The conventional wisdom in Silicon Valley is that the best venture capitalists are light years ahead of the rest. That it’s only worth investing in venture capital if you can get an allocation to a brand-name venture firm (which you almost certainly can’t). But while this may be true in terms of returns, I’m not convinced that it’s true in terms of the actual human capital operating these funds.
I know it’s a bit heretical to say this around these parts, but I’m willing to bet that the “gods of venture capital” are not nearly as divine as many believe. They’re good investors, but their legendary status is, in my opinion, owed to structural advantages developed over time rather than some superhuman company-picking skills among the partners.
Let’s call the secret sauce of venture capital investing structural alpha. And the more I learn about this phenomenon, the more I think we may be able to apply it in other contexts with good effects. (Spoiler: It is definitely something that can be applied in other contexts with good effects.) Given this, I’ve been spending quite a bit of time thinking about this topic, and I thought I’d share some of these thoughts. So here goes:
The endogeneity of performance in the venture industry, and other alternative asset classes, means that small (or even random) differences in investment capabilities within GPs are magnified over time through the emergence of structural advantages. These advantages come from the identification of, and capitalization on, “positive feedback control loops” that reinforce hegemony. Got that? Yeah, I barely understand what I just wrote there too. Basically what I’m saying is that in private markets investors can, quite legally, cultivate sources of private information that may be, in turn, exploited in the form of investments. In public markets, this wouldn’t be legal, which is why it’s so hard to find persistence in performance among public managers. For example, just 0.07% (!) of mutual funds achieve top quartile performance in five consecutive years; that’s just 2 out of 2,862. (Remind me again why anybody pays for active management?)
Investors that are adept at capturing structural alpha know how to identify (and even cultivate) market, organizational, and societal inefficiencies that they and they alone can navigate or overcome. So, in the venture capital industry, I think performance is less about human abilities and more about structural advantages. This is why, even with all the bravado and the cult-of-personality that surrounds top VCs, they are militant about protecting their secrecy – even demanding that LPs preserve that secrecy on their behalf. (Has anybody seen the Princeton endowment’s website? It’s hilarious.) This is, I’ll say it again, because VC performance relies on a set of structural advantages that have maximum impact in markets that have minimal transparency.
Capital tends to flee uncertainty, which means you can generate very high returns if you can position yourself as the actor that removes that uncertainty. And that’s what the best VCs do. Through structural advantages in certain markets, they remove uncertainty (as well as retire risks) and get paid very well for it. Here are four examples (and there are plenty more) of structural advantages that help the top managers persistently outperform their peers:
- Signals: Brand-name VCs attract excellent entrepreneurs because the entrepreneurs want to “certify” that they are indeed excellent. Interestingly, the impact that today’s success has on future success is readily quantifiable. Seminal research shows that brand-name VCs acquire equity in startups at a 10-14% discount compared to other VCs. On a fund of $500 million, this would imply that a brand-name VC would have an additional $50-70 million more to invest in companies than an average VC. (That’s a lot more companies!) And the exit multiples would also be greatly inflated for all of the investments in the fund thanks to the lower purchase price.
I think this is a big deal. So it’s worth figuring out why entrepreneurs are willing to sell their equity more cheaply to brand-name VCs. Research shows that companies sell their equity to brand-name VCs at a discount to try to shore up access to future rounds of capital. Founders are, according to even more research, happy to trade present day equity to de-risk future equity funding rounds. And the reason future funding rounds are de-risked with brand-name VCs is — obviously — because the VC shares its brand with the company (i.e., certification).
I think there may be cheaper ways to de-risk financing down the road. For example, if brand-name VCs can acquire equity for a discount because of a signal that de-risks future funding rounds, why can’t a sovereign fund do the same? The latter could write checks all the way to commercial scale! Anyway, the important factor here is the role that signals play in uncertain environments. For investors willing to invest in uncertain markets, the very act of making an investment will help to remove some uncertainty and make the company more valuable.
- Networks: VCs claim that their community of portfolio companies and “alumni” serve to help catalyze the current generation of companies being financed by the same VCs. And they’re right: Research shows that the best-networked VC firms perform the best. Moreover, the research also shows that the network of the VC is the biggest determinant of the fund’s returns. In other words, who VCs know is more important than what VCs know. Thus the VC gets access to world-class engineering and market knowledge for free. As the network gets bigger, the VC has an ever-larger stable of experts to draw on for opinion about new potential investments.
Again, I’ve argued that Giants need to start taking their own networks more seriously, and even think about hiring Chief Networking Officers. This is about taking relational capital to the next level. Given the importance this plays in venture returns, why wouldn’t you at least try?
- Access: A common theme among VCs these days is the access they can provide their portfolio companies to other companies or even geographies. There are many VCs that brag about their global network and their ability to accelerate companies thanks to cross-border arbitrage opportunities, such as in Asia. These VCs cultivate a structural advantage by fostering relationships with foreign companies that don’t have visibility into what’s happening in the Valley and thus welcome the opportunity to co-develop assets. (Again, this is about opacity, networks and the control of opportunities.) The VCs with these privileged, foreign relationships can immediately de-risk investments by opening up a company to foreign markets.
This could be a powerful concept for the Giants. Having privileged access to a region or industry should be a common occurrence for these funds, especially university endowments or sovereign funds. They should use this structural advantage to their benefit.
- Organizations: How investment organizations are set up will have a big impact on the returns they generate for investors. For example, evergreen funds that are run on budgets offer an example of how organizational design can provide structural alpha, as these vehicles can help investors do what’s right for the companies (rather than what’s right for the funds) as well as avoid banking fees and churning of assets to trigger carry, etc. This should allow for higher net returns on the basis of the same or even lower gross returns. Unfortunately, VCs are too secretive for me to find a good example of this (see above). As such, I’ll revert to a classic example of a structural advantage: Warren Buffet. Berkshire’s performance is driven, at least in part, by its structure. It is an evergreen vehicle with a mix of private and public companies. The private businesses are largely made up of insurance companies, which provide Buffet with loans that are as much as 3% lower than the average T-bill rate. With a cost of capital that low, layering on leverage is cheap. Moreover, the insurance capital offers him the ability to invest over longer time horizons, as he isn’t vulnerable to redemptions in the way other investors are.
These are just a few examples of structural alpha opportunities that VCs use to drive outperformance.
I personally find it empowering to think that the top VCs, with all their secrecy and bravado, aren’t individually light years ahead of average investors. Rather, it’s the ability of these funds to capitalize on structural advantages that drive the light years of differentiation. That’s a powerful insight that could serve as inspiration to the Giants thinking about where they are going to find outperformance in the decades to come, especially if they’re looking to venture capital. Because it’s my belief that there are many institutional investors with structural advantages that are not being taken advantage of.
So, if I’m a Giant looking for alpha, I’m going to think hard about where I can find structural alpha akin to that of VCs. I’d be thinking about opportunities that don’t fit in silos or boxes. I’d be looking for markets that are complex, inefficient and opaque, and I’d be focusing on a subset of those markets that I have an advantage in understanding the inefficiencies better than others (perhaps thanks to my network or unique access). If I’m a university endowment, I’d be thinking about my own campus and alumni. If I’m a sovereign fund, I’d be looking for opportunities emerging locally that I can help catalyze internationally (and vice versa). If I’m a family office, I’d look for family assets and networks.
And once I have identified a truly unique structural advantage, then I’m either going to target these opportunities on my own or I’m going to seed a team to do it for me. Why seed a team? Because the above data shows me I can get a team that will succeed: If you can find the right structural advantage for the right investor, you don’t need a brand-name team running your seeded fund. In fact, with a good team and a great structural advantage, you can end up doing something legendary. And that’d be just fine by me...
