Early this week I interviewed with the owner of famcap, a British publisher of family office strategies and, separately, with the creator of a new fund-of-funds focused on a specific type of technology promulgated by venture capital. Both conversations reminded me of how few financiers understand the nature of the investible asset, innovation, so let me guide the way.
First, I must highlight that the gaping opportunity to invest in a greenfield of technology adoption is about 80%, roughly equivalent to the people currently not on broadband with a device with sufficient technological capacity to improve their lives.
Hence, the opportunity to invest and produce returns in venture (otherwise known as venture capital further down the finance food chain) remains massive. And that is just when you evaluate technology procurement from a monolithic perspective. Lots of innovation will occur by which the need for technology will be a supporting consequence, rather than the causal reason for adoption as in modern cars now consisting of close to 40% pure technology componentry.
So, the opportunity for technology, and thus venture as its arbitrage, must justifiably be correlated to an even more significant greenfield than previously framed here, and because of its size remains rather unsusceptible to macro-economic aberrations.
As the opportunity for technology improved dramatically with the internet as its omnipresent foundation, the returns in venture, as an asset class, have been, admittedly, extremely disappointing, as also voiced by the late and great Joe Dear, CIO of CalPERS, the largest pension fund in the U.S., with then some $220B in assets under management.
Even the 2008 vintage return numbers suggest my initial assessment of 99.4% of VCs unable to produce monolithic venture-style returns appears to be correct, the numbers even worse when you incorporate what innovation creates innovation the world even cares about. Running pump-and-dump valuation schemes in venture may rachet up the numbers temporarily but will not produce the consistent asset class returns and build a solid reputation to garner the steady commitment of institutional investors. Hence, the pursuit of innovation must rise above a mere goose-chase of make-believe valuations sold to a chain of innocent greater-fools.
Few individual investors made out like bandits in the early days of expansion when strong winds made even turkeys fly. The VC emperors, like KPCB, DFJ, and many others wore no clothes. And, none of the institutional investors, I know of, have allocated significant more money to venture since. Many still prefer to allocate money to 80-year old asset-classes with low yet somewhat repeatable return characteristics.
Now, you have to wonder why the massive amounts of dry powder by institutional investors on one end, and the gigantic size of greenfield in technology adoption on the other end (see the chart above from the first-ever State of Venture Capital) cannot be matched by venture capital as its chosen expert conduit. Something in the distribution of risk and money by the arbitrage of innovation goes badly awry.
Indeed, the arbitrage of innovation, venture capital, has overwhelmingly turned subprime. And since the thesis determines what can be discovered (Einstein) the innovation a subprime thesis can detect is by definition subprime. Worse, the subpriming induced by general partner collusion, deal fragmentation, and thesis uniformity has created a debilitating pageantry of innovation through which it is now, for the subprimers, extremely time-consuming if not virtually impossible to separate the wheat from the chaff.
Any investment arbitrage turned uniform is, by definition, incompatible with finding outliers.
To wit, not a single venture capitalist could see the opportunity in Tesla until it showed up in their rearview mirror, ready to pass them by. After Tesla crossed the chasm, some desperate venture firms have elected to hold on to Tesla for dear life, and to boost the marketability of private placement memorandums of new funds.
It would be incredibly foolish to leave the debilitating dominance of subprime venture capital for what it is. For that would further paralyze the expansion of humanity held hostage by opportunistic and uncommitted play-funds that amidst aloof diversification can afford to lose Las Vegas-style, as well as deflate the propensity for responsible technology applications and services to improve society.
Human evolution relies on a fractal of continual expansion of human ingenuity to meet the demands of an ever-changing equilibrium with nature prolonging our survival. With technology innovation, at the same time, freeing human ingenuity from the burden of mundane and repetitive tasks. A double whammy of human advancement.
Key to improving the outcome of venture capital, as the arbitrage of innovation, is to turn the operating model and thesis of investing from subprime to prime. To deploy a thesis closely aligned with the nature of its assets; outliers capable of improving our world, in compliance, observance, and respect of the unique and unprecedented success factors of outliers.
Not everyone can be an outlier, but an outlier can come from anywhere.
The investment methodology to turn venture from subprime to prime must, therefore, fundamentally change, diametrically opposite to today’s prevalent methodology, to name a few changes:
- turn downside investing into upside investing,
- swap the false safety of hindsight for the daring alignment of foresight,
- ditch coagulating uniformity for unprecedented compositions,
- attach to new norms of evolutionary truth rather than existing norms,
- induce dissenting views rather than compliant views,
- enable proprietary rather than open-source technology,
- move away from what is to what must be,
- turn broad base investment risk escapism into impactful expert risk-seeking,
- eradicate ten levels of embedded bottom-heavy diversified investment risk,
- remove collusion with peers,
- forbid deal fragmentation (save for tranching),
- remove superfluous embedded critical paths,
- deploy accountable transparency,
- facilitate a true investment meritocracy.
Running a prime VC fund requires a fundamental understanding of the nature of outliers as its investable assets. No limited partner should allow general partners to run a fund with their money without a solid understanding of how to spot an outlier. For only outliers can consistently produce the returns expected from the deployment of venture risk.
No prime entrepreneur, referred to as an outlier, is enamored by the subprime investment thesis of uniformity so prevalent in Silicon Valley today. In the same way, a professional dancer is unlikely to enjoy dancing, every day, with an amateur for the next seven years. Prime entrepreneurs with a macro-view of the world have options, including a willingness to wait until the tide of mediocrity clears.
Institutional investors and intelligent family offices cannot afford to miss out on pursuing the massive greenfield available to innovation derived from a new normalization of evolutionary truth. Just because the size of the expanding fractal of humanity, expanded by outliers, is like the human skin, the largest organ of the body, yet to be intelligently explored.
The sheer human ingenuity coming out of the woodworks happy to dance with prime investors will produce returns that dwarf the mediocre returns of subprime.
Apart from evolutionary and monetary importance to invest in venture, the future of multi-asset allocation strategies is highly dependent on the expansion of chairs in the musical-chair game of asset management, to renew the long-term repeatability, renewability, and consistency of asset allocation returns.
Pension funds, like $349B CalPERS in the U.S. or $1.7T Amundi in Europe, must deploy a multigenerational investment strategy to reap the rewards from the ever-expanding fractal of humanity, the real assets, they also aim to serve in perpetuity. Prime venture will expand the fractal of asset management as it expands the fractal of humanity, producing many offshoots of proven stability to other asset classes.
Venture, as the necessary and truly unexplored impetus of change, must be deployed strategically to reinvent the stale asset allocation strategies that are, unchanged, relegated to barely producing returns over 7%.
Investing in venture unchanged is the definition of insanity. Converting the prevalent and failing investment thesis of subprime venture to prime is an absolute necessity to reap the rewards of outliers who change the world and strengthen the renewal of humanity. I invite you to call on my advisory or attend one of my masterclasses on how to achieve such a transition.