There is no shortage of think-pieces on the state of venture, bemoaning concentration, slipping returns, and the challenging environment for smaller managers.
Few have tried to answer the underlying question:
The perspective that VC consolidation is poisonous for both innovation and returns is slowly but surely becoming mainstream.
Can’t wait for this to become a given so we can (finally!) move onto the much more interesting topic of “What comes next?”
First, the most concise formulation of the problem:
LP allocation to “VC” grew so quickly that there was no opportunity for the strategy to adapt and properly allocate the additional capital. Instead, it was captured by opportunists.
Thus, a majority of today’s “VC” activity is simple financialisation.
Venture capital involves making long-term investments in innovative, high-growth companies, with the goal of capturing outlier returns at exit.
“VC” is the process of using financial engineering to optimise fee income. Maximising proxy performance metrics by manifesting herd-like market momentum.
“VC” isn’t intrinsically bad: the agglomerators are responsible for pulling billions of dollars into technology investment, by developing a product suitable for the largest and wealthiest LPs with the lowest expectations.
However, there are three points the market needs to grapple with in order for venture capital to move forward:
1. Agglomerators have no business investing prior to Series C
The argument for their existence is that technological development often requires vast pools of growth capital, so why do they invest at seed?
The truth is rooted in financialisation: it’s easier to produce a mirage of proxy metrics if you can pick startups that fit the momentum narrative, and founders that will go along with it.
Another part of the reason is that these firms are doing very nicely from absorbing capital in the “VC” allocation bucket. Registered RIAs moving further away from early-stage investing might invite some unfavourable comparisons to their PE peers.
Indeed, exactly whose allocation are they displacing? Is it venture capital? Or is it the PE firms they maybe more closely resemble? Or is it the public markets they have drained of new growth opportunities?
We also know:
The hypercapitalising behavior of these large firms systematically breaks young startups.
They poorly built for early-stage investing, as large firm dynamics favour more obvious investments.
A decade of deal activity shows these firms are actively concentrating into consensus anyway.
The early-stage activity of these firms achieves very little of any merit. They bend the market to their consensus narrative, suffocate genuine innovation, and turn startups into volatile commodities in their hunt for “market winners”.
2. The agglomerator model of “VC” is an experiment
For all that many of these firms are well-established names in the venture capital ecosystem, their strategy is not.
In describing this bifurcation of the venture market, back in 2020, Nikhil Basu Trivedi stated “the next decade will be a referendum on agglomerators“. Essentially, until we see how these multi-billion dollar funds play out, it’s unclear what future the strategy has.
Indeed, we can learn from history: after the dotcom bubble burst, the industry collectively swore off >$1B funds (for a while), with GPs reflecting on the challenges of scaling venture capital.
There are similar lessons from the history of “mega-buyout funds”, as described by Meghan Reynolds of Altimeter:
“Mega Fund dynamic in VC mirrors the meteoric rise of Mega Buyout funds in ’05-’08. Post GFC, Mega Buyout went out of favor w/ many LPs. What happened after was an emergence of strong, highly sought after <$2B “middle market” funds that were thought to have greater alpha.”
3. Agglomerator practices have corrupted venture capital
Perhaps the most painful and pernicious aspect of all of this, is that the conflation of these multi-stage agglomerators with venture capital has led to a corruption of standards and practices.
Let’s be clear: venture capital has very little in the way of standards and practices. What there is, tends to be a mimmicry of “the loudest model“, which is the agglomerator playbook.
So, when they say things like “entry price doesn’t matter”, or “non-consensus investing is dangerous”, or “the only thing that matters is getting into the best deals”, they are talking their book. It reflects a strategy that simply does not apply to venture capital, where entry price does matter, all alpha is non-consensus, and nobody can predict the best deals.
The same is true for LPs, who derive much of their understanding of venture capital, and what “good” looks like, from these “loudest models”: When Marc Andreessen says “AI will save the world”, LPs demand that GPs have an AI thesis, even when a smart GP may be looking beyond that horizon, or at overlooked alpha elsewhere.
So, what comes next?
Hopefully, a number of things play out over the next five years:
We see the limitations of the agglomerator model, and venture capital can reclaim the early stage, yielding more effective and diverse origination with saner pricing and less volatile outcomes.
LPs slowly wise-up to this bifurcation of strategies, re-educate themselves about venture capital, make better allocation decisions and feel less inclined to impose upon GP strategy.
Agglomerators (re-classified as “venture growth”) become a defined sub-category of LPs private book, like venture capital. Publications like Pitchbook and CA start disaggregating performance into this new bracket.
Anyone who wants to play a fee-driven financialised game can go to venture growth, those who are driven by performance and impact can work in venture capital. Two different systems, each better understood and playing to their strengths.
Increasingly, venture capital will be able to tap into venture growth for liquidity as their portfolio matures, accelerating liquidity and feedback cycles to produce compounding performance gains.
Slowly but surely, venture capital may return to being a better-performing and more positive-sum strategy, focused on finding outliers and the discipline of properly managed risk. Less herd behavior, and less cognitive dissonance.
(top image: Meindert Hobbema’s The Avenue at Middelharnis)
Whether you’re investing in mature companies in the public market, or fast-growing startups in the private market, one question separates good and bad investors:
Do you understand valuation?
Valuation is the rationale by which you determine which opportunities to pursue. To develop your understanding of valuation is to develop your ability to recognise potential.
Despite the central role in investment decisions, valuation is often misconstrued as financial engineering or market-driven pricing exercises.
Valuation is an opinion
Here’s three things valuation is not:
Based on verifiable inputs
Provably accurate in output
A mirror of market sentiment
Instead, valuation is always an opinion based on a set of assumptions about an unknowable future.
“People act like it’s an award for past behavior. It’s not. It’s a hurdle for future behavior.”
Whether that valuation is based on a detailed DCF model or napkin-math, it’s an opinion. And it’s no more or less of an opinion as your process gets more or less sophisticated; the only difference is how clearly you outline the assumptions.
When one investor states that a company is overpriced, and another that it is undervalued, neither is right or wrong in the moment — they just have differing opinions.
Valuation can be a simple, implicit part of the process, or it can be an explicit exercise used to better understand an opportunity and check assumptions.
Valuation is a story about the future
In order to form an opinion about a particular future, you must first listen to its story.
“The value of a stock is what people believe it is and could be. A stock is a story.”
Valuation is the art of using stories to develop opinions about the future
Valuation can be broken down into a few pieces:
How do you judge the credibility of a story?
How do you estimate the economic potential of a story?
How do you estimate the risk associated with a story?
You can think about this via two extremes:
You’re looking at a company you’re familiar with. You’ve got a good mental model of the industry, the technology, the market forces, trajectory, and risks. It’s relatively simple for you to make a rough judgement on value in your head. This reflects Kahneman’s “System 1” thinking.
You’re looking at a company you have no familiarity with. The technology is novel, the market is emerging, and there’s no real precedent. In order to make a good judgement, you have to submerge yourself in details and scenarios. This reflects Kahneman’s “System 2” thinking.
In the latter case, a more sophisticated valuation process can help you understand the credibility and economic potential of a story. It provides a framework for ingesting information that can control biases, while allowing you to recognise and scrutinise the main drivers of value.
Valuation is essentially the act of running simulations of the future described in a story, focused on the numbers rather than the narrative, to explore the potential.
Pricing is not valuation / Trading is not investing / The present is not the future
Venture capitalists often choose to focus on relative pricing, instead of valuation, as an attempt to proxy experience through crowdsourced activity — allowing for speedy “System 1” style investment decisions.
This means analysing industry activity, which biases investment towards categories with low information friction like B2B SaaS, at a cost to sectors with more idiosyncracy, like deeptech.
Unfortunately that focus on market data also means these investors are not developing their ability to make judgements about the future, only to pattern match today. This compounds into a ‘knowledge worker atrophy‘ problem, weakening venture capital’s institutional competence at funding creative endeavors and novel solutions.
That would appear to be a critically weak link in the value proposition of venture capital, and the premise that it funds important solutions to humanity’s problems.
Relying on market efficiency while investing in idiosyncrasy
Venture capital is the hunt for outliers; ideas that are not well understood by the wider market. This strategy is rooted in the need for risk capital to finance frontier businesses.
You can see how this played out in previous generations of tech: Amazon, Airbnb, Canva, Coinbase, Dropbox, Google, Shopify, Slack, Uber… All of these companies faced an uphill battle with investor interest, and went on to produce incredible exits for the early believers. Similarly, there are many examples where the founder’s own capital paved the way: SpaceX, Tesla, Palantir, Anduril…
On the other hand, it seems relatively more difficult to find stories of competitive early rounds leading to great outcomes. Stripe, perhaps?
This understanding of venture capital is reinforced by the data:
We find that consensus entrants are less viable, while non-consensus entrants are more likely to prosper. Non-consensus entrepreneurs who buck the trends are most likely to stay in the market, receive funding, and ultimately go public.
Despite this, today’s venture capitalists have an absurd reliance on the market as their lens to understand value. Herd behavior drives investor attention, and (what passes for) valuation is primarily derived from relative measures like ARR multiples.
Investors set out to generate alpha with their unique ability to recognise novel opportunities, but rely on broad market sentiment as a lens to understand what is worth pursuing.
This paradox has stumped observers.
This heavy reliance on comparable companies in the VC valuation process is perhaps unsurprising, given that relative pricing methods are not uncommon in M&A markets overall. What is less clear, however, is the exact driver behind this method, and the understanding of why a relative pricing methodology will impact startups’ valuations.
Whether it’s marketplaces, crypto or today’s AI boom, capital herds into the category and drives up prices, and those prices then become “comps” for others.
Ultimately, the surge in deals creates a greater volume of market data for that category, reducing information friction for investment, allowing for more deals to be made more quickly. This compounding influence quickly overheats activity.
In addition to competition driving up prices and compressing due diligence timelines, there’s a further pernicious consequence: while information friction is reduced around the consensus, it is increased elsewhere.
Founders building truly innovative products find themselves facing a wall of blank-faced investors programmed with category multiples. The difficulty of raising capital becomes so great that many simply reorient their ambition to lower quality projects closer to the experience of venture capitalists. This is clearly a fundamental failure:
Information frictions in valuation can lead startups to select projects that align with the expertise of potential venture capital (VC) investors, a strategy I refer to as catering […] where a startup trades off project quality with the informational benefits of catering.
If all of this was to hold true, we should see an increase in performance by the few VCs that maintain a lens on fundamental (rather than relative) value. In theory, these investors would be better able to recognise outlier value and unique opportunities.
Indeed, that does appear to be the case. Multiple studies on venture capital investment performance and decision making processes have reached the conclusion that VCs would benefit from a better understanding of fundamental value:
Venture capital funds who base their investment strategy on fundamental values and a long-term view seem to have a measurable advantage over those who engage in subjective short-term trading strategies.”
Ideally, a startup would combine a full fledged fundamental cash flow-based approach with a thorough comparable companies analysis to cover both its intrinsic value and a market-based measure.
So, the paradox is laid bare and the remaining question is why this is the case. There are two potential explanations:
VCs do not understand valuation. A decade of ZIRP-fuelled spreadsheet investing has destroyed the institutional understanding of risk and the purpose of venture capital.
There are other incentives at work which explain this phenomenon; reasons why VCs would be reluctant to closely analyse fundamental value.
Explanation 1: Hanlon’s Razor
Unsurprisingly, there’s plenty of evidence to make the case that this is unintentional; a result of simple incompetence and herd behavior. Indeed, herding is a well-studied phenomenon in professional investment, particularly when insecurity is high:
Under certain circumstances, managers simply mimic the investment decisions of other managers, ignoring substantive private information. Although this behavior is inefficient from a social standpoint, it can be rational from the perspective of managers who are concerned about their reputations in the labor market.
Chronic groupthink, and the atrophy of independent reasoning, further explains why VCs are also often unable to clearly articulate the process that goes into their investment decisions:
The findings suggest that VCs are not good at introspecting about their own decision process. […] This lack of systematic understanding impedes learning. VCs cannot make accurate adjustments to their evaluation process if they do not truly understand it. Therefore, VCs may suffer from a systematic bias that impedes the performance of their investment portfolio.
Many VCs have simply emulated the practices of their peers without fully understanding why. Indeed, those peers probably couldn’t provide a rationale either. It’s an industry of investors copying each other’s homework while pretending to be original thinkers.
Action without understanding purpose naturally erodes standards. Not only does this make VCs bad fiduciaries, it also precludes any learning and institutional development.
Almost half of the VCs, particularly the early-stage, IT, and smaller VCs, admit to often making gut investment decisions. We also asked respondents whether they quantitatively analyze their past investment decisions and performance. This is very uncommon, with only one out of ten VCs doing so.
The alternate theory is that there may be some genuine motive for VCs to avoid looking too carefully at fundamental value. That somehow they are able to profit from a reality in which it is not an important driver of activity.
Perhaps it is simply because today’s VCs behave more like traders, rather than investors. That the easier opportunity is to glom onto hot categories and ride the exuberance to an overpriced exit somewhere down the line, rather than trying to find good investments.
This is also not an original accusation:
For those who are holding on to the belief that venture capitalists are the last bastion of smart money, it is time to let go. While there are a few exceptions, venture capitalists for the most part are traders on steroids, riding the momentum train, and being ridden over by it, when it turns.
Venture capital, as a discipline, runs an existential risk of invalidating itself by becoming institutionally what crypto is colloquially. If venture capital is just about “[creating] the impression [of] recoupment”, then its no better than the pump and dumps of the crypto bros.
Yet again, there’s evidence that this is the case.
VCs are heavily influenced by market conditions, optimism and FOMO. None of these are original accusations, although it might be interesting to learn this has been demonstrated in research:
The optimistic market sentiments and fears of missing out in hot markets can significantly shift VCs’ attention towards cheap talk, such as promises of high growth. Such conditions may even prompt VCs to neglect costly signals such as the profitability of new ventures.
This is confirmed by research looking at this question from the other side, where it is demonstrated that VCs are commensurately less likely to herd in periods with greater uncertainty and less optimistic momentum to channel capital:
The study finds a significant negative relationship between economic policy uncertainty (EPU) and herding behavior, indicating that venture capitalists are more likely to make independent judgments when EPU rises.
Even when a VC talks about wanting to find category winners, they are also implicitly talking about riding a category. Were they hunting for genuine outliers, the category wouldn’t matter. There is a reason, for example, why some VCs widely publicise the categories they invest in as great opportunities, and others choose to keep any alpha for themselves.
The final reason is simple: subjective, market-based pricing is opaque and open to manipulation. VCs can collectively produce and support higher marks regardless of underlying value. They can also choose to be “opportunistically optimistic” about a portfolio company:
During fundraising periods the valuations tend to be inflated compared to other periods in the life of the fund. This has large effects on reported interim performance measures that appear in fundraising documents. We find a distinctive pattern of abnormal valuations which matches quite closely the period up to the first close of the follow on fund. It is hard to rationalize the pattern we observe except as a positive bias in valuation during fundraising.
Indeed, much of the fallout post-2022 involved LPs feeling fairly miffed that managers weren’t being honest about underlying portfolio company value. As long as VCs broadly maintained marks, there was still hope to raise another fund on those mostly meaningless proxy metrics of performance.
In Conclusion,
Many VCs choose to play a short-term trading game By focusing on market momentum, rather than companies, through relative valuation methods, VCs operate more like traders.
Most VCs take the path of least resistance when adopting practices While analysing fundamental value offers outperformance, relative value is easier to understand and offers strategic advantages.
Most VCs identify as investors, and some of them still are. Mostly the smaller, boutique firms who were quick to realise that they could not compete in consensus categories against the multi-stage platforms.
There is value in being a trader if you have multi-billion dollar funds and can both manifest and then coast on the beta of technology markets. They behave like market makers on the way up, extracting opportunistic liquidity, and can aim to concentrate resources into the handfull of winners before the market turns.
This strategy is toxic to smaller investors, many of whom are simply washed out in the boom-and-bust cycles that this amplifies. Instead, these investors, focused on identifying true outliers, need to consider polishing their lens on fundamental value.
(top image: Ascending and Descending by M.C. Escher)
The two faces of what we sometimes call venture capital, and the cognitive dissonance they create.
This blog started out as a place to write about the intersection of science fiction and technology. The first article about venture capital, and the opium of consensus, emerged from watching VCs herd into thinly-veiled crypto scams in the name of “web3“.
The influence of consensus remains poorly understood, and the subject of distracting counterfactuals, despite being widely discussed for as long as “investor” has been a profession.
Words must have meaning
Venture capital is the practice of identifying nascent business opportunities with radical potential; the application of process to extract outsized value from extreme idiosyncratic risk.
In this context, venture capital is clearly not a consensus-oriented discipline. Both theoretical and quantitative perspectives support this reality; the intention, goals, behavior and performance.
We find that consensus entrants are less viable, while non-consensus entrants are more likely to prosper. Non-consensus entrepreneurs who buck the trends are most likely to stay in the market, receive funding, and ultimately go public.
Simply look back at the early-days of venture capital’s largest outcomes, where the majority did not have investors competing for access, driving up the price. Fundraising was a struggle for those founders, and in that struggle was the opportunity for those on the other side of the table.
It’s very hard to make money on successful and consensus. Because if something is already consensus then money will have already flooded in and the profit opportunity is gone. And so by definition in venture capital, if you are doing it right, you are continuously investing in things that are non-consensus at the time of investment.
Indeed, if consensus were to play a meaningful role in venture capital, it would fail on the only two things it sets out to achieve:
Maximise ROI for LPs through idiosyncratic risk
Finance the development of novel innovations
In addition, there is no such thing as a downstream supply of “non-consensus capital”. If you fund non-consensus companies then you have to be able to support them to the point where their potential is obvious and larger/later generalists can be convinced. It’s paradoxical to believe that other investors will share your non-consensus viewpoint.
Cognitive dissonance
The root of the confusion about consensus (and entry price, portfolio construction, attention, relationships…) is the mixing of two different private market strategies. One is venture capital, and the other is something else that just falls into the venture capital allocation bucket.
This other strategy emerged in the period from 2011 to 2021, enabled by low interest-rates, as described by Everett Randle in “Playing different games“:
Tiger identified several rules / norms / commonly held ideas in venture/growth that are stale & outdated and built a strategy to exploit the contemporary realities around those ideas at scale.
So you have massive capital allocators looking for places they can farm yield and they don’t want to be slinging hundreds of $30M checks. Capital agglomerators represent the perfect solution. Hit your 7-8% yield target, be able to park $250M a pop without being the majority of the fund, and sit back and relax.
This hunger to capture the most extreme “power law” category leaders is a requirement of the exit math involved in multi-billion dollar funds. Consequently, these platforms also raise substantial early-stage funds to index any emerging theme, putting an option on the future of those companies.
A mega-VC with $5-10B annual funds is really searching for only one thing: a company they can pile over $1b into with a potential for 5-10X on the $1b. With this, seed fund is inconsequential money used to increase the odds of main objective.
The startup industrial complex that has emerged is not optimised for non-consensus investing, and nor does it need to be. Investors at these platforms are hired to compete and win in known areas — and have attitudes to match:
Successful startups fit into a mold that investors understand, and that more often than not those startups attracted meaningful competition among top investors.
If a company has tons of hype and seems overvalued, don’t run away. Run towards it. Hype is good. Means they’ll raise, exit at higher valuation. And the price likely won’t feel overpriced after the startup exits.
The output is a rough index of high-growth private technology companies. The platforms are harvesting the beta from innovation, rather than finding the alpha in outliers. Even the giant outcomes become so well/over-priced that their returns risk converging with benchmarks.
Categorically, this is not venture capital in any meaningful sense.
The only reason we call this venture is because LPs need to call it venture so CIOs can hit annual allocation targets they promised boards. This is venture allocation, not venture returns.
To repeat a point already well-hammered, the platform strategy is entirely different, with a different LP base, a different return profile, and different rules.
The difference between the Andreessen quote above, and the more recent quotes from Chen and Casado, is simply that in 2014 Andreessen Horowitz was a venture capital firm. Today it is an asset manager, an RIA with a multi-stage platform strategy, perhaps best described as a venture bank.
Many VCs have sought to assimilate “tier 1” multi-stage behavior, acting out what they believe LPs and peers expect to see despite the fundamentally incompatible models. This herding around identity and behavior reflects the extreme level of insecurity in venture capital, a product of the long feedback cycles and futility of trying to reproduce success in a world of exceptions.
There is no harmony with venture capital, and the behaviors of these platform investors should not be emulated by venture capitalists — whether or not they also call themselves venture capitalists.
To put a point on this: The platforms explicitly benefit from consensus and price inflation. Both are toxic to venture capital.
As long as both strategies are discussed under the banner of venture capital, we’ll keep wasting time on pointless debates about markets and incentives, and investors will keep making dumb, confused decisions.
(top image: A Steam Hammer at Work, by James Nasmyth)
One of the concepts we emphasize at Equidam is the inversion of qualitative and quantitative factors in startup valuation, as you go from Seed1 to pre-IPO funding.
The archetypal Seed startup (perhaps just an idea) has nothing to measure. Investors must use their imagination, peer into the future, project a scenario. On the other hand, a startup raising the last round of private capital before an IPO will be weighed and measured almost entirely on financial metrics.
Even as early as Series A you have access to some useful data. Can they actually build the thing? Do customers really want it? Does anyone want to work there? All sources of rich signal to help you make an objective decision about the company.
Seed is different. Success comes down to the quality and consistency of your subjective, independent judgement. In many ways it is a unique discipline within the strategy of venture.
What happens if you try to find a path in the data?
Essentially, it’s a hunt for outliers with no shortcuts and two specific qualifiers for any investment strategy:
Any attempt to pattern-match to past success is going to dramatically limit your pool of opportunity, with no clear upside.
Any constraints built into your investment strategy (sector, region, industry) are essentially a sacrifice of volatility (potential alpha).
Thus, the ideal Seed investor is likely to be a generalist, with no preconceptions about what great founders look like, where they come from, or what they might be building.
Rather than the hubris of a (supposed) rockstar stock-picker, Seed investors will find confidence through constructing solid processes, systematically rewarding good decisions and mitigating bad ones.
Finally, and perhaps most importantly, they’ll have a firm grip on the biases which manifest in all forms of investing. Particularly the curse of overconfidence which erodes the positive influence of success.
In summary, considering all of the above, we should expect Seed investors to present with an idiosyncratic worldview, some robust fundamental skills and an appetite for risk.
Sadly, reality is the opposite: Seed investors are often risk-averse herd animals with little real competence. They have Rick Rubin-esque affectations, pontificating on ‘taste’ and ‘craft’, while copying each other’s homework and hiding deep insecurity.
In the last 15 years we’ve seen the emergence of a Startup Industrial Complex, where a treadmill of capital, services and brand-strength was offered to participating firms and startups. If you wanted quick, reliable markups and easy downstream financing for your portfolio then you hopped on board.
This movement destroyed the institutional contrarianism of Seed investing. Billions of dollars were piled into safe SaaS money-printers when capital was cheap. When the market for safe investments was saturated, investors responded by dumping huge sums of capital into silly ideas (remember NFTs?).
That’s “risk”, right?
This worked during ZIRP, because everything was going up and to the right. Public markets were so cracked-out on COVID and cheap capital that they grabbed anything at IPO. But it was never going to last.
Seed VCs (and their LPs) need to recognise that role is, and always has been, to find breakout companies before they are obvious. Not to compete for deals. Not to seek validation from colleagues. To find those outliers. To be uncomfortably idiosyncratic. That’s it. That’s everything.
Critically, while it may lag by a decade or so, everything else is downstream from Seed.
The entire venture capital strategy depends on Seed investors doing their job properly. The entire premise of venture-backed innovation, and the promise of venture-scale returns, are entirely dependent on the health of Seed.
(image source: “Venice; the Grand Canal from the Palazzo Foscari to the Carità”, by Canaletto)
The story of venture capital (and its precursors) is a story of risk. You can take this back as far as you like, from ARDC to Christopher Columbus. From whaling expeditions to space exploration.
Risk is the product.
And, essentially, it boils down to this calculation:
The merit of any investment depends on whether the probability of success multiplied by the forecasted return is greater than the cost.
Investments that are perceived to have a high probability of success attract a lot of competition.
Investments that are perceived to have a low probability of success attract very little competition.
Venture capital is at the far end of this spectrum, where the ‘skill’ is in recognising when the market has mispriced risk because an idea is unconventional rather than bad.
This brings us to the first category of risk in this conversation: idiosyncratic risk.
Idiosyncratic Risk
(the specific risk of an investment)
Idiosyncratic risk reflects the specific potential of an investment: the probability of success, and the assumed return if it is succesful.
Assuming you cannot change the probability of success or the assumed return, there are two ways to handle idiosyncratic risk:
Making low probability investments profitable by diversifying away total failure.1
These are the two main levers of venture capital, which is focused on what Howard Marks refers to as uncomfortably idiosyncratic investments:
The question is, do you dare to be different? To diverge from the pack is required if you’re going to be a superior in anything. Number two, do you dare to be wrong? Number three, do you dare to look wrong? Because even things which are going to be right in the long run, maybe look wrong in the short run. So, you have to be willing to live with all those three things, different, wrong, and looking wrong, in order to be able to take the risk required and engage in the idiosyncratic behavior required for success.
Idiosyncratic risk contrasts with the other main category of risk that investors must consider: systematic risk.
Systematic Risk
(broader market-related risk)
If idiosyncratic risk is typified by venture capital, then systematic risk is typified by index funds. Consider the extent to which index fund performance is influenced by individual companies versus major political or economic events.
Nevertheless, systematic risk is a consideration in venture capital, and there are two ways to handle it:
Avoid consensus, where competition drives up prices without increasing success rate or scale.
Avoid market-based pricing, where macro factors can drive up prices without increasing success rate or scale.
Exposure to systematic risk essentially destroys an investor’s ability to properly manage (and extract value from) idiosyncratic risk.
Alpha vs Beta
If we consider idiosyncratic risk as the source of ‘alpha’ (ability to beat benchmarks) in venture capital, systematic risk reflects the ‘beta’ (convergence with benchmarks).
A striking shift in venture capital over the last 30 years, particularly the last 15, is the extent to which the balance has shifted from idiosyncratic risk to systematic risk. This is a consequence of prolonged ‘hot market’ conditions, where consensus offers a mirage of success.
Consider a typical VC in 2025. They’re likely to be focused on AI opportunities, guided by pattern-matching and market pricing (aka, “playing the game on the field”). Investing, in this scenario, is reduced to a relatively simple box-checking exercise.
All of this implies significant systematic risk; the firm is riding beta more than they are producing alpha. This creates extreme fragility.
Systematic risk has always been a concern, but it has been amplified in recent years by cheap capital and social media. The herd has grown larger and louder; more difficult for inexperienced or insecure investors to ignore:
Taking systematic risk means following the crowd. It’s an easier story to sell LPs, and there’s less career risk if it goes wrong as accountability is spread across the industry.
Taking idiosyncratic risk means wandering freely. It’s tough to spin into a coherent pitch, and there’s more obvious career risk associated with the judgement of those investments.
Despite mountains of theory and evidence supporting idiosyncratic risk as the source of outperformance, it’s just not where the incentives lie for venture capital.
The Jackpot Paradox
There are fundamental consequences of the drift towards systematic risk in venture capital:
The muscles of portfolio construction and valuation atrophy, as consensus-driven ‘access’ dominates behavior and idiosyncratic risk falls out of favour.
The typical ‘power law’ distribution of outputs collapses as few genuine outliers can be realised from a concentrated pattern of investment.
As returns converge on a mediocre market-rate, investors manufacture risk by feeding power law back into the system as an input, trying to create outlier returns.
Success is further concentrated in a system that becomes increasingly negative sum overall.
This broadly summarises where we’re at today. A disappointing scenario that represents failure to the actual bag-holders on the LP end, failure to founders, and failure to innovation.
A lot of the blame falls in the lap of LPs. The low fidelity interface with GPs means that LPs have a general bias towards compelling stories which invite systematic risk.
Thus, venture capital is reduced to a wealth-destroying competition for access to the hottest deals, fundamentally at odds with the concept of ‘uncomfortably idiosyncratic’ risk and generating alpha.
Show me the incentive and I’ll show you the outcome
Charlie Munger
One of the most thought-provoking articles in venture last year was Jamin Ball’s “Misaligned Incentives“, in which he talked about the difference between 2% firms and 20% firms.
The 2% firms are optimizing for deployment. The 20% are optimizing for large company outcomes. There’s one path where the incentives are aligned.
The article was significantly because it was represented a large allocator acknowledging the issue with incentives in private markets. Not a novel take on the problem, but resounding confirmation.
Ball stopped short of suggesting an alternative incentive structure, which was probably wise given visceral opposition to change. Many influential firms have grown fat and happy in the laissez-faire status quo of venture capital.
Ball — like many people, myself included — framed carried interest as the ‘performance pay’ component of VC compensation. The problem is implicit: we have therefore accepted that fees are not connected to performance.
For decades, we’ve accepted the wisdom that carry = performance, and fees = operational pay. Nobody thought to question that reality.
Unfortuantely, for many firms (and certainly the majority of venture capital dollars under management), carry is a mirage. It exists so investors can pretend that performance is a meaningful component of their compensation while they continue optimising for scale.
European Waterfall vs. American Waterfall
European waterfall is a whole-fund approach to carry, whereby GPs don’t receive carried interest until LPs have had 1x of the fund (plus a hurdle) returned to them. American waterfall operates on a deal-by-deal approach, with a clawback provision if the fund isn’t returned (plus a hurdle).
We know the american waterfall model (while imperfect) has historically outperformed, and yet the european waterfall has become standard. Venture capital has biased towards the ‘LP friendly’ approach to carried interest, even though it reduces their carry income, because it enables more easily scaling funds.
We find strong evidence that GP-friendly contracts are associated with better performance on both a gross- and net-of-fee basis. The public market equivalent (PME) is around 0.82 for fund-as-a-whole (LP-friendly) contracts but is over 1.24 for deal-by-deal (GP-friendly) contracts.
In summary, the problem is not that VCs have picked fees over carry as the more attractive incentive, it’s that carry has been used as a smokescreen for the exploitation of fees.
Consider these few points, from the perspective of a seed GP:
If you charge a fee to manage the fund, you should not raise a successor fund without a serious step-down in those fees. Otherwise, what are you being paid for?
You should not charge management fees on investments you’re no longer truly managing. If you have no meaningful influence over a company in your portfolio, what are you being paid to do with it?
Indeed, if you’re no longer truly managing those investments, it’s incumbent on you to sell enough of your stake to lock-in a reasonable return when the opportunity is available.
If you raise a larger subsequent fund, you should be able to explain how that strategy allows you to extract a similar level of performance from a larger pool of capital. Otherwise, how can you rationally justify a larger total fee income?
Everybody knows that markups are bullshit. If you want to raise a second fund, get at least 2x back to your LPs through secondaries first. DPI is the only proof that there’s value in your investments.
None of this should be surprising or even unintuitive, and yet…
Successor fund step-downs are remarkably uncommon.
Most US funds still do fees on total comitted capital, not even fees on invested capital, never mind fees on actively managed investments.
Few GPs have a sophisticated view on early returns, with most still focusing on MOIC rather than IRR and assuming late-stage price inflation will continue.
VCs expect founders to present a coherent pitch covering growth strategy and the implicit capital requirements. The LP-GP relationship is far cruder.
The whole venture ecosystem knows markups are barely worth the paper they are written on — and yet these incremental metrics continue to drive fundraising activity.
Over the past 15 years, LPs have become so preoccupied with getting into the hottest name-brand funds that there has been little scrutiny given to the fundamental logic of terms.
In an entirely fee-based environment, without carry as a smokescreen for bad actors, fees would likely be more clearly connected to performance — addressing the concerns laid out above.
This has the benefit of being a more predictable approach to compensation, likely attracting more responsible fiduciaries and level-headed investors. Less swinging for the fences, and more methodical investing and steady DPI.
However, it would also mean losing an important minority of brilliant investors who are genuinely motivated by carry.1
Ending the AUM game; 100% carry
In a scenario where investors only ‘eat what they kill’, performance would matter so much — across so many dimensions — that VCs would have to very quickly develop better practices on portfolio management and liquidity.
Of course, the downside is that compensation would be heavily backloaded, with no compensation for the early years of deploying capital and developing exits. A deeply unhealthy barrier to entry for emerging managers.
What’s interesting about these two edge-cases, on opposite ends of the spectrum, is that both produce the same outcome: a greater level of professionalism, with a more sophisticated view on portfolio management and liquidity than we see today.
Clearly, neither extreme is a good option and the ideal is somewhere in the middle — with both fees and carry in the mix. However, central to incentivising better outcomes is an end the fee exploitation game, with two key realisations for LPs:
Fees must be connected to performance, in that a GP should not be able to raise another fund if they have not yet demonstrated concrete performance.
The only meaningful demonstration of performance is DPI. Fortunately, as the market embraces secondaries, it’s possible to generate meaningful DPI much sooner.
Venture capital needs to evolve alongside more distant exit horizons by making better use of secondary liquidity, more cleanly dividing the market into early and late stage strategies — which can each then better play to their strengths:
We were able to take a 1x or a 2x of the entire fund off [the table] and still be very long in that company. That locks in a legacy, locks in a return, and shortens the time to payback.
For funds like [mine], selling stock of private startups to other investors will be “75% to 80% of the dollars that [limited partners] get back in the next five years.
You sell at the B, and you actually — for us, with the way our math worked — could have a north of 3x fund. But I also wouldn’t want to give up the future upside. We actually ran that through the C and the D. The big ‘Aha’ for me was that selling at the Series B, a little bit, was actually very prudent for a couple of reasons.
With all of this in mind, it no longer unreasonable for LPs expect something like a 2x return on their capital by year 6, and for VCs to raise new funds based on hitting that 2x target. Ensuring a decent return (on an IRR basis) for their LPs while companies are still within their orbit of influence.2
Unsurprisingly, proposals to fix fee income are unpopular, and not only with those who profit from the status quo. There is a lack of systems thinking which would allow participants to grasp the interconnected factors which shape outcomes, and see the opportunity for change.3
secondaries aren’t a good market ➝ because they’re only used to sell poor quality assets ➝ so they’re not a good market
returns in venture come from a few giant outcomes ➝ so we hold to IPO ➝ so more value accrues to a few survivors ➝ so most of the returns come from a few giant outcomes
you can’t get liquidity on markups➝ because they’re optimised for fees not liquidity ➝ so markups aren’t liquid
In essence, power law and illiquidity are both absolutely realities of the venture strategy, but both have also been used to excuse and entrench suboptimal practices.
The Opportunity of Secondaries
A common misconception: the value of investments increases consistently (even exponentially) over time, so GPs should always hold to maturity. This idea has played a significant part in slowing down the use of secondary transactions. It’s not really true.
Investments often don’t increase in value. Quite often, they fail outright. Failure rate does reduce over time (39% at seed, 13% at series D), but it remains significant throughout.
Typically, you think of a series A startup as less risky than a seed startup, and a series D startup as less risky than a series A startup. This is often true, but because VC dollars both add and remove risk, the move down the risk curve is less linear.
This is especially true for ‘the biggest winners’ who are often absorbing huge amounts of capital from the ‘venture banks’:
But in recent years, this picture has been skewed even more, especially if the capital raised comes from a mega VC fund. At each funding round, there is a significant re-risking of the startup, to the point that you are not moving meaningfully down the risk curve for a long long time. And even at a late stage, a mega funding round can bring you right back up to the point of maximum risk.
These rounds are also often highly dilutive; particularly with the proclivity of large firms to ignore pro-rata and cram-down early investors.
So, in an absolute sense, there is a sustained risk of failure which slowly concentrates portfolio returns into fewer companies over time, which will decelerate TVPI growth (or even turn it negative).
On top of that, there are often terms included in later rounds which mean that shares held by early investors become relatively overvalued. Particularly, IPO ratchet clauses and automatic conversion vetos. Thus, even if the theoretical TVPI of a seed fund remains flat, in reality it may be falling:
“In November 2015, Square went public at $9 per share with a pre-IPO value of $2.66 billion, substantially less than its $6 billion post–money valuation in October 2014. The Series E preferred shareholders were given $93 million worth of extra shares because of their IPO ratchet clause. This reinforces the idea that these shares were much more valuable than common shares and that Square was highly overvalued.”
Looking at AngelList data, the best time for a fund to sell (on an IRR basis, and ignoring the clauses above) would be year 8 — with value concentrating (but not really net expanding) in years 9 through 12.
That means the typical investment (assuming a 3 year deployment period) would be best positioned for a (partial) sale in years 5-7. Considering this, it’s difficult to make the case that GPs should be holding 100% for the ultimate outcome, every time. If they do, they are concentrating their risk without necessarily improving the portfolio outcome.
To take this a step further, we could assume in a more rational market, less dominated by hype (more secondary activity driving more pricing tension, fewer bullshit markups), the illustrated TVPI would flatten out more gradually — so less of an obvious time to sell.
In short, the story here is not about opportunistic secondaries to drive better IRR. The real case to be made is for a comprehensive secondaries strategy, and opportunistic holding. For too long, there has been ideological friction around secondaries which has held back venture performance and enabled some very bad habits. It’s time to change that.
If there’s a chance to wipe the slate clean for venture capital, for LPs and GPs to return to first principles on compensation, incentives and ideal outcomes — to begin aligning venture capital with a high-performing meritocracy — it’s here, today.
Ironically, innovations in venture capital haven’t kept pace with the companies we serve. Our industry is still beholden to a rigid 10-year fund cycle pioneered in the 1970s. As chips shrank and software flew to the cloud, venture capital kept operating on the business equivalent of floppy disks. Once upon a time the 10-year fund cycle made sense. But the assumptions it’s based on no longer hold true, curtailing meaningful relationships prematurely and misaligning companies and their investment partners.
While GenAI can improve worker efficiency, it can inhibit critical engagement with work and can potentially lead to long-term overreliance on the tool and diminished skill for independent problem-solving. Higher confidence in GenAI’s ability to perform a task is related to less critical thinking effort.
In colder markets, founders just need capital on reasonable terms, and it doesn’t really matter where it comes from. Value-add propositions and brand strength are less important; access to hot companies doesn’t move the needle as much for LPs. Instead they care more about differentiation through strategy.
In hotter markets, the opposite is true. Investors will be chasing the fastest growing companies in the most attractive categories, out on the thin ice of excess risk. LPs, sold the same dream, care only about how GPs can parlay their way into those deals. How you invest is irrelevant, what matters is your network and your brand.
Strangely, at the peak things begin to come full circle. In 2021, when there the incredible amount of capital was spread across a record 1,594 firms, there was a horseshoe effect: with such abundant opportunity for investment, LPs and VCs once again saw the opportunity in strategy-driven alpha.
In normal circumstances, the next stage of this cycle is the crash. The firms that leaned the hardest into chasing heat would be the most exposed, with portfolios that are the most obviously out of alignment with value. What’s left are the firms who chose to focus on solid strategy, who can begin harvesting deals in the down market.
In 2022, this shift was derailed by the emergence of venture banks, designed to escape the typical cycles of venture. The largest firms raised the most capital in subsequent years. Access remained an important part of the story for LPs, especially with the convenient rise of AI.
In fact, you could argue that this was the second time that cycle was disrupted, as many experienced investors called the top in 2016-2018 only to be thwarted by COVID. Two years of intense, irrational enthusiasm for digital only exacerbated the problem.
The Importance of Cycles
Consider how much of the natural world has evolved alongside fire. Wildfires serve an important purpose in preventing ecosystems from choking themselves to death on redundant biomass, and there are even species that have evolved to use fire as a mechanism to spread their seeds.
Humanities view of fire as a threat, and the goal of suppressing it entirely in the natural environment, has had disastrous consequences. We have seen the emergence of ‘mega-fires‘, where biomass accumulates to the point where spread is fierce and inevitable.
There’s a compelling parallel to venture capital. The extent to which the market is suffering today is proportional to the amount of time it took to hit a correction. There’s even a ‘redundant biomass’ problem of zombie unicorns.
What’s worse, for reasons described above we haven’t yet really allowed the full cycle to complete.
Forcing a Reset
While venture banks steam off into the distance, and venture capital tries to figure out how to navigate this environment, there are three signs of change.
Increasingly, there’s talk of smaller LPs like family offices looking to pursue direct investing strategies. In theory, this affords them a similar level of risk with better economics, but questions remain about their bandwidth to do this properly.
There’s been a surprising number of high profile GP departures, both launching their own funds and not. In many cases, this means partners are giving up wharever carry incentive they had. This suggests some discomfort in the status quo.
An increasing number of founders talking about bootstrapping or ‘seedstrapping’ (one and done fundrasing), or other strategies to avoid the problems assocaited with getting on the venture capital treadmill and the expectations involved.
For the GPs that remain, it’s time to consider what the world would look like if the cycle had completed. How would they be forced to act in a truly ‘down market’ environment. Indeed, if you consider that many smaller firms have been priced out of AI, that may already feel like their reallity.
It is clear that the bar for performance is significantly higher in a cash constrained environment with higher interest rates. While that may not change the reality for venture banks, it is existential for traditional venture capital.
The ‘Knowledge Work’ Problem
In hot markets, where investors take a prescriptive approach to investment, there is a huge problem with atrophy. Completely separate to the poor investments that come out of these periods, it’s also worth examining the practices they establish.
Investors that spend all of their time chasing hot deals based on a number of set criteria have the same basic problem as knowledge workers that rely on Generative AI solutions: they are not using their critical thinking muscles. Executing orders, not problem solving.
Consider how little actual thinking you have to do about an investment if your process is focused on second-order factors. Is it on an a16z market map, is it on YC’s Request for Startups, are other “tier 1” investors are in the round? Will downstream investors will give you the markups you need, and will LPs will be excited about it?
This behavior, geared towards capital velocity, is focused on second order information and pattern matching. It is a prescriptive approach that informs what gets investment, displacing the first-order considerations about things like team, opportunity, valuation, market and strategy.
This dissertation focuses exclusively on moral hazard, which refers to a venture capitalist’s propensity to exert less effort and shirk their fiduciary duties to the investors to maximize their self-interest; specifically, a VC’s propensity to choose subjective selection criteria over more cognitively taxing objective criteria when faced with multiple options and fewer resource restrictions.
While this approach might broadly work for venture banks, with an army of low-impact investors looking to index across new technology trends, it will not deliver the returns required by the traditional venture model.
This might sound like cowboy investing. A Rick Rubin-esque vibes based approach to venture capital. It certainly can be, and if you happen to be Rick Rubin it might just work — but why take the risk?
The way for these investors to operate from a position of strength is to build process alpha. That is, do everything you can to prevent being wrong for predictable reasons (controlling for bias), and to manage the risk of being completely wrong a lot of the time (portfolio construction). Not to overintellectualise investment decisions, but to give yourself the strongest foundation to embrace the risk of uncertainty.
To take the analogy a bit further, for all that Rick Rubin is a total eccentric, guided by his own taste without the need for external validation, he is not cavalier about it. He pays immense attention to environment and routine in order to help him get the best return on his time.
There’s never a need for investors to stray from this disciplined mode of operation, it just so happens that most are prey to the cycles of venture capital and the temptation to inflate fees when opportunity arises.
Discpline is easy when opportunity is limited. (top image: “Lesnoi pozhar (Forest Fire)”, by Aleksej Kuzmich Denisov-Uralsky)
I had a meeting once with Howard Marks, who I had wanted to meet for a long time. He’s a famous bond investor that does a lot of writing. For 15 minutes he asked me questions about the venture industry, a lot of structural questions, and I answered him as best I could.
He said, “That’s a really shitty industry”. I said, “Why do you say that, what do you mean?”, and he said “Cyclical collapse is built into the structure.”
Bill Gurley on his conversation with Howard Marks, All In Summit, May 2022
‘2024’ could have been a short chapter in the history of venture capital. Another post-boom year of declining deal activity, recovering valuations, recaps and shutdowns. We left it with the public markets looking healthy and hope that IPOs might reappear on the horizon. All good reasons to flip the page to 2025.
Before you move on from 2024 entirely, consider the boiling frog. Venture capital has been quietly outgrowing traditional definitions over the last 15 years. Last year, as AI drove heat into a cool market, the cracks started to appear.
The venture capital industry has historically worked as a relay race where investors at one stage bring in the next stage of investors to fund and support companies as they scale. Right now, it feels like AI investing breaks this model in a few important ways.
This isn’t just about inflated valuations, overcapitalisation and ZIRP. It’s about the effort of a few firms to outgrow the boom-and-bust nature of venture capital through a new model for investing.
Consider the well documentedrivalry between Andreessen Horowitz and Benchmark, with their opposing views on capital abundance in venture.
Bill Gurley declined my requests for comment, but he has publicly bemoaned all the money that firms such as a16z are pumping into the system at a time when he and many other V.C.s worry that the tech sector is experiencing another bubble. So many investors from outside the Valley want in on the startup world that valuations have been soaring: last year, thirty-eight U.S. startups received billion-dollar valuations, twenty-three more than in 2013. Many V.C.s have told their companies to raise as much money as possible now, to have a buffer against a crash.
Benchmark has set the standard for “traditional” venture capital, managing small and efficient funds, close relationships with founders, and exemplary returns. In contrast, Andreessen Horowitz represents the era of ‘capital of a competitive advantage’; a confluence of hyper-scalable SaaS, digital growth channels, and historically low interest rates. Not merely a competing venture strategy, but the emergence of a fundamentally new product that trades efficiency for scale.
The divergence of Andreessen Horowitz (and a few similar firms) from the traditional playbook has created some confusion, as greener GPs attempted to emulate aspects of both. Lacking either the AUM of Andreessen Horowitz or the discipline of Benchmark, they inevitably hit the slippery slope of badly managed risk. This can also be seen in the muddled logic on topics like entry multiples, valuation and concentration, where the ‘common wisdom’ has often made little practical sense.
Fortunately, there is light at the end of the tunnel: As this new product is better understood by LPs, GPs and founders, the chaos is better controlled: LPs will have more realistic return expectations, benchmarks and timelines. GPs will be able to identify coherent strategies and compatible advice. Founders will have a clearer choice between traditional venture capital, and the new model of “venture bank”, and the expectations associated with each.
Too Big to Fail
In 2009, with the launch of their first fund, Ben Horowitz and Marc Andreessen slipped into the role of VC brilliantly. They had strong opinions about capital efficiency and portfolio structure, a level of sophistication that surpasses many of today’s GPs.
Despite the success of that first outing, capturing huge outcomes like Skype, the market soon presented a new opportunity. In 2010, rebounding from the GFC, incumbent firms were raising funds in excess of $1B—a throwback to the dotcom exuberance that Benchmark had criticised. Institutional money was once again on the hunt for new opportunities and software had begun ‘eating the world’.
As entrepreneurs (another contrast to Gurley) Horowitz and Andreessen felt no loyalty to the traditional playbook. They saw an opportunity to innovate; the chance to build a scalable model for venture capital and take a dominant position. So, they invested heavily in media to build a ‘household name’ brand. They sought network effects by launching scouts programs and accelerators. Platform teams were assembled to handle their growing portfolio. Rather than an investment team, they built something more like a sales force. Essentially, they exploited a “boom loop”: raising money to maximise exposure, manufacture category winners, distribute healthy markups and raise more capital. In this environment, venture capital became a cutthroat zero-sum game with very little discipline.
Some of the VCs who funded predation succeeded spectacularly, and the basic incentives of venture investing that tempt VCs to employ this strategy persist. The goal of antitrust law is to push businesses away from socially costly anticompetitive behavior and towards developing socially valuable efficiencies and innovations. We think that Silicon Valley could use a nudge in that direction.
Jump to mid-2022, and the post-ZIRP hangover experienced by the venture market. Almost everyone had gotten caught-up during the decade of near-zero interest rates capped off by pandemic-driven irrationality (except Gurley, who had stepped back from Benchmark in 2020). The critics of the Andreessen Horowitz model began to emerge, pointing to their inflated check sizes and irrational pursuit of “Web3.0”. Now, like everyone else, Andreessen Horowitz would surely suffer from falling returns and backlash from LPs?
It happens that Andreessen Horowitz raised more than $14B in new funds during the first half of 2022, close to the combined total of their funds raised in the preceding three years. They were well prepared for the fundraising winter of 2023, a year which many large firms used to rebalance their portfolios through secondary transactions—playing on the extreme heat around companies like OpenAI, SpaceX and Anduril.
In 2024, as the slump continued (down roughly 50% from the funds raised by VCs in 2020 and 2021) Andreessen Horowitz came back and raised another $7B. In fact, the 10 largest venture banks raised more than half of all venture dollars last year. The firms that had contributed most to the collapse were suffering from it the least. How could this be? The outcome frustrated many smaller GPs who had been squeezed out of deals and were having a harder time closing funds.
Plans Measured in Decades
If you want to build a venture bank, you need billions of dollars on a regular basis, and it needs to be truly patient capital. Not high-net-worths, not family offices, perhaps only the largest pension funds and endowments. Most of all, you need sovereign wealth.
This transition away from venture capital’s traditional LP base was the central gambit of venture banks. With performance stabilised by the scale of their AUM, the ability to extend into other assets and an internationally recognised brand, they are able to court some of the world’s largest pools of capital. Rather than hunting alpha, they farm ‘innovation beta’—indexing across as much of the fast-growing tech market as possible, with exposure to every hot theme, at every stage, both private, public and tokenised.
A lot of the detail is lost when you’re operating at that altitude. Valuation, consensus, discipline, markets… they all matter less if you’ve escaped the typical venture capital fund cycles. Liquidity can be delivered through the secondary market, continuation funds, distributions of public stock or sales of crypto holdings. If it’s a tough market for IPOs, you have the scope to wait it out. When there’s a ‘liquidity window’, like 2021, you can jettison as much as possible—as quickly as possible.
Our results suggest that the early success of VC firms depends almost entirely on having been “in the right place at the right time”—that is, investing in industries and in regions that did particularly well in a given year.
There is also opportunity in this bifurcation for GPs at traditional firms. While venture banks smother consensus themes, they do so on behalf of this new class of supersized LP. For everyone else, there should be less competition in the traditional LP base—once they recover their enthusiasm for the asset class.
The shift obliges smaller firms to focus on non-consensus themes—which they should have been doing all along. Access to ‘hot deals’ is no longer a core proposition for LPs, as it becomes clearer that the juice isn’t worth the squeeze. Instead, GPs should focus on evergreen investing theory. This includes portfolios structured to optimise for outliers and manage risk and a sourcing process that minimises bias, or what Joe Milam calls “Process Alpha”.
The conventional venture model relied on the power law to rationalize overly concentrated portfolios and “hot deal chasing” when basic portfolio management theory emphasizes (non-systematic) risk management through diversification.
Some of that shift has been cultural, but much is simply that the pervasive practice of pricing with ARR multiples has favoured well-understood segments over the last decade. Deep tech and hardware suffered because VCs simply weren’t sure how to put a price tag on those companies.
Calculating or qualifying potential valuation using the simplistic and crude tool of a revenue multiple (also known as the price/revenue or price/sales ratio) was quite trendy back during the Internet bubble of the late 1990s. Perhaps it is not peculiar that our good friend the price/revenue ratio is back in vogue. But investors and analysts beware; this is a remarkably dangerous technique, because all revenues are not created equal.
As VCs develop a keener and more independent sense for value, the exit pipeline begins to look a lot healthier. Metrics that look at financial health in addition to sheer growth of revenue will more effectively align companies with the expectations of both public market investors and prospective acquirers. Like the old days of venture, much of growth and prosperity will be available for mass market retail participation — which is great for the ‘soft power’ of tech.
Some of the world’s most highly valued public tech companies entered the public markets with quite modest valuations, at least by today’s standards. Microsoft, Amazon, Oracle and Cisco all debuted with market caps south of $1 billion. Of those, only Microsoft topped $500 million. This translated to relatively modest gains for their private market investors, compared to the massive value appreciation they have all experienced post-IPO.
On the other hand, venture banks who have developed monster companies like OpenAI, SpaceX and Anduril, will be able to keep tapping into this expanded pool of private market capital via secondaries. Where companies are strategically sensitive, particularly in the realms of AI or defense, this may be seen as preferable to public company disclosure requirements or the threat from activist shareholders.
Secondary markets also represent an opportunity for traditional venture capital. As managers pick up better standards for valuation, providing greater transparency and explainability, activity is bound to increase. This means more options for liquidity, more consistent buy-sell tension to keep prices under control, and participation from a more diverse base of investors. Finally, it also offers greater cap table flexibility to founders and early investors.
Let’s be realistic here; you’re better off in the fullness of time if certain players are in your cap table, and not a seed fund.
2025 should mark the end of confusion about venture banks and their role in the ecosystem. After a decade of increasingly confused standards and benchmarks for traditional VC, the two products have been neatly split by the wedge of AI.
This is an opportunity for rehabilitation, as the confusion around the change has created more issues than the change itself. Both sides are now able to lean into their strengths, consensus vs non-consensus, alpha vs beta, and deliver the commensurate returns to LPs with matched expectations.
Make no mistake, 2025 will be a crucible for venture capital. The divergence of exits from public market performance is worse than ever, and confidence is low. Despite this, there seems to be a resurgence of smaller firms raising capital—matching historical patterns where incumbents lead the rest of the market by a year.
Critically, how will smaller GPs execute in the new environment? Will they learn the lessons from the last five years and play to their strengths? Or will they keep trying to span the chasm of small fund risk tolerance and large fund risk appetite?
In venture capital circles, the most widely discussed trend of 2024 (outside of AI) has been the concentration of capital into “venture banks” like Andreessen Horowitz, General Catalyst and Thrive Capital. The household names of venture capital have had a blockbuster year, while others carefully ration the tail-end of their last fund.
The first quarter opened with Andreessen Horowitz and General Catalyst scooping up 44% of the available capital. 2024 is closing on a similar note, with 9 firms having captured more than half of all funds raised so far. The 30 most capitalized firms this year collectively represent three quarters of the pool raised by at least 380 funds.
However, the real anomaly is not how much the large funds have raised, but rather how poorly everyone else has done. Why has the bottom fallen out of the market for smaller funds, if the giant firms are still able to vacuum up capital?
Ask a hundred GPs or LPs where they draw the line between small funds and large funds, or how they define multi-stage and multi-sector strategies, and you will get a hundred different answers. The lack of standard definitions and common understandings has dramatically hindered productive discourse about venture capital over the years.
Importantly, it has obscured the manner in which multi-stage venture capital has diverged from the rest of the market. Today, it operates a novel model for startup investment, targeting a new class of LPs with a very different premise.
A Rapacious Playbook
In 2011, Jay Levy of Zelkova Ventures wrote an article about the conflicting interests involved in insider pricing. His point was simple: when investors led rounds for existing portfolio companies, their desire for greater ownership would be outweighed by their need to show performance.
Two things are striking about this article:
Jay’s concern probably seems alien or overly-dramatic to anyone who entered venture capital within the last decade. Today, it’s just the game on the table.
It is also likely to be the single largest contributing factor to the pricing bubble that grew during ZIRP and exploded in 2022, if you follow the incentives created.
In a rational market, where VCs are all stage-specific, each round of investment has a different lead investor. That means, at regular intervals in the company’s development, it will be valued by a neutral third-party. Outside investors that want to maximize ownership will go up against founders that want to limit dilution. From that tension, we expect a generally fair outcome to emerge.
Venture capital relies on this tension, and the increasing financial savvy of investors as the investment moves downstream, stewarding companies toward exits. From qualitative analysis at the earliest stages to the quality of cash flow at maturity; you move the dial from founder strength to financial performance as you go from pre-seed to IPO, and so the expertise of investors evolves in parallel.
Multi-stage firms have a different (and fairly rapacious) view on this process. Instead of inviting scrutiny of the value of their portfolio companies, their strategy is to keep that in-house, or within a network of associated firms. Rather than rational pricing through the tension of buyer and seller, they have embraced the jagged edge of what Jay Levy described: why worry about valuation if pricing can be a competitive advantage?
Want 3-4x markups on investments to show LPs? Just do subsequent rounds at 3-4x and get them rubber-stamped by networked investors. With “performance” taken care of, it’s easier to raise more capital to feed portfolio companies, fuelling aggressive growth to grow into those markups. It’s putting the cart before the horse, compared to conventional venture thinking, but it has a certain brutal charm.
So, we’re beginning to see that the ‘capital as a competitive advantage’ playbook didn’t expire with ZIRP. A decade of cheap capital was what it took to prove the model, and today it just needs a different class of LP to back it. Indeed, multi-stage GPs appear to have spent 2023 with their heads down, consolidating around the best-looking secondary opportunities (SpaceX, OpenAI, Anthropic, Anduril) ahead of a grand tour in the Middle East. Sovereign wealth, with giant pools of capital and no great pressure on liquidity, are complementary to the traditional large institutional LPs for this strategy.
Exploiting Venture Capital’s Flaws
As multi-stage firms have expanded their funds under management, they’ve had to similarly scale their ability to capture market share. This has been solved through a fairly innovative list of features, each of which exploits a different dynamic of venture markets:
Platform Teams: Leaning into size as an advantage, multi-stage VCs have built platform teams with the advertised intent to offer support and resources to portfolio companies. In reality, portfolio teams are the serfs of the venture world, managing the burden of a large portfolio for a relatively small team of partners while generally adding little value for founders.
Signalling Risk: VCs are wildly vulnerable to herd behavior. An example of this is “signalling risk”: concern about the signal of how other investors respond to a startup. Despite being obviously silly, this essentially means “tier 1” firms get prima nocta on every founder they touch, so they scoop them up en masse with scout programs and EIR initiatives.
Backing GPs: While the rest of the market struggles, multi-stage funds can raise additional vehicles through which they become LPs in emerging managers. They look like the good guys, supporting the underdogs, broadening the market and encouraging competition. In fact, they are entrenching centralized positions in the relationship model of venture capital.
Operator Investors: In the last decade, there has been an ideological shift towards the idea of ‘operator investors’. Former founders are seen as the ideal archetype for venture capital, having first-hand experience building companies. As it turns out, they don’t really make for better investors, they’re just extremely well networked and have credibility with founders.
Procyclical Pricing: A huge amount of valuation wisdom has been discarded over the last decade, as the industry as a whole adapted to deal velocity with cruder pricing models—e.g. revenue multiples, raise/ownership, etc. These common practices lack critical specificity and amplify volatility in the market, a problem for venture firms that rely on rational pricing.
The Value of Venture Beta
The product of this multi-stage approach to startup investment is “venture beta”: returns will broadly track the market, while they expand in network, assets, and market share. For the largest institutional LPs, like sovereign wealth, this is fine: acceptable returns with minimal volatility, and they can brag about funding innovation with the support of the most prestigious firms.
Further out, this model’s success depends on whether it can produce companies that are attractive to public market investors or private market acquirers. Up to now, large infusions of capital with crude pricing have produced sloppy, undisciplined businesses. The IPO market is still reeling from being force-fed companies with poor financial health in 2021. Whether this misalignment can be fixed, or is inherent to the strategy, has yet to be seen.
Some early stage VCs have commented that multi-stage VCs still rely on small, contrarian firms to identify opportunities before they are ‘legible’. It seems more accurate to say that small firms are just another source of signal about new market opportunities for the mutli-stage strategy, rather than a crucial part of the chain. Scout programs, hackathons and accelerators all create redundancy for the competence of small firms in this capacity.
For Those Seeking Alpha
While historical patterns would indicate that the funding will bounce back for everyone else next year, it is worth some urgent reflection on how the growing share of multi-stage capital influences the market.
In the short term, multi-stage firms tapping into a new LP base shouldn’t have a huge impact on smaller funds, although many of their usual LPs will be spooked by the shift. GPs should have a good answer for how they adapt to this reality. How can they compete against the capital, network and brand strength of multi-stage firms in future? With increasing skepticism about the “value add” from venture capitalists, what do they offer founders that the multi-stage firms can’t?
For GPs with high domain expertise in hard sciences, there is enough evidence of outperformance to differentiate them from large generalists. For everyone else, the burden of proof is going to be higher than ever, and will require becoming disciples of venture theory: Read everything there is about portfolio construction, historical performance, decision making, biases and strategy, and build a rock-solid case for LPs that you deliver on the two critical fronts:
The potential to deliver excellent returns, in contrast to the mediocre performance of the largest firms. Not by swinging for the fences on every hit, but with properly optimized portfolio, price discipline, and solid understanding of the underlying theory.
Backing the best founders with the most important ideas. However good a multi-stage fund gets at identifying early stage opportunities, their model will always bias towards consensus themes and capital-intensive ideas. It is a limitation.
Essentially, GPs of smaller funds need to meet divergence with divergence, and embrace the strengths of their size and strategy: contrarianism and discipline, which amount to a form of value investing for early stage companies. Finding the easily overlooked. The alpha.
The Fork in the Road
Multi-stage GPs spent the last decade cosplaying as VCs, despite their practices being opposed to the conventional rationale of venture capital. You can’t make good judgements about price vs value or question consensus themes if your existence is predicated on assigning arbitrary markups and chasing the hottest companies.
Over the last decade, many VCs have sought to emulate “tier 1” multi-stage behavior, acting out what they believe LPs and peers expect to see despite the fundamentally incompatible models. This herding around identity and behavior reflects the extreme level of insecurity in venture capital, a product of the long feedback cycles and futility of trying to reproduce success in a world of exceptions. It has also produced some extremely poor practices, and bad attitudes.
The more VCs study the history, theory and current reality of private market activity, the more conviction they can develop about their own mindset as investors. The more confidence they have, the better they will fare as individuals in a discipline where peer-validation is poison and the herd is always wrong.
If that’s not for you, then there is a lucrative future to be had working at a venture bank.
