The Big Venture Capital Mistake

Georges van Hoegaerden

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Venture capital is not supposed to have become subprime micro-private equity. Furthermore, the risk profiles of private equity and venture capital are polar opposites.

When you think about how 99.4% of venture capital firms fail and how currently 80% of the new money raised is doled out by asset managers to only five (5!) venture capital firms, those of us with a pulsating brain and a beating heart combined with a desire and passion for a brighter future have to wonder why an 80% greenfield of innovation that invites progression, is instead yielding the regression of its arbitrage and therefore severely erodes the opportunities for groundbreaking entrepreneurs.

The current (and past 20-year) arbitrage of innovation, venture capital, is simply incompatible with the opportunity for innovation.

 

Deadly alternatives

And while many alternatives to venture funding are feverishly spun up (like crowd-funding, government interference, syndication, fragmentation, resales, angel investing) to keep the business of innovation and its karma abuzz, all of those alternatives in actuality promote the deployment of more uniform and subprime risk (by inducing more investor socialism), which by economic principle can only lead to more subprime returns. False positivity abounds.

More entrepreneurs will fall into the infamous capital efficiency trap than before, the same one that has yielded -4.6% IRR (Internal Rate of Return) during its prime 12 year vintage “hay days”, that in turn is responsible for many limited partners (the investors in venture capital firms) to flee the asset class and put their money elsewhere.

Real disruptive innovations have a harder time reaching investors (the five) with merit, and more subprime innovations will land the equally subprime money unable to yield any meaningful kind of socioeconomic value.

The definition of innovation has become commoditized as a function of overwhelmingly subprime arbitrage deployed by “the best practices of venture capital.” And with it attracting hordes of opportunistic flies and bottom-feeders cheering on the subprime investment candidates.

 

Systems-thinking

To restore the potential of venture capital (and thus innovation), we cannot allow it to be brought back to the direction it is headed today, smaller in effective size than 30 years ago.

We have an economic fiduciary obligation to reverse the 20-year attrition of 20% of GDP (venture contributed to), to build an adolescent version of venture capital into an economic system in which the matchmaker in-between the assets of limited partners (money) and the assets of entrepreneurs (ideas) produces in line with innovation greenfield potential.

That new economic system should not entail an endless plethora of new distributions of the deployment of subprime risk, but a focused pursuit of (non-uniform) prime. Precisely what and how that economic system will look like will not fit in a single blog (my findings are scattered across many blogs already), and instead be distilled into the cohesive subject of my upcoming book.

 

Broken from the top

In fairness, all of the participants in the venture ecosystem are responsible for its failure. Hence the reason why systems-thinking is the only way to curtail venture capital’s adverse economic outcome. The single silver bullet is the one that forces us all to change.

Entrepreneurs are at fault for taking money from – and submitting to – venture capitalists without verifiable merit proven to yield viable venture-style investment returns. Venture capitalists are to blame for waddling in endless investor socialism to magically produce outlier returns, with their worst downside a cushy retirement from only management fees. But most of all the limited partners at the top of the venture food chain and as the supposed experts of financial risk deployment are to blame, who with their “eyes wide shut” in the deployment of pancake economics should have realized that no deployment of ten levels of bottom-heavy diversification (in any asset class) can ever yield proportionate returns to the potential of the underlying asset.

 

Venture capital is not private equity

When as an entrepreneur and CEO, having built successful companies and responsible for managing company risk, you have the chance to speak with limited partners (the investors in venture capital), you soon realize that most do not know anything about the business of, and the risk deployed to innovation. Not just because most limited partners contribute only single-digit percentages of their total assets under management to venture capital, but also because they confuse risk with money and money with merit. I discovered that limited partner asset management strategies (not just in venture capital) are resembling of what I refer to as pancake economics, wide in circumference and extremely shallow in-depth.

The first and most troubling evidence of limited partner’s limited knowledge of the asset they are investing in is that they categorized venture capital as a sub-sector to their private equity asset class, and subsequently further tuck that investment strategy in a grab-basket of diverse and uncorrelated investments, often referred to as alternatives.

The problem with that structure is that while both venture capital and private equity are investing in private companies, their risk profiles couldn’t be any more different. Limited partners should instead organize their asset management strategies based on similarity in risk (and return) profiles, not types of investable companies.

 

Unique risk profiles

The risk profile of venture capital is diametrically opposite to the risk profile of private equity. Here are my top 5 of reasons why:

  1. Venture capital investing requires foresight; private equity requires close proximity to hindsight.
  2. Venture capital requires the merit of outlier vision; private equity requires the diligence of operational excellence.
  3. Venture capital drives upstream economic impact to change the world; private equity drives downstream economic impact to benefit from current economic circumstances.
  4. Venture capital requires capital to ignite market-pull, private equity requires capital to drive market-push.
  5. Venture capital is upside investing; private equity is downside investing.

 

Unique skills

Because limited partners have grouped venture capital along with the private equity asset class, limited partners have logically deployed identical skill sets, processes, and expectations (often tucked away into “multi-strategy” fund-of-funds). A big mistake.

While you can hire Ivy League graduates to drive operational excellence in private equity effectively, venture capital requires the merit of foresight, which one will not learn or acquire in business school. The private placement memorandum (the “business plan” of a fund) from private equity fund, built to provide confidence in the deployment of somewhat uniform operational excellence, should look completely different from a private placement memorandum of a venture capital fund, established to ensure confidence in the deployment of non-uniform (outlier) risk.

Hordes of general partners have benefited from this lack of understanding by limited partners and in the slipstream of venture capital’s early success raised significant funds, that are now responsible for the ball-and-chain of false positives that created the mistrust of innovation with the public, and the wall of false negatives that keeps real entrepreneurs disenfranchised (or submitting to more daring arbitrage).

 

Unacceptable misconceptions

Experienced entrepreneurs know their chances of success are higher than 50%, or otherwise, they would not bet their life savings, relationships, time away from loved ones, a cushy paycheck, and many other conveniences on it. So, no limited partner should accept the performance of a venture capital fund to be out of step with that success rate, especially not when venture capital already bathes in ten (10!) levels of bottom-heavy diversification that allows them to smooth out investor returns.

A general partner at a venture capital firm who wants limited partners to believe investments in groundbreaking innovation are a crapshoot is not successful in identifying successful entrepreneurs who know different. Only subprime entrepreneurs are foolish or greedy enough to gamble on success and reputation.

 

Fixing venture capital

To solve the problems of venture capital so that it again performs in step with the massive greenfield opportunity for innovation requires us to educate limited partners on the qualitative and quantitive elements of groundbreaking innovation and the trail of risk and money needed to support it. We need an economic system that promptly punishes and eradicates the failing arbiters of innovation and promotes the successful arbiters. We need a meritocracy of innovation arbitrage that will severely reduce the fog of false-positives and false-negatives that clouds the potential for venture capital today. An economic system that, by design, promotes and builds the deployment of prime risk-and-returns across the board.

Given the past 20-year performance of venture capital (in which the damage of bull and bear arbitrage are equally destructive to innovation), limited partners should not expect the new dawn of venture capital to be provided by the protectionists who benefit and are responsible for its current attrition.

 

Start fresh

The deployment of a new and modern economic system (with its fundamentals proven elsewhere) that each limited partner can implement independently or in a syndicated venture capital focused fund-of-funds, will not only serve the allocation and returns of money to venture capital, but become a foundation upon which the investments in any asset class will transition from a mindless hedging “strategy” to a sustainable investment strategy with an accurate representation of the value of the underlying asset.

The answers to improving investor returns lie in fundamental economics we can all understand and appreciate. And I can’t wait to share those with you.

 

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