Top-quartile wins my proclamation as the most delusional way to measure VC performance or any financial firm for that matter. And none of us should be surprised that innovation cannot reach maximum potential, with such meritless accountability of its arbitrage.
When a swaggering private-equity reporter of an unfortunate finance publication attempts to soften the blow of how yet another Silicon Valley venture capital emperor is losing its clothes, by stating “the emperor” may still perform in the so-called top-quartile, it becomes clear how he and those who feel comfort in this argument know nothing about math, finance, its investable attribute and the business of innovation.
Change must come
Even the venture firm in question, KPCB – to their credit – appears not at all satisfied with the reporter’s rationale, given their purported apologetic confession, not worthy of grand excuses to their limited partners. For being one of the best of subprime venture capital (99.4%) is not a badge of great honor. KPCB appears to and should be ashamed of itself, not being able to produce outlier venture style returns amidst a young and gaping 80% adoption greenfield of innovation.
KPCB is not the only top-brand venture firm in Silicon Valley losing steam; we have similar indications to believe others, including Draper Fisher Jurvetson with massive stacked and parallel fund diversification in tow, suffer from the same fate. So, how many more heads of the state of venture capital need to roll before limited partners realize the Silicon Valley emperor has genuinely lost its clothes (as I wrote back in August of 2009)?
When will the majority of limited partners realize that the many problems in venture are not merely incidental, but systemic? Systemic, as in the deployment of the vast embedded risk of old-school asset management is incompatible with the needs of innovation.
When will we all realize that to allow venture capital firms to deploy greater-fool economics, is to erode the 20% of GDP innovation can generate steadily? And that if – and only if – we fix the flawed deployment of ten levels of embedded risk (regardless of private placement investment thesis) in venture capital, we have a chance to once again successfully tap into the unique entrepreneurial culture and capacity this country has to offer.
We should not be surprised that if the arbitrage of innovation does not fundamentally renew itself from time-to-time (along with the innovation it selects), its performance will mimic that of a gold-winning Olympian: very hard to replicate as time goes by.
The term quartile is commonly used in the finance world to qualify the past performance of an investment firm. As such “top-quartile” is used to denominate the best performing venture capital firms by past (and sometimes trace current) cumulative performance of all funds under management.
In descriptive statistics, three quartiles divide a data set into four equally populated groups. In finance specifically, the quartiles of a population delineate the four subpopulations (defined by classifying individuals), according to whether the value concerned falls below or above the three delineating values. Thus, an individual venture capital fund described as being “in the top quartile” merely when all venture capital firms are taken into account cumulative fund performance tops the performance of 3/4 of other firms.
To simplify the above a little, in the Olympics the gold and silver medal winners of the 100-meter sprint can be considered top-quartile, for they represent the best 25% of all performers (of that race). The bronze medal winner is near the edge of top-quartile.
The morass of top-quartile
The problems with the top-quartile definition are many, and indicative of the foolishness that has permeated much of the financial world.
Let’s pull a few of the many fallacies out:
Fallacy #1: The meaning of top-quartile population is relative to the sample size and composition of the active population measured. Meaning, if limited partners know the performance of all venture firms that sample may be complete at one point. Most limited partners do not have access to the full live sample, nor the refreshment of the population needed to stay aligned with the changing nature of innovation. Not all venture firms raise money from institutional investors, and not all do from private investors, and they are not all inclined to share. So, what population subset defines top-quartile?
In Olympic-runner terms: the question should be asked if the ten runners lined up at the starting line are all the best runners one can find today. How do you source new talent, who still qualifies – where are the pre-trials of new blood?
Fallacy #2: Regardless of sample composition there is no universal method of choosing quartile measurement values. Meaning the low and high-bar and standard deviation fluctuate dramatically based on the performance criteria you intend to measure the population on. The plot thickens when some firms use the ever so popular, but nebulous, internal-rate-of-return (IRR) metrics. And many venture firms even get away with establishing their metrics, er excuses. Some are allowed to use stock-market indices, which include shares of 100-year old asset classes with highly commoditized characteristics and almost depleted greenfield, to be compared with an emerging asset class of technology innovation with opposite traits.
Again, in Olympic terms: how relevant is the performance of one of the ten runners, if one or each runner gets to define during or after the race what it means to be a winner?
Fallacy #3: Relative performance of the sample population deployed to highly untapped and thus still inefficient markets, such as an 80% greenfield of technology innovation, is a highly non-representative metric for how it will perform in the future. Even the best venture capital performer, using today’s investment model chockfull of collusion and price-fixing may produce an occasional venture-style return for limited partners, yet never propel a meaningful adoption of innovation. Thereby questioning its renewable value, the trust it needs to earn from the public, and thus its merit as an asset class.
In Olympic terms: the best runners may win the race now and then, yet perhaps never secure a world or Olympic record to write home about. Or inversely, people like Lance Armstrong (he is not alone) can rig a system by which the proclamation of winner gets a whole new meaning.
We are fools
There are many more reasons why the denomination of top-quartile earns my proclamation as a ridiculous way to measure venture firm performance or any financial firm for that matter. None of us should be surprised that innovation cannot reach maximum potential, with a financial arbitrage atop that is held accountable for such meritless and meaningless definitions as top-quartile.
We need to take a serious look at the foundational economics that allows this nonsense to erode everything we stand for and produce. Or we as entrepreneurs will continue to succumb to the failed policies derived from that nonsense.