Putting on a VC Hat
Ask A CIO #21
I kicked off this newsletter, sort of on a whim, back in May. My co-founders and I were chatting about some random topic, and I confessed to loving advice columns. We had previously batted around the idea of starting a newsletter for Ivy Invest, and suddenly, this seemed like the obvious format.
Since then, we’ve covered a pretty wide range of investment strategies (private equity secondaries, direct lending, specialty finance, risk parity, international equities, etc.) and other odds and ends investment related topics. Hopefully it’s been useful and informative!
This week’s question is about venture capital, which I was surprised to realize we haven’t previously covered.
How do you think about multi-decade old venture firms vs newer venture firms? How do you think about the advantages held by the older, established firms?
We haven’t really touched on venture investing here in the newsletter, but your question presents the perfect opportunity!
For those who are less familiar, venture capital is the business of investing in start-up companies. For the sake of keeping things simple and high level in this discussion, and because I think it’s more relevant for your question, let’s focus only on early stage venture capital.1
For as much as every asset class has its quirks, early stage venture capital still stands apart. Whereas most other asset classes are directly or indirectly tied into broader capital markets, early stage venture really isn’t.2 And by being somewhat divorced from the rest of the investment world, early stage venture capital often marches to the beat of its own drum. The investment framework, portfolio construction, ecosystem, etc. looks very different in venture versus other asset classes.
In many pockets of investing, when an investor is considering buying a thing, there is usually a current price or some observable inputs to figure out a reasonable approximation of value. When considering whether to buy the thing, an investor’s evaluation process might include some version of:
what is the potential downside?
what are the possible outcomes, the likelihood of those outcomes, and the potential returns from those outcomes (i.e. what is the likely future value of this thing)?
andis the combined risk/return profile compelling?
In this framework, an investor is typically looking to make a series of compelling, risk-aware investments. Great investments might slip by from time to time, and that’s ok. The bigger sin is arguably that of commission – investing in a very bad investment that leads to significant impairment of capital, or potentially worst of all, a total loss on that investment.
The early stage venture framework is usually very different. At the earliest stages of venture capital (particularly pre-seed/seed), companies can have seemingly arbitrary values.3 When considering whether to invest in a thing, a venture investor’s evaluation process basically boils down to – do I believe this thing is an outlier that can generate 100x (or higher) return on the dollars I invest?
All of a sudden, risk looks different. After all, the most that can be lost are the dollars invested. But the opportunity cost of missing out on an outlier investment could be 100x the dollars invested. And so in venture, unlike just about every other kind of investing, the far bigger sin is arguably that of omission – not investing in the outlier investments that just don’t come along that often. In other words, the FOMO is real.
Now, tying it back to your question. If the greatest risk is missing out, then the most important condition is to have the opportunity and choice to invest in the first place. Investment success for an early stage venture firm in many ways starts and ends with sourcing and deal flow.
When I think about where a multi-decade old venture firm might have a strategic advantage, I think about how the brand and visibility of these firms reinforces their ability to attract robust inbound deal flow. Of course I would expect that institutional knowledge, networks, pattern recognition, and experience all accrue over time to make these firms better at identifying big trends and great investments. I would expect that these established firms have thoughtful approaches around ownership, reserve and follow-on capital, and ways to support investments for the best odds of success. But it still starts with having the necessary deal flow to make it all work.
Strong deal flow increases the odds of seeing the best investments, which is a necessary precondition to being in the best investments. Being in the best investments begets strong fund performance which begets more deal flow. And in venture capital, more so than in other private markets, there appears to be greater persistence of performance (i.e. managers that do well continue to do well).4 I would expect that this virtuous cycle contributes to that persistence.
But of course, it’s rarely that simple. Multi-decade old firms also often have to contend with leadership transitions, more complex organizations, and (perhaps the biggest challenge) larger fund sizes. Newer venture firms may need to work harder to establish their place in the market, but the math to generate high returns for their limited partner investors can be a little (or a lot) easier based on the smaller fund sizes.5
All that said, perhaps you were trying to get at the question of why so many institutional LPs appear to favor large, established venture firms over smaller firms (even though the data on performance suggests perhaps they shouldn’t)?6 Well, that would be a much longer and hairier discussion on governance, resources, and incentives. Maybe we leave that for another day.
Thanks for joining this week, and as always, reach out with questions: askacio@ivyinvest.co!
Until next week,
Wendy
Everything from pre-seed/seed to let’s say, series B. For those less familiar, pre-seed/seed is the earliest stage of a company, everything from just an idea and business plan to a product newly in market. The next round of investment is called the Series A and typically occurs if a company reaches product-market fit. The following round of investment is called the Series B, and so forth. We can debate whether Series B is still early stage, but certainly anything after would be considered late stage/growth and a different value proposition.
Some might argue the availability of the IPO window impacts growth and late stage venture, which has knock on effects for early stage, but I think that’s a stretch.
Early stage venture company valuations are basically whatever the broader venture ecosystem coalesces around as a reasonable valuation for companies at that same stage, because why not?
Journal of Corporate Finance, Volume 81, August 2023