Fundraising is not just limited to companies. Venture Capital firms have to do this as well. It is an interesting process and you get to meet fascinating people. Potential limited partners (or LP’s as we call them) come to the table with a set of beliefs that are, well, sometimes peculiar and rarely challenged - after all, the VC that is raising capital does not want to upset their potential investor. The net result is that certain "truths" often have to be addressed and given consideration, such as:
- You will be shut out of the hot deals if you’re not one of the best-known funds
- You need to have a broad, deep team of senior investment professionals
- Specialization is the best way to generate the best returns
The underlying issue is that many LPs feel they know the fundamental requirements of a successful VC firm, have boiled it down to a few precepts, and anything that does not meet those precepts cannot work. This is the same logic as reportedly used in the argument that bumblebees cannot fly.
Supposedly during dinner a biologist asked an aerodynamics expert about insect flight. The aerodynamicist did a few calculations and found that, according to the accepted theory of the day, bumblebees didn't generate enough lift to fly. Once he sobered up, however, the aerodynamicist realized what the problem was: a faulty analogy between bees and conventional fixed-wing aircraft. Bees' wings are small relative to their bodies. If an airplane were built the same way, it'd never get off the ground. But bees are not like airplanes, they are like helicopters.
We believe that the only way to measure success in venture capital is via returns, not firm structure: flight and not ones assumptions about flight. Now success can also be due to simple luck, but a long consistent track record would indicate process has something to do with it. In fact, a continually refined process. For us returns are a function of process which breaks down into finding great companies, selecting those you want to work with, and then determining the amount of capital to deploy each time there is an opportunity to invest, or simply:
Success = returns = deal-flow + selection + deal negotiation + portfolio management
Far too much discussion is based on deal flow, and in particular the notion, or belief, that hot deals lead to successful companies. As a firm, we are wary of hot deals and far prefer ones that are 'cold'. Why? Well, as we invest at an early stage, we want to invest ahead of an opportunity, preferably 3-5 years ahead. As such if a deal is hot, then the idea is likely of the now and not the future, and the company will not have the time to grow to the right size and heft to dominate that opportunity. Successful companies, like successful people, often have tough childhoods and adolescent periods - there is no silver spoon. Deal selection is simply tougher that latching onto the next hot idea, the theme-du-jour, the company with the cool kids or the cool co-investors. We love cold deals with no 'social proof'', just amazing CEO's and management teams.
Larger funds are at a triple disadvantage vs. smaller funds:
(A) No professional active money manager should be too diversified, and so focusing on investments below 0.5% of their capital base is asinine. No fund manager can seriously do so as fund management is a matter of balancing time on a portfolio position vs. the potential return. The capital that is most scare is intellectual capital.
B) The people working at the fund focused on seed investments tend to be the most junior. They will feel they have been given the short-stick opportunity, as whatever they do they feel that they cannot move returns for the whole fund. The fund will also feel conflicted out of putting larger amounts of capital to work in competitors when the early stage company almost inevitably pivots in a space that is just emerging.
(C) The tool-set for early stage investing is simply different. The toolset that makes for a typical partner at a $500mm VC fund is different than the toolset needed for early-stage deals. The early stage toolset is way more qualitative than quantitative.
The bar of having "a broad deep team of senior investment professionals" is interesting – after all who can argue that more talent is better. After having worked at Goldman Sachs and some other very large companies, I fully understand the value of a large team, but the downside of a large team is that it leads to groupthink and a consequent conservatism – remember the quote about a camel having been designed by a committee. In addition, a large team creates a higher cost structure that requires a larger fund, which is counter to our approach.
So many people manage money so that they can manage more money. The management fee that is insignificant for a small fund becomes a raison d’être for a large fund. Their objective is to manage the maximum possible so that they can have significant asset based fees and be less reliant on performance fees. They become asset gatherers. One of the most successful asset gathering strategies is to specialize. After all, a specialist will know much more about something than a generalist. That leads to higher returns, right?
As a firm we respectfully disagree, especially with regard to the world of early-stage investing. This is despite some academic research on later-stage investing that has indicated some advantages to specialization for later-stage funds; see “The Performance of Private Equity Funds: Does Diversification Matter?” Specialists focus on areas they think that investors want to invest in today, and so are always proposing the theme-du-jour. In early stage investing, this is a bit like fighting the last battle. Early stage investing is a long-haul game, and not one that should be tied down to a tantalizing theme during the capital raising period. Technology moves too fast to tie a successful fund down like that. Specialist investors have to turn down investments that they think are going to be successful if outside of their theme. Specialist investors that are hands-on cannot invest in the best companies in the space; as they might compete. If they are not hands-on then they cannot help their companies succeed and have to watch from the sidelines. Specialist investors have one hand tied behind their backs.
When my partner, David Teten, wrote his research study on best practices in deal origination, one of the people he spoke with was Bill Morrow, formerly COO, Mid Europa Partners, a European private equity fund, which is comprised of a team of 30 people from 19 different countries. Bill observed, "We have deliberately not chosen a country-specific origination model, because we're afraid of adverse selection. If you pay someone to eat what he kills in Romania, he may bring something not palatable back from Romania because that is all that was available."
Bill went on to say: "Similarly, we're debating the extent to which we should be sector-focused. We're wondering to what extent a well-defined sector focus is good or bad. It comes with some logistical issues. If your focus is retail, and nothing is going on in retail, then you're either a wasted talent or again face adverse selection. We want our people to be fungible. We don’t hire the Czech investment professional just to originate Czech deals, although we recognize he or she will be more likely to source deals in that geography."
Similarly, in Robert Finkel’s excellent book, The Masters of Private Equity and Venture Capital, there’s an interview with John Canning, chairman of Chicago private equity firm Madison Dearborn Partners LLC. He observed that during the telecom bubble, his team thought of creating a dedicated telecom fund, because they had made so much money from telecom investments. Madison Dearborn did not, and were very glad about that decision with the advantage of hindsight.
We are unapologetic generalists and invest for returns. We think that limited partners actually want returns and we work to deliver them. Specialization is a sub-optimal strategy for early stage venture capital.
So, how do you measure success in the space? What are the best proxies for future returns? We maintain it is having a philosophy of investing for returns in a fund with aligned interests and a proven track record that is way above the median for the space. Returns are all about looking at a ton of deals and finding the few management teams you want to work with, then working with them and giving them more capital as they succeed. It is a long game, it is an unconventional game, and it is tremendous fun.
Look out for the bumble bees.