Venture Capital 2.0: It's All A Game

There is a report today in the New York Times (registration required, of course) that Sevin Rosen Funds has elected to not raise a tenth fund, for now.  First of all, I have to congratulate the partners at Sevin Rosen for a triumph of integrity over greed.

This withdrawal led me to think about Why? And the conclusion provides another path to the model of a crossover fund as a VC 2.0 format. 

Viewing venture capital as a distinct market, one is led to a classic Prisoner's Dilemma formulation of the business.  Excess returns (a.k.a. top quartile) are a zero-sum game.  Not everyone can be top quartile and the presence of more firms competing for the same finite set of 'top deals' leads to the lose/lose quadrant for all players.  Exiting the market marginally increases everyone else's expected returns.  So each player faces the choice of stay/exit and if everyone choose stay, everyone loses. If everyone exits, capital is scarce and returns are excessive. 

The hypothetical payoff matrix in this construction illustrated in this figure.

 

Your firm faces the same choice as all firms -- stay or exit.  If everyone exits, of course, everyone's return is 0%.  If everyone, stays, everyone else has a median return which is -20%. Since you are a top-quartile firm (isn't everyone?), you only have a -10% return.

 

 

 

Now take a multi-period view. You can decide to take the same capital each period and "play" in a different game.  Assume that everyone also decides to "play" each period, but there are multuple games.  Each game corresponds to a different equity market.  In each period, one of the games is has better payoff characteristics than the others.  Your decision now changes to which games to play.  Note that your average return from picking the right general game each period is 15%, while each player playing playing only one game has an average -10% return.  You don't have the maximum return of 20% in any period, but you do have huge spread between the average return and your return. 

This is another way to look at the crossover model of risk capital.  Whether it is achieve by evergreen funds, merchant banking, blind pools with stage- and instrument-independent strategies is a detail.  The important point is flowing capital to the more attractive risk capital market creates the highest return. 

I realize this is a trivial example.  But it does illustrate the point that the question of whether Venture Capital is Broken (overfunded) is different from whether Risk Capital as a whole is broken.  VC may (or may not) be broken now.  But somewhere in the world of risk capital the sun is always shining.  And it will shine again in VC land.

Comments

[Jonathan Aberman]

There is no doubt that there has been a tremendous pooling of capital in larger and later stage venture capital funds, as well as in hedge funds and private equity funds. What is interesting, however, is that while there is much capital available for "built out" companies, many of the emerging software start ups that we see are more capital efficient. Meanwhile, the public markets remain more difficult to tap. It's almost a "perfect storm" for larger VC funds. It's understandable that SR would make the decision they did (taking their announcement at face value).

However, what is not really elaborabed in the SR announcement is that it's also a time of great opportunity for smaller venture capital funds that can make sense of sub million dollar rounds. We think that the return opportunities are still there for funds that are configured for the new market realities.

[Jason Wood]

Peter,

While I think intellectually (after all, this is classic game theory stuff you're talking about) your point is sound, it neglects the real life friction that comes from crossover vehicles.

Domain expertise, risk tolerance, time period tolerance, liquidity, regulation (lets not forget hedge funds are required to register with the SEC now, save for some gray areas that will be going away in the coming years) are but a few of the hurdles.

For the very large capital pools, I can see this working; which is why you see some of the largest LBOs and hedge funds pushing down into venture. But the fact is, hedge funds aren't idly looking to get into venture and LBOs for sheer whimsy, our market dynamics too are becoming crowded and "overfunded."

As I've said time and time again on my blog, there is excess capital EVERYWHERE, not just in venture. Therein lies the problem, particularly as it relates to domestic investing.

[Peter Rip]

Jason:

Some folks are making this work in various formats. Bain, IVP, TCV, and Crosslink are all top-performing PE firms -- all following this model. Execution challenges exist, for sure, but they aren't all that unique.