Perfect hindsight on VC gloom is no predictor of future performance

The announcement by Sevin Rosen that they would be releasing their LP commitments was the timely reality check needed to buttress a number of comments announcing a deep crisis in the venture market.  The bellweather said it best.  Sevin Rosen is old news already, but I was prompted to post on this by the newly released NVCA data, courtesy of Primack again, who points to likely wrong conclusions based on lagging indicators:

So “stick with us,” the VCs tell their LPs, because "we’ll make you money in the end."  The “blind” part is that such statements do not seem to acknowledge that the 10-year VC performance figures are around one year away from a harrowing fall.

We must distinguish between VC seeming unattractive because of the difficulty in raising funds (arguably the result of wrong asset allocation decisions driven by past returns and not future market opportunity) and a structural change in the underlying market that would make VC unattractive in the long run.  Most of my simplistic thoughts on this topic had so far been focused around two central themes:

  • Mature market: Has the industry matured and is it time to do brand extension (into, say, cleantech)?; the analogy being that with less cutting edge innovation, R&D really means process innovation rather than product innovation, which in turn favours the players with scale in R&D.  It happened to automotive in the 20’s, it is now happening to enterprise software.
  • Spoiled returns: Is there too much money chasing too many deals and are returns on average being depressed for everyone ?  In other words, every pension manager on the planet now wants c. 6% of assets in venture capital and that flow is essentially driving returns down for the industry on average.

I am with those who say that the death of innovation has been vastly exaggerated.  But you do need to rethink competitive dynamics in light of fast market evolution, and what LP’s do need is a way of identifying managers that goes beyond looking at past returns, and in particular focus on ways of identifying promising managers.

There are in my mind two key factors that will help pull us out of the hole:

  1. Key LP’s will simply refuse, collectively, to overfund the market and will help in driving further industry rationalisation.  In Europe there has been a deep wave of portfolio secondaries which has benefited the likes of Tempo or Cipio.  More funds are likely to run out of dry powder in the years to come.  A number of my peers now think we are below critical mass, but apart from Germany  and Holland I disagree.
  2. The best dealflow will continue its migration to the best funds, those with the best brand and most marketable partners, and best track record.  That will make it very hard for anyone but the top tier of funds to generate sustained venture returns.

Some bloggers have been thinking constructively about these issues, in particular about predictors of performance.  I like the VC 2.0 series written by Peter Rip, of which an abstract follows:

The net result is that the prevailing model for venture investments appears to be driven by two selection criteria: 

  1. Longevity as proxy for performance and
  2. Current top-quartile performance as a predictor of next fund top quartile performance.

Last year Alignment Capital published a really interesting analysis of fund managers that speaks to these two criteria.  After analyzing 645 separate venture funds, they found:

  1. Longevity weakly correlates with IRR, showing continuous improvement between funds I and III, leveling off thereafter.
  2. Second quartile funds were nearly as likely to have a top-quartile follow-on fund as the current top-quartile funds.

What Peter is highlighting is what we instinctively know to be true, i.e. that (a) great funds have trouble reinventing themselves and (b) looking at past returns is a poor predictor of future performance.  His final post in the series identifies boutique branded approach and crossover funds as the two valid alternative models to invest in early-stage tech.  Max, does that make you a crossover fund ;-) ??   What he describes as crossover funds are essentially like public/private hedge funds.

I am firmly of the view that, whilst hedge funds will come and steal a few investments, they won’t be able to manage at our scale, and that ultimately "boutique", highly branded capital run by dedicated and highly focused individuals will continue to be the right way to fund innovation.   In fact, with venture becoming professionalised, I am reminded of investment banking.  Who will be the GS, MS, LB of venture ?  And why did they eat the European banks’ lunch even though these Euro houses were so firmly entrenched in their home markets ?

I am also convinced that there will continue to be a way for new players to get into the market.  The most promising example of an emerging brand in Europe is Mangrove Capital Partners.  A number of people say they just got lucky on Skype, but I think such complacent attitude simply betrays a misunderstanding of what this team is really trying to do.  Being solely focused on ecommerce / digital media, it is perfectly possible that they will fail.  But the way in which they go about building their brand and business is what boutique venture capital is all about.

I bet you that in ten years time, you will read this guy and think "famous last words".  I will be there for the champagne opening.  If not I guess he will be the one buying the drinks…

[UPDATE: Came across some valid food for thought which I am stealing off A VC here in the comments: "I think you are ignoring some fundamental shifts. Everybody seems to ignore the fact that back in the ‘golden age’ the real secret to VC’s success was that there was effectively only three centers of IT advanced technology excellence – Silicon Valley, Dallas/Austin, and the Boston Rt 128 corridor. The VC’s in those locations basically charged monopolistic rents at exit for a scare resource which they had propriety access to – IT innovation. Today IT and tech innovation is broadly distributed on a global basis, as are the capital relationships and information flow. This serves to drive down pricing – and exit valuation. Things have changed fundamentally!&q uot;]

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