Chasing home runs
Updated: Jan 13, 2021
A friend of mine, who works at one of Europe's top venture LPs, joked this week: 'Aren't you a bit overeducated for throwing darts in early-stage tech?' He knows, of course, that this is far from the truth and how hard it is to drive great fund performance over and over again. These days it might sometimes look easy with public tech stocks surging, and some private tech companies raising monster funding rounds.
The Power-law distribution. The Loss and Win Ratio.
Early-stage venture investing is tough because portfolio returns follow a power-law distribution. This means that, on average, over 60% of VC investments do not return any capital ('Loss Ratio'*). On the flip side, only 12% of startups generate >5x returns, and less than 5% generate >10x returns ('Win Ratio'). On top of that, investment cycles are long. The vast majority of venture success stories take 7-10 years to turn into real businesses and exits to generate these returns. At the end of the day, before you exit a business, you did not generate real, but 'on paper' returns.
* I hate to use the term loss ratio, but, hey, it is the standard industry jargon.
One does not have to be a world-class mathematician to see that VC is not about minimizing losses but about maximizing 'home runs' ('Win Ratio'). It is about spotting and supporting the great entrepreneurs who can overcome seemingly insurmountable obstacles and, in the end, create big businesses. In other words, you have to really 'go for it.' If not, your returns will suck.
VCs (and people in general) consistently overestimate luck and underestimate skill. Without structure, the odds of finding companies that generate outlier returns are just extremely low. This is where discipline and portfolio construction come into play, on top of focus and pattern recognition (more on the latter topic below). We are obsessed with portfolio construction. Among other things, it is one reason we were able to generate consistent and great returns over the last two decades.
Disciplined Portfolio Construction makes the difference.
Different risk / return profiles require different portfolio construction approaches. This is the secret sauce of any successful venture firm. Every team has its own experiences and focus to build its strategy. Let's have a look at some key elements.
(1) 'Deciding whether or not to invest represents the highest leverage point of venture capital.' My friend Rob told me this at the beginning of my career in venture. It is key. While you look at thousands of companies every year as a team, you only pull the trigger on 4-10 of them (depending on fund size, but this is the average I have come across). Think about it. The 'loss ratios' for the good and bad VCs are the same. The difference is that the good ones have some super-winners. Conviction matters.
(2) The Symbiosis between the number of companies and ownership needs to match. The bigger the portfolio, the higher the probability of having more outliers in it. For an average VC, the chance of a fund outlier increases from 18% to 64% with 10 to 50 investments. For a 'top tier' VC, the chance of a fund outlier increases from 37% to 90% with 10 to 50 investments! At first sight, a big portfolio could theoretically make an average VC look and perform at the top tier level. However, when your portfolio is too big, the average investment per company becomes too small. As a result, your ownership in each startup is too small to drive substantial returns.
(3) Follow-on Investments: Creating the returns only venture capital can provide.
This is probably the toughest part of venture investing. When they partner with entrepreneurs, great investors believe in every single company they back. They do everything to help it flourish. On the flip side, great investors need to drive the best possible returns to their investors. To do so, they need to make sure to double down and reinvest as much as possible into their winners. Portfolio construction is vital here again. This is also where pattern recognition, a mix of experience and data, has probably the most significant impact.
As you can see from this chart, most investors do not do this well. For the segments x > 10 and 5 < x < 10, if you look at the two metrics '% of Capital Invested' (capital win ratio) and '% of Companies' (number win ratio), you can see that the capital win ratio is below the number win ratio. So, the average investor does not reinvest enough into his winners to maximize returns. Homeruns represent 80%+ of value creation in early-stage VC (note that, besides 'value of companies', the rest of the data represents all venture investing, from early to late). So, what really matters is the number of home runs, not the loss ratio.
As Howard Marks puts it, 'to be a VC is to only care about the upside. An equity investor has to be an optimist, but a venture capitalist has to be a real dreamer.' But too much optimism can also be one of the greatest risks. That's why partnerships are so important to challenge every single investment decision. Picking home runs early on is hard. And it is what drives the returns only venture capital can provide.
My firm has been very fortunate to drive great performance across all funds with a 3x+ average return. The key reason for that success is that we backed in each fund, at seed or pre-seed stage, brilliant founders that built a multi-billion dollar company (two of which have exited), which substantially drove the x > 10 segment.
This weekend I went for a long run. There is something extraordinary about forests in the winter. The calm before the storm. This year will be special.
Life is awesome,