Venture capital is a seriously long-term game, with investments taking somewhere between 8 and 16 years to return liquidity.
The distance to that horizon creates a lot of eccentricity.
For example, VC does not reward following patterns or navigating market movements, neither of which is relevant to decade-long cycles. Consensus of pretty much any kind is toxic, as the more people agree with something the less profitable it becomes. Investment experience is like comfortable entropy, slowly eating-away at your ability to remain objective.
In a sense, success itself is antimemetic: the better the outcome of an investment, the more likely you are to try and repeat it through pattern matching — destroying the calibration which allowed you to find it in the first place.
Can you imagine how maddening that is?
This is why the best GPs are oddballs. They live with the paradox that being a ‘good investor’ is a process of constant discovery, and the more lost you feel the better you are probably doing.
It takes a certain madness to do well, and that is not something you can pick up on the job. You cannot be taught how to think in a contrarian manner. Nobody can give you the confidence required to wait a decade to see if you have good judgement. You have it, or you don’t.
This is why great VCs earn a lot of respect. The role they play in financing entrepreneurial dreams is critical. From the semiconductor origins of Silicon Valley to SpaceX and our future on other planets, someone had to be there to write the check.
If the incentives were well aligned, that’s where this story would end — as a fan-letter to weirdos. VC would remain a cottage industry investing in wacky stuff, offering strong returns for LPs.
Unfortunately, that is not the case.
Over the past decade we’ve seen the emergence of a new type of VC: one who moves between trends with the swagger of a heat-seeking missile, investing as if their money might go bad. This behavior is contrary to pretty much everything that we know about venture capital, and yet the trend has only accelerated.
To understand why, we have to look at VC compensation:
The ‘2 and 20’ structure of VC compensation is pretty well understood and has remained unchanged for a long time: You get 2% of the fund per year in ‘management fees’ to pay your bills and support portfolio companies, and 20% of ‘carried interest’ as a share in any profits made.1
For people passionate about the outliers, carried interest is the hook. Secure enough big wins and you can make a vast amount of money, in contrast to management fees which aren’t exactly lucrative for a small fund. It’s also nice that carried interest aligns success of the firm with success of the founders.
However, as capital flooded into private markets over the last couple of decades, and exits took longer to materialise, some cunning individuals recognised an opportunity: the 2% is guaranteed, independent of performance, and it is possible to ‘hack’ venture to maximise that income.
You can do things the old fashioned way, raising (for example) two $100,000,000 funds in a ten year period, with the implied annual income of $4,000,000. Alternatively, you can squeeze three funds into that period, at double the size, and scale your income to a mighty $12,000,000. All without really needing to worry about underlying performance.
To build that second scenario, you need to do three things:
- Invest in the most overheated, capital-intensive industries, which allow you to justify raising and deploying larger funds ever more quickly. These industries are also an easy-sell for LPs, who want something to talk about at dinner parties.
- Systematically undermine the understanding of valuation by promoting crude and illogical practices, and calling people nerds if they say things like “free cash flow”. Venture is a craft, not a science — which basically gives you carte blanche, right?
- Pour capital into brand and status building for your firm, which LPs love. Celebrities, political figures, impressive offices, big events… Anything that shows them you’re a serious institution (with the perks that entails) and not some garage-band firm.
Instead of looking 8 to 16 years in the future with your portfolio, you want to focus on the next 2 to 3 years in order to align with your fundraising cycles. You want companies that are likely to grow in value rapidly in the near future, so hype and consensus are powerful allies.
The aim is to invest in a company at Seed and propel it to a Series A within 2 years at a 4-5x markup, which — if you can repeat it often enough — will look great to LPs. If they ask about DPI just talk about how the IPO markets should open next quarter next year.2
It doesn’t even matter if you don’t think your portfolio companies are attractive investment with that markup, as there’s no obligation to participate. You have the growth on your books to help you raise the next fund, and some compliant downstream bag-holders, that’s all that matters.
You can even build this strategy into how you price deals. Rather than try to objectively value the business, just tell founders to think about what a reasonable Series A price would look like for them, and then divide it by 3 for the Seed. That way, you’ve got the expectation of at least a 3x markup already built-in to the investment!
You want to make sure the heat persists, to ensure prices at later stages remain frothy and your markups get better and better. So consider a bit of thought leadership to keep interest on your chosen sector. As long as LPs believe the hype, and keep investing in other funds on that theme, capital will keep piling in. Amplify that market momentum as much as possible. Volatility is your friend, and over time it can even help you wash out smaller managers that offer an unfavourable comparison on performance.
Obviously the actual investment returns from this strategy are likely to be terrible, unless you’ve somehow timed another ZIRP/2021 exit phenomenon and can unload all of your crap on the public markets just before the music stops. It doesn’t really matter, because the median return in VC is so poor that you might just luck your way into top quartile anyway. Keep the paper marks strong, keep bullshitting LPs about the market conditions and the insane potential of whatever it is you are investing in, and you can probably keep buying back in with a new fund.
It’s going to be toxic to founders, as they watch huge piles of capital being incinerated chasing hype instead of genuine innovation.
It’s going to be toxic to innovation, as founders increasingly choose to pursue ideas that they think VCs will back, rather than real passion projects.
It’s going to be toxic to VCs, as good practices around markups, pricing and portfolio management are ditched in favour of capital velocity and short-term incentives. It’s already frighteningly clear how much basic investing knowledge washed out of VC during ZIRP.
It’s going to be toxic to LPs as already pretty shitty performance metrics for venture capital get even worse.
- The management fee is often frontloaded and scales back after the investment period. The 20% carried interest may also have a hurdle rate (e.g. 8%) which guarantees some return on investment for LPs before they split profits with the VC. [↩]
- It might not matter though, as many institutional LP allocators collect their bonuses on markups, so their incentives are totally aligned with yours. They’ll probably have moved on to a new job in a few years anyway. [↩]