Last week’s 20th anniversary of the IBF Venture Capital Investing Conference (congrats to Alex Scott and Christina Riboldi) in San Francisco was a unique opportunity for me to witness the atmosphere between 487 Limited Partners and General Partners (also referred to as Money Managers by LPs).
My first ringing of the closing bell on NASDAQ followed by a premier packed event of the Asian American Association of Investment Managers (AAAIM) at The Harvard Club in New York, with keynotes from Julian Robertson, CEO of Tiger Management, and David Rubenstein, founder of The Carlyle Group gave me some great insights into the world – and thinking – of LPs.
It is clear from these sessions that LPs (and Fund-of-funds) are misled and confused about how to improve the performance of Venture Capital (VC). The VC sector of the Private Equity asset class has been plagued with the dismal performance of less than 10% IRR (Internal Rate of Return) for the last 9-years, leading some LPs to question and reduce allocation (US: 10-15% of total assets per firm, Europe: ~4%) in a sector that deserves quite the opposite.
The emerging opportunity in technology VC
The technology sector, which is my passion for the last 30-years, is at the beginning, not the end of its emergence. Perhaps the critical indicator of the innovative runway we have ahead of us is the following: more than 5/6 of the world’s population does not yet use a computer connected to the high-speed/broadband internet today. And all should and will, given the right technology. That’s where technology innovation comes in, not just in connecting people to the internet but in deploying innovation that uses the internet as a distribution mechanism. The way we use the internet today is rudimentary, and many new technology stacks will emerge to improve its impact on everyday citizens.
Given the early days in the life-cycle of the technology sector relative to any other sector or asset-class is, low-cost to produce, low-cost to distribute and because of the internet has immediate customer impact with independently short sales-cycles. That means with relatively little money in a massive impact can be produced, virtually instantly. A fantastic investment allocation opportunity for LPs still lies ahead.
Why the VC sector is not producing
In the words of Cesar Millan, the famous dog whisperer on National Geographic, who states that the behavior of the dog is the responsibility of its owner, so should LPs demand control of the behavior of the VCs. Like dogs, VCs exhibit primal behavior that can make them great money-managers, but only when they are controlled. An issue even The Carlyle Group recognizes by including a code-of-conduct in its recently published annual report. LPs should let go of the leash after VC performance becomes apparent, not before.
— Risk deflation
VCs sell well upwards to the LP at fundraising time, but they seem to have forgotten that they need to serve the entrepreneurs just as well. In the investment pyramid between the dollars from the LP and the ideas of the entrepreneur, the VC is merely the derivative that should serve both. Today it does neither. The money-tree report further hides the ugly reality under-the-hood as the funding stages have disrupted the equilibrium between entrepreneurs and VCs and steadily turned VC into loan-sharking.
— Lack of relevant experience
Most VCs in Silicon Valley have no relevant operating expertise that allows them to service the needs of entrepreneurs adequately (see sub-prime VC). And that, in turn, creates a massive amount of false negatives and false positives to which no liquidity mechanism (from the NVCA or Tim Draper) will suffice. Beginning in the early 2000s, the VCs have merely consistently invested in entrepreneurs that submit to sub-prime innovation and terms.
— Lack of vision
No surprise that, according to a conversation with a Chinese private equity investor at the AAAIM conference, recently, 12 highly successful Chinese immigrant entrepreneurs left the U.S. disappointed to go back to China because the VCs did not allow them to take the helm at their own companies. They will work in China. Smart entrepreneurs won’t submit to sub-prime VC, leaving the VC (and therefore indirectly the LP) alone in their spiraling sub-prime demise.
To echo Jessica Reed Saouaf, Managing Partner of Hall Capital Partners (with $17.5B in assets under management) who describes at IBF that the VC business today is too institutionalized with too few visionaries to create promising returns. LPs need to do a better job in sourcing, segmenting, controlling, and demanding transparency, so the behavior of VCs remains an extension of the LP’s investment brand and integrity.
The myths sold to LPs
But the incumbent VCs are not taking this criticism without a fight, a fight to hold on to their cushy management fees and plush existence. From the focus of their rebuttal (by way of pump-and-dump liquidity plans, annex funds, etc.), you can glean their true nature; they worry more about protecting their downside than improving their upside.
A welcome exception to the majority of followers of the auto company’s plan to fixing VC is the younger VCs like Jason Green (Emergence Partners) and Paul Holland (Foundation Capital). They on the IBF panel proclaim that unlike the NVCA, they do not lie awake at night about the impending increase in capital gains tax on their carry. Instead, just like great entrepreneurs, they worry first about delivering value and returns, trusting that personal wealth will naturally follow.
Here are the most frequent myths I hear VCs attempt to imprint on the LPs that I want to debunk here quickly to prevent a further slide down the sub-prime spiral:
— It’s the economy; new fund – stack fund – annex fund
Nonsense: even the most successful startups do not achieve revenues or market-share above 10% of their total-addressable-market (TAM) during their private funding cycle. That means that 90% of the total-addressable-market is still not served effectively. With a few exceptions, it is hard to imagine that a 10% decrease in the market will have any effect on the success of the startup. I would argue that in a down-market, the opportunities for new technologies improve because an early adopter can more effectively compete with 90% of its competitors. So, conversion rates of companies with macro-economic differentiation should improve, and so will their market share and revenues and, consequently, the opportunities for great exits.
— We are in a down-cycle, we will bounce back; new fund – stack fund – annex fund
Nonsense: the barrel of a downward spiral is cyclical too, be sure to recognize the difference. Sub-prime investments have no exits and will not yield valuable fund returns, no matter what the liquidity structure is. VC portfolio choices that cannot withstand the test of time have no fundamental differentiation and independent future. And a GP that cannot distinguish between prime and sub-prime will never be successful.
— Companies are cheaper to build; new fund – less money
Nonsense: I have heard LPs echo the term “Capital Efficiency,” and it is a trap. Not just for the entrepreneur but everyone in the technology ecosystem. Unlike in the past, no product can withstand the scrutiny and the power of social networks unless it is well-built, offers fundamental and disruptive value, and delivers authenticity and trust. Only then will users adopt it. And since distribution is virtually immediate, more competitors will spring up to provide the noise that makes life harder. So products are more expensive to build and require a different ecosystem makeup and funding trajectory for the company. VCs that look for smaller funds demonstrate further misalignment with reality and therefore exits.
— There are not enough great ideas; new fund – less money
Nonsense: but sub-prime VC behavior and terms turns off great entrepreneurs. Only idiot CEOs and unsuspecting entrepreneurs submit to terms that hands control and destiny to underperforming VCs. Other forms of artificial arbitration, such as a geographic distance of 20 minutes, moves the VC even further from the meritocracy it should be looking to embrace. The institution on Sand Hill Road is severely limited by its lack of peripheral vision of technology and the world.
— New (government) regulation is strangling exits; new fund elsewhere
Nonsense: the bar has been raised for technology companies as it should. No longer can public markets be fooled by valuations that have no value. Real value jumps the hurdles of regulations with ease (as witnessed by OpenTable and Rosetta Stone). The current startup inventory that was subject to sub-prime investment tactics, to begin with, may not be able to get to the finish line. Such is the punishment for lack of independent differentiation and value.
— The grass is greener in green; new fund – a hot market
Nonsense: I have witnessed the rush to these “hot-pockets” before, but hot-on-supply does not equate to hot-on-demand. Or, as Julian Robertson says, “there is a difference between having a bakery and baking bread.” Contrary to technology, Greentech is expensive to produce, expensive to distribute, relies on long sales cycles and arbitration (subsidies, politics, etc. ) that are beyond the control of the startup (and much more complicated in its regulative risk than, for example, healthcare). Dependency on government is dangerous in meeting the time-to-money milestones for early-stage companies and fund returns. I believe in the value of green-tech and energy-tech to create a greener planet. Still, I don’t believe the current VC funding models with former technology GPs looking for greener pastures can support its early financial success within the current funding vintages. It is ironic to see VCs use the capital-efficiency slogan under the same roof as their capital-intensive strategies for energy-tech.
— The grass is greener global; new fund – new fund elsewhere
Not yet: as we move up the technology stack and specifically the investments in software, the origination becomes less relevant, I will yield to that (although I see still see an entrepreneurial quality difference), but startup investments should reside where the execution is, regardless of origination. While other geographies score well on low-cost manufacturing (and programming), real disruptive ideas and the majority of early adopter markets (driven by the frantic pace of unbridled capitalism) still reside in the U.S. So VC funds should be equipped to handle international deal sourcing (and be the first investor in) and only become truly international once the remote exits prove to justify an independent local operation. For that to happen, creation, execution, and exit values need to yield appropriate dynamics. Remote execution and exit values remain sporadic today, but that may change as those markets develop and emerge as prominent technology visionaries and consumers.
How to fix VC
Optimizing VC is probably more straightforward than most LPs think since the issues plaguing VC have to do with regaining the necessary leadership of the investment ecosystem. Simply put, LPs need to become “VC whisperers” (to use the Cesar Milan analogy), those that can control the performance of VC so the leash can be loosened. The good news is that none of the deficiencies in VC are rooted in the complicated micro-economics of technology, contrary to what some GPs may want you to believe. But LPs must hear more than the repetitive sugar-coating from underperforming VCs and keep a close eye on entrepreneurs who represent the monetizable assets.
— No more “duh” PPMs
No more Private Placement Memorandums (PPM) that look remarkably like a wish-list without substance. Yes, I’ve seen the memorandums produced from brand-name VCs that get replicated by many other VCs in the valley. No right-minded VC would accept a business plan from an entrepreneur that looks like that, neither should an LP. The quality of the PPM is a direct indication of the quality of the VC fund and should help the LPs segment the risk associated with technology investments. LPs have invested deep rather than wide in the technology sector, hence the birth of many false positives.
— Assess the GP’s unique vision
Many of the PPMs talk about rearview mirror analyses, but the only advantage one investor has over any other is his forward-looking views on the industry or vision. So LPs need to assess the risk associated with that vision, much of which again is related to macroeconomic impact rather than technology waves. GPs should be able to demonstrate that their unbridled vision in the past came true.
— Assess the GP’s relevant operating experience
To become a valuable partner to the entrepreneur, the GP needs to be able to prove relevant operating experience related to the investment thesis and specifically to the segmentation. Information technology is a broad sector, and experience in consumer technology differs from the application of technology to healthcare. Being able to help entrepreneurs develop a large vision with concrete baby-steps is a skill that GPs need to master to improve the size of disruption and returns. That experience needs to map directly to the investment thesis in the PPM.
— Assess the GP’s track-record for deal sourcing
Getting your hands on real disruption requires a proactive approach to finding the “diamond-in-the-rough.” Many early-stage entrepreneurs, hurt by sub-prime VC tactics, need help thinking bigger. The size of the disruption, rather than the cost of entry, is crucial. Finding deals that can be turned into game-changers is fundamental to the success of significant returns.
— Hire an expert
All this deep-diving may be too much for an LP who has nearly 90% of its assets allocated to other asset classes. Hence, the smart thing to do is to hire an expert that speaks the language of the entrepreneur and ensures that the needs of LPs and entrepreneurs are adequately met through an intermediate VC vehicle.
Crucial to the success of the technology sector is to do the opposite of what most VC funds are currently setup or guided to do. To follow Warren Buffet’s advice: when everybody is investing using sub-prime tactics, then now is the time to do just the opposite.
Venture Capital is a sector that can produce significant returns when it takes significant risks, not when it becomes risk-averse and fragments and commoditizes investment dollars. Deflating the risk through sub-prime investment tactics has killed the want to innovate and may lead to an accelerated intellectual exodus that will hurt our economy as a whole.
Apart from fixing the broken, I think the time is right to fundamentally restructure early-stage innovation and make its financial support just as innovative as the inventions themselves. Facebook sets a great example of how it taunts the institutionalized investment “rules of Silicon Valley.”
LPs who cannot see the massive opportunity in technology should exit from Venture Capital. But continuing to support sub-prime VC funds is a sure way to maintain the spiral of suboptimal returns we have been stuck with for the last ten years and damage the innovative ecosystem our economy depends upon.
So dear LP, go big or go home. And when you plan to go big, I will make myself available to put words into action. I cannot wait to turn this page.