector, etc.) If they sense the original investment thesis no longer is a return-maximizing strategy, they face a difficult choice – pursue a new thesis to maximize return and become accused of ‘investment drift’ or remain a pure play and forgo top-quartile status.  Those who construct the portfolios (the LPs) want pure play strategies and top-quartile outcomes.

Some investors might consider this sturm und drang in VC ranks as part of the eternal Darwinian process of winnowing of investment managers.  But I think there is more to it.  The ballooning of the total amount of capital in private equity is changing the drivers of rates of return in venture investing.  The sheer number of practitioners is at all time high.  As a result, private equity markets are more efficient and more volatile.   This means that sustainable investment theses based on technical parameters are not as durable as they used to be.  Sometimes early is better; sometimes late.  Sometimes traditional private is better; sometimes PIPEs.  And venture capital is a long-only bet.  But while you can’t always pick the private winner, you often can pick the public losers.   The notion of a pure and enuring sector/stage theis is in jeopardy as a profit-maximizing strategy for any fund with a ten year life, or even a five year investment period.

Venture capital is evolving into two models.  One is the traditional model of the long-ball home run outcomes driving the portfolio.  For descriptive purposes, I refer to this as the Boutique Model. This is what we know as Venture Capital 1.0. It is the model practiced by most VCs today. This is becoming increasingly difficult for most, but not all, VCs.  This model relies on VC brand as a beacon to attract entrepreneurs. The brand owners rely on their networks to expose them to and validate proposals from the best entrepreneurs.  In theory, the best entrepreneurs are the tail of the distribution that can achieve that long-ball outcome. 

The 100x return has always been rare. The 10x return is becoming an endangered species, and  the  "not great, but I'll take it" feeling associated with the 5x is now a cause for celebration.  I illustrate this outcome compression in the associated graphic. These so-called "brand firms" have always operated at the right tail of the graph.  So the outcome compression from excess capital probably has minimal impact on them.  But those who pursue the traditional 'long-ball" strategy of VC and fail to attract those increasingly scarce 10X+ outcomes are likely to find themselves in that investors' paradox and scrambling to "re-define" their investment thesis.

The influx of capital and capitalists is changing the definition of the business.  When the public and private technology equity markets were less institutionally populated, the world of risk capital was segmented into separate businesses.  Early stage venture capital was a different business from private investments in public companies (PIPES).  Late stage venture investing was different from leveraged buyouts.    Shorts and longs were as different as night and day.

I say they were different businesses because the classic tests of business definition all pointed to this conclusion.  Reaching back to my early days at Bain & Company, we relied on three tests to assess if two lines of business were indeed the same business (I knew this stuff would come in handy some day).

1. Do they serve overlapping sets of customers? (Shared Customers)
2. Do they share overlapping sets of competitors? (Shared Competitors)
3. Can you invest in one line of business and materially impact your cost position in the other?  (Shared Costs)

The more the answers to these questions were answered in the affirmative, the more likely the two initiatives were in the same business. And the VC industry is seeing more competition from other investment sources as all forms of risk capital converge.  These various forms of capital are not perfect substitutes.  Angels don’t compete mano-a-mano with hedge funds.  Seed VC funds aren’t bidding on LBOs.  But there is enough contamination at the edges in each class to cause asset inflation from increased total competition. This convergence is bidding up prices in all sectors. 

This is my core observation about venture capital.  It is no longer just a pure and separable business.  It is a feature of the overall business of providing risk capital. It is a product in a risk capital product line. Like many of my VC brethren, I am an early stage venture capitalist; I am a product line manager. As a principal in an early stage firm, I am a general manager in a single product company. Single product companies can be highly profitable or abject failures.  Lack of diversity is neither an asset nor a liability. It is simply an attribute. But the boutique segment is winnowing down to a very small handful of successful brands, representing a very small portion of the market.  The best brand-driven VC 1.0 firms will continue to succeed.  However, the sheer amount of total risk capital available will continue to make it difficult for many firms to build the very brands that drive predictable and continued success in VC 1.0.

If the basis for competition in the boutique segment is brand, what is the basis for competition in the larger business of risk capital? 

This brings me back to my  opening remarks about the separation theorem. The separation theorem assumes that individual investments have risk/return properties which are affected by the construction of the portfolio. An early stage investment's alpha and beta are not affected by the inclusion of a distressed debt instrument.  Now suppose the insight about how to price the distressed debt arose from knowledge you gleaned from the early stage investment. Or suppose a profitable public market short position arises from the insight acquired from chasing, but ultimately being outbid in pursuit of a 'hot' late stage investment.  Or suppose experience with a PIPE provides a source of market and customer diligence to generate ideas about potential new Series A companies to form and fund. I refer to this as a Crossover Model of risk capital. The crossover model is a model for Venture Capital 2.0.

It is best to illustrate with a hypothetical. Suppose I believe Apple is developing a Skype-like Ipod for release in 2007 and I believe it will successful.  I could simply communicate that to investors and let them construct portfolios of longs and shorts around this thesis (the separation theorem in action). Alternatively, I could use this to construct what I believe is a risk/return maximizing set of investments around the insight. I could place early stage bets (communication services), midstage bets (new battery technologies), and public bets (Apple) on the thesis.  If I go long on all bets, I have a better return than if I simply picked a market basket of early, midstage, and public technology companies. If I hedge my bet by shorting , instead I can perhaps construct a  better risk/return than a pure long, early stage VC position.  If I communicated the "Skype Ipod" insight to my investors, they could construct their own portfolios. But by communicating the thesis runs the risk of disclosure and loss of advantage.  The risk of disclosure is a real transaction cost. And the separation theorem assumes zero transaction costs.

The basis for competition in the Venture 2.0 Crossover model is a focus on markets, independent of stage, geography, and risk capital instrument. The Boutique model relies on a brand-generated magnet status to find outlier long-bets.  The Crossover model would rely on a full-spectrum view of private-to-public to generate an appreciation for inefficiencies in an otherwise fairly efficient market for risk capital.  Like everyone else in the industry, it faces the risk of competing for deals with marginal competitors who have excess cash burning a hole in their pockets.  However, unlike everyone else, the crossover firm can leverage the insight in multiple, non-competitive forms.

So Venture Capital 2.0 is increasingly about applying capital to market insights, across the continuum of private and public, early and late.  Move money where the insight-driven opportunities are.   This cuts directly against the grain of most LPs who want to combine investment products from great firms with different stage foci.  But in doing so, they give up the inherent advantage of cross-leveraging an insight with either hedges (to reduce risk) or additional longs (to increase return).  Financial and product markets are no longer independent. The hedge can be to go long in both the private upstart and the public incumbent.  The short can be to short the incumbent.  Finally, if  the startup loses to an incumbent, the lost capital may be recovered by shifting assets to the incumbent before the broader market fully appreciates the dynamic.

Venture Capital 2.0 is happening. The industry is consolidating into larger firms.  These larger firms, while still calling themselves VC funds, look nothing like the VC funds of 15 years ago.  They have multiple products (early, late, PIPE), multiple geographies, affiliate or satellite entities for distribution, etc.  Few are formally affiliated with hedge funds, but I believe that is inevitable.  The multi-year partnership structure is probably not in jeopardy -- investment managers will still need to finance private companies over several tranches.  However, the venture model of capital calls and distributions will likely give way to more evergreen or closed end funds in which capital can be recycled across investments.  This has its own valuation and liquidity issues. Nothing is perfect.

I began this series with a flippant remark about Venture Capital 2.0.  I don't think traditional venture capital is going away any time soon.  There is too much momentum, i.e., money.  But I do think there is a real alternative model for the practice of venture capital investment as a product within a larger risk capital portfolio.  It won't emerge soon.  LPs decision models are still based on a demand for venture products packaged to look like they conform to portfolio construction models. However, there is enough  "investment thesis drift" afoot these days that some private equity firms are going to realize that they can use this "drift" to their advantage and drift head-on into crossover forms of investing.

Thanks for taking the time. I hope you found it worthwhile. I don't claim to be a financial economist.  So if you are, and you think my reasoning is flawed, please let me know.

Comments

[Andrew Fife]

Bill Burhnam had a great post on the topic of hedge funds crossing over in to VC earlier this year. The whole article is definitely worth a read but here is the most relevant portion:

Snipped url: http://snipurl.com/wabq

“The ironic thing is that most hedge funds will probably [create VC funds] as almost an afterthought. With some funds having gross exposures in the tens of billions of dollars, they could dedicate just a few percent of their assets to venture and become a major player overnight. While the direct returns on such funds probably wouldn’t move their own needles, the private market information flow that the hedge funds would gain access to could be worth a few hundred basis points of edge on their public holdings, which is nothing to sneeze at when your are levered 2-1 on $10BN. Thus, the day a hedge fund walks down Sand Hill Road offering the “25% solution” is the day that those rumblings of change might just become a full blown earthquake.”

I see a couple of potential problems with the cross over model:

1) Regulators may view cross-over as a new form of insider trading when it involves public companies. For example, how would the SEC feel if Nordstrom's board members made cyclical investments in retail clothing based on access to Nordstrom's sales figures. I don't know if that is insider trading or not, but it certainly strikes me as at least murky.

2) Placing new bets around information gained from investments in a private company may inadvertently provide signals to competitors that kill the initial investment. No sooner cross-over investing becomes a known strategy competitors will certainly be looking for these signals and attempting to cover them up may increase transaction costs.

3) Cross-over investing pushes VCs’ and Entrepreneurs’ interests slightly further apart. If the VC can win from either the data collected or the liquidity event entrepreneurs may perceive that the VC is less motivated as a board member, which could have a negative impact on firm’s reputation and deal flow access.

However, I think the likelihood of any of these issues having a significant impact is low.

[Adam Lindemann]

I loved this post, Peter. Well done! Your approach to investing in the business of investing as well as investing in the emerging semantic web is all about bringing otherwise discreet and independant entities together by finding unifying themes at a higher level of abstraction. Applied to other areas of human endeavour your thinking approach might lead to some stunning insights that could break human spirituality out of the limiting religious cylos that they currently inhabit. Actually maybe it would be safer to leave that to someone else. Looking forward to chat sometime soon about our new project. I will be in Palo Alto next month...

[Neville]

I think you've basically described Bain Capital.

[adam]

Peter- Good Post. I presume thats similar to what Carlyle is trying to do with thier hedge fund strategy right and also with Quadrangle group is doing with thier PE and Hedge Fund focus on Communications industries. Thier basis thesis is that insights gained from running large public companies can be used to profit in trading strategies.

One can always argue that Goldman's prop trading group is able to generate superior insights because of thier "insight/information" flow from thier banking and sales and trading desks...

While I agree with all this, there could be some issues (while challenging can be worked out) i.e. compensation models (i.e how do you compensate a fund for someone who generates the idea versus somebody who actually trades in it), subtle but important differences between having an insight and actually trading/structuring a profitable transaction, providing an overall level of risk and liquidity structures for LPs...

Adam- wtf is "discreet and independant entities together by finding unifying themes at a higher level of abstraction. Applied to other areas of human endeavour your thinking approach might lead to some stunning insights that could break human spirituality out of the limiting religious cylos that they currently inhabit."

[Adam Lindemann]

“Finding unifying themes at a higher level of abstraction”

Example 1 from Peter Rip’s Mind

(From Venture Capital 2.0: Not So Separate, But Still Equal”

This is my core observation about venture capital. It is no longer just a pure and separable business. It is a feature of the overall business of providing risk capital. It is a product in a risk capital product line.

Example 2 from Peter Rip’s Mind
(From Investing at the Intersection of Opportunity and Serendipity

The Abgenial Pivot was to see the dots were connected. Consumer web….enterprise web…..Saas….legacy apps…. Mashups….SOA were all variations on a theme and that theme was “Programming the Web”
---------------------------------------------------------------------------------------------------------

“Applied to other areas of human endeavour your thinking approach might lead to some stunning insights that could break human spirituality out of the limiting religious cylos that they currently inhabit."

Example 1 from John Lennon’s Mind
Imagine there's no countries
It isn't hard to do
Nothing to kill or die for
And no religion too
Imagine all the people
Living life in peace

You may say that I'm a dreamer
But I'm not the only one
I hope someday you'll join us
And the world will be as one

[Will Price]

Peter - I think you summarize the market dynamics quite well. However, I believe that the VC 2.0 model is essientially the same argument that conglomerates used in the 1960s. Ie that internal capital markets and allocation of capital would out perform individual investors ability to allocate capital and build their own return/risk maximizing baskets of securities. While it is undenaible that the model is attracting capital today, ultimately i think these models will suffer from an adverse selection problem - in that is only unsophisticated LPs, who cannot themselves build the optimal portfolios, will find the conglomeratization of risk capital attractive. Moreover, creating incentive structures and colloboration across groups within a platform, delegating deal decision making, ie managing the complexity of multiple asset classes, vertical markets, geographies demands incredible management, structure, and discipline - something that most investors are terrible at. My own view is that the best LPs will prefer boutiques and will seek to build return maximing portfolios across pure-play exposures to risk - this clearly is inverse to investors building platform copmanies predicated on LPs outsourcing their alloaction to a group that will build that basked for them.

[just.a.guy]

It sounds like you've described Technology Crossover Ventures (TCV) and Crosslink Capital. Any others come to mind pursuing the blended public/private strategy?

1970s Congolomerates are a bad counter-example to the strategy, because they typically fail the 'Bain Criteria' Peter laid out (shared customers, competitors, and costs)

[Scott Rafer]

I'm sure that you are spot on vis-a-vis large-scale LPs and GPs, but you bring up a fascinating point about ways in which the tech-investment business in changing at the "low end."

I hadn't focused on the separation theorem in far too many years. Unlike what the definition page says (i.e. "Investors are considered to be a homogeneous bunch"), I'm not sure you can consider the proof of it to be trivial any longer. Now that microeconomics have given up on the rational consumer (and therefore supply-demand equilibrium) in favor of game theory, wouldn't one need to challenge the separation theorem as well?