Follow me @samirkaji for my thoughts on the venture market, with a focus on the continued evolution of the VC landscape.
Over the last 20 years, venture capital has increased its place in investor portfolios, primarily owing to a few factors: 1) Performance of the asset category relative to other categories (top quartile VC according to Cambridge Associates has averaged nearly a 28% net IRR from 1996-2019 2) Growing length of time tech companies stay private (over the past 25 years, we’ve seen the duration to exit go from 4 years to over 8 years) and 3) Increased influence of technology in our everyday lives.
For high-net worth investors, venture capital has historically been only 5-15% of their portfolios. However, as we’ve said many times, venture capital is something that is easy to do poorly, and very difficult to get right.
As such, it's crucial for Limited Partners (LPs) to be aware of common pitfalls and navigate their venture capital strategies with careful planning. Here are some common mistakes we see:
Investing cyclically: The venture capital landscape is not immune to market cycles. The investor frenzy that we witnessed from 2019-2021, followed by a retreat in 2022-2023, is a testament to this fact. Historical Cambridge data suggests that the top-quartile returns increased by 27% and 38% in the five vintage years following a correction, compared to the three years leading up to it. This underscores the importance of consistency in VC investing across market cycles and vintage years. A long-term commitment to VC allows the asset to self-fund over time (typically by years five or six), mitigating the risks of high-point investing (and missing out on down market vintage years). It's prudent for investors to establish a desired asset allocation and maintain consistency in annual deployments.
Overrating track records: Track records are an important glimpse into a manager’s ability to execute. However, while it provides a reference point, it may not always be a strong proxy for future performance. Though studies have shown some level of performance persistence in venture capital, the reasons typically have to do with the “why” and “how” a manager has succeeded (or not). Additionally, track records take a long time to truly provide an accurate representation of a manager’s probability to perform. When looking at track records, investors must also consider micro (team / fund size) and macro (competition, economic) when making an ex-ante decision on a manager. In recent years, valuation methodology also needs to be further examined as it’s often possible a track record may be inflated (or deflated) due to the holding value a fund is keeping of a particular asset. A nuanced understanding of VC is required to understand how to go deeper than headline numbers.
Treating Venture as an index: Venture capital is not a monolithic industry, but a multifaceted landscape where a small percentage of companies drive the bulk of returns. It is an outlier business, and it's crucial to understand that the narratives that often make headlines are overly simplistic.
According to indices from Cambridge and Pitchbook, top quartile VC has historically outperformed bottom quartile VC by over 20 points of net IRR per year since 1996. This significant dispersion of returns underscores the fact that, like other private fund categories, there are good VCs, and there are poor VCs. The difference is that the return dispersion between these groups is vastly more prominent in VC.
As venture capital has fragmented across firm and fund types and stages, it's become increasingly challenging for investors to distinguish between opportunities. For instance, a $20MM seed stage fund cannot be compared to a $2B venture fund simply from a cash on cash return potential standpoint without assessing risk, cash flow (time to liquidity), and other relevant factors.
The venture market has arguably broken into three very distinct categories - small seed stage firms, multi-stage early stage funds, and growth-focused funds. Comparing funds across cohorts that have very different characteristics often leads LPs to inaccurate and incomplete comparisons.
Fees: When it comes to fees, they are indeed an important metric and need to be taken into account. However, the ultimate objective when investing in VC is maximizing net return performance. We often hear investors state they won’t invest in funds over the long time standard of 2/20. Instead, the analysis should be whether the fee structure presented by the manager is justified and can still provide the appropriate performance (i.e., top quartile returns).
Many of the top funds, including Sequoia, have 30% carry structures, yet they have consistently provided performance to investors. Fees shouldn’t be ignored in the analysis, of course, but they shouldn’t be a single data point to be dogmatic around.
Ad-hoc Investing: A common pitfall in VC investing is the tendency to select funds based on a one-off assessment, without enough evaluation as to overall portfolio fit. Successful VC investing requires careful portfolio construction and an understanding of how different investments correlate. It's not just about picking winners; it's about building a balanced, diversified portfolio that can weather market volatility and deliver sustainable returns.
Momentum Investing: The Fear of Missing Out (FOMO) is a common phenomenon in VC. Whether it's market-based (like the late-stage investing frenzy of 2019-2021) or sector-based (AI funds, Web3 funds), caution is definitely advised. When trends become hot and apparent to everyone, marginal companies get funded at inflated valuations, increasing risk and depressing returns.
Market Timing: The average VC fund deploys capital over 3-6 years, yet some investors attempt to time the market, waiting for valuations to decrease further or something else to happen. In a long-dated asset category like VC, where funds have built-in time diversification, market timing is ineffective and often counters return optimization. The focus should be on deal quality and manager expertise, not on trying to predict market movements.
Self-sourcing direct deals: While investing directly in companies and co-investments can be exciting, it's also risky. Most startups don't return 1x capital, and if you're not fully immersed in the field, the risk of adverse selection is high. We've seen individuals invest in companies based on their networks, only to underperform due to the skewed risk/return profile of these deals. Remember, over half of VC funds each year, run by full time professionals, underperform (below median) relative to expectations. A more effective approach is to start with fund investments and gradually move towards sponsor led co-invests, and then ultimately self-sourced direct deals.
Diversification: Diversification is crucial in VC, both across time and managers. Each year, 30-50 companies (at the high end) drive the majority of returns. Ensuring sufficient coverage, particularly in early-stage investing, is key to capturing these winners.
VC investing is a complex and dynamic field that requires a strategic approach, a long-term perspective, and a deep understanding of market dynamics. It's not about chasing trends or timing the market; it's about building a diversified portfolio, staying committed through market cycles, and focusing on deal quality and manager expertise. As we navigate the venture capital landscape, Venture capital (VC) is a journey, not a sprint. It's a marathon that demands a steady pace, a clear vision, and an unwavering commitment to the long game. The venture capital landscape, with its ebbs and flows, the rise and fall of trends, and the constant evolution of sectors and technologies, is a dynamic and complex field. As such, it's crucial for Limited Partners (LPs) to be aware of common pitfalls and navigate their investment strategies with prudence and foresight.
Great observations. +1 on Treating Venture as an index. Too many LPs lump all pre-public investing together. VC is, of course, not one but several asset classes.