Profitable Investment Opportunities Definition

Profitable Investment Opportunities Definition – Many newcomers to venture capital fail to appreciate some of the nuances that distinguish venture capital from traditional forms of financial investment. This article examines three areas that new venture investors should understand.

From humble beginnings, the venture capital (VC) industry has grown into one of the most significant and certainly well-known asset classes within private equity. Venture-backed startups have redefined entire industry concepts, with some of the pioneers usurping traditional oil and banking giants to become the most valuable companies in the world. The venture capitalists who backed them also took their place in the spotlight, with the likes of Marc Andreessen, Fred Wilson and Bill Gurley gaining recognition far beyond the confines of Sand Hill Road. You can compare this cult of personality to the “corporate raider” era of the 1980s, when Michael Milken

Profitable Investment Opportunities Definition

Partly as a result, the venture capital space has seen an influx of participants and experts. First-time fund managers continue to raise new venture capital funds at a steady rate, and the once clear lines separating venture capital from private equity, growth capital and other private asset classes have begun to blur. Corporations have also moved into the space, creating venture subsidiaries and participating in startup financing at increasingly higher levels. And perhaps the biggest sign of the times is that celebrities are increasingly throwing their hat into the startup investment chain. As John McDulling says,

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Venture capital has become [one of] the most glamorous and exciting corners of finance. In the past, rich heirs founded record companies or tried to produce films, but now they invest in start-up companies.

Success in venture capital is not easy. Indeed, while valuation data for the asset class as a whole is scarce (and performance data for individual funds even harder to find), it is clear that the asset class has not always lived up to expectations. As the Kauffman Foundation points out,

Venture capital returns have not significantly outperformed the public market since the late 1990s, and since 1997, less money has been returned to investors than was invested in venture capital.

Even the best-known venture funds have been scrutinized for their performance: In late 2016, leaked data showed that the results for Andreessen Horowitz’s top three funds weren’t all that impressive.

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The reasons for this poor performance are, of course, varied and complex. Some still believe we may be in a bubble, which, if true, could explain the poor performance of many funds (inflated valuations, slowing exits and declining IRRs). Others argue that current fund structures are not properly set up to encourage good performance. Scott Kupor’s account of the leaked results from Andreesen Horowitz was that a lack of broader understanding of the performance of the value equity asset class was driving the negative rhetoric.

But while all of this may or may not be true, another potential reason for the poor performance of many funds is that they are not following some of the basic principles of venture capital investing. As ex-bankers and consultants recast themselves as venture capitalists, they fail to assimilate some of the key differences that separate more established finance and investment activities from a different form of venture capital.

To be clear, I’m firmly in that camp. As someone who made the transition from the more traditional fields of finance to the world of venture capital, I have witnessed first hand the differences between these activities. I am by no means a venture capital sage, but through continuous learning I recognize and respect some of the important nuances that distinguish venture capital from other investment activities. Therefore, the purpose of this article is to highlight three, in my opinion, most important VC portfolio tactics that many participants in the space fail to master.

The first and perhaps most important concept to understand is that venture capital is a game of domestic results, not averages. By this we mean that, when thinking about putting together a venture capital portfolio, it is extremely important to understand that the majority of the fund’s return will be achieved by a very small number of portfolio companies. This has two very important implications for the day-to-day activities of the entrepreneurial investor:

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For many, especially those with traditional financial backgrounds, this way of thinking is puzzling and counterintuitive. A traditional financial portfolio management strategy assumes that asset returns are normally distributed in accordance with the efficient market hypothesis and that therefore most portfolios achieve their returns evenly across all segments. Analysis of a 66-year sample of one-day returns from the S&P 500 actually matches this bell curve effect, where the mode of the portfolio is more or less its mean.

Departing from the more liquid public markets, private market investment strategies also strongly emphasize the need for careful portfolio balancing and downside risk management. In an interview with Bloomberg, legendary private equity investor Henry Kravis said the following:

When I was in my early 30s at Bear Stearns, I was having drinks after work with a friend of my dad’s who was an entrepreneur and owned a bunch of companies. Never worry about what you might earn at the top, he would say. Always worry about what you can lose on the downside. And that was a big lesson for me because I was young. All I was concerned about was trying to close a deal for my investors and hopefully myself. But you know, when you’re young, you often don’t worry about things going wrong. I guess as you get older you worry about it because a lot of things have gone wrong.

And leaving aside what financial theory teaches us in general, VC Chris Dixon mentions how adversity to losses can be a built-in human mechanism:

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Behavioral economists have shown that people feel much worse about losses of a certain size than they feel good about gains of the same size. Losing money is unpleasant, even if it is part of an investment strategy that is generally successful.

But the crux of the matter with venture capital investing is that the above mindset is completely wrong and counterproductive. Let’s see why this is so.

Most new companies die. Like it or not, this happens a lot. Unfortunately, there is enough data to confirm this. The US Department of Labor, for example, estimates that the survival rate of all small businesses after five years is approximately 50% and drops dramatically to the lowest 20% over time. When it comes to startup investments from venture capital funds, the data is more ambiguous. A study by Correlation Ventures of 21,640 financings between 2004 and 2013 found that 65% of venture capital deals returned less than the capital invested in them, a finding supported by a similar data set from Horsley Bridge, a major PE in several US venture capital funds, which reviewed 7,000 of their investments from 1975 to 2014.

Careful readers may, of course, note that the failure rate of initial investments may simply be skewed upward by a series of bad funds that have invested poorly. And they would be forgiven for thinking so. But the fascinating result of the data from Horsley Bridge is that this is not actually true. On the contrary, the best funds had more hits than the mediocre funds. Even weighted by the amount invested per job, the picture is unchanged.

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In other words, the data shows that the number of failed VC investments does not appear to reduce the fund’s overall return. This actually suggests that the two may be inversely proportional. But if that’s the case, then what drives hedge fund performance?

What matters is the other side of the coin: home runs. And that for the most part. Going back to Horsley Bridge’s data, it’s clear that the top-performing fund returns mostly come from a select few investments that end up delivering huge results. For funds that had returns greater than 5x, less than 20% of trades accounted for roughly 90% of the funds’ returns. This provides a tangible example of the 80/20 Pareto principle that exists in VC.

But it goes further than that: not only do better funds have more home runs (and as we saw above, more strikeouts), they have

Running around. As Chris Dixon says, “Great funds don’t just have more home runs, they hit more home runs,” or as Ben Evans says, “The best venture capital funds don’t just have more failures and more big wins — they have more big wins.”

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No matter how one puts it, the end is clear. Fund-level venture capital returns are highly skewed relative to the returns of a few excellent successful portfolio investments. These investments ultimately make up the majority of the fund’s overall performance. It’s a Darwinian existence where there’s no time to sort out a stop-loss portfolio

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