Venture Capital: Hindsight Does Not Equal Foresight
Georges van Hoegaerden is an active critic of the venture capital system and is working hard to reform it. Here is an extract from his latest post:
The recently spawned statistical hindsight by reporting firms covering Venture returns post 9/11 has suddenly produced a new crop of followers to criticize Venture, with one problem. Hindsight does not produce foresight, and leaves many looking for short-term trailing micro-indicators rather than macro-economic compatibility and rudimentary principles of risk.
...Now, some suggest that the solution to Venture is to simply hang in, or use escapism in one of its many flavors to either constrict its workings further, lower risk even more, adjust management fees or exit out of Venture altogether.
The bottom feeders of the ecosystem fed by the attention from zealous media reporting (that still confuses stage with risk), popularize the oxymoron of Angel and micro-VC investing that yield even less scalable and smaller absolute returns than VC, and employs even more deflated risk profiles and a debilitating outcome to the production of Social Economic Value public markets care about.The problem with Venture is that it is broken on many fronts, all of which are responsible for the improper deployment of risk. Let's list a few important ones:
- Endless diversification
Most Limited Partners I speak with are completely unaware of the deployment of no less than thirteen (13!) levels of bottom-heavy diversification of risk in Venture with the money they ultimately make available to entrepreneurs.
Think of it in simple terms: if I were to tell you that there are thirteen roads to drive to the beach, some or all intersecting with each other at one point, which one would you take at what point in time, and what town would you end up in?
Go ahead and read the private placement memorandums from Venture Capital firms like I have, and you will notice how Limited Partners in Venture have overwhelmingly invested in a thesis that does not list a critical path, but merely state a desire to end up on a beach.
Multi-level bottom-heavy diversification in any financial system serves as the ultimate detection that the original asset holder is being taken for a ride. And Limited Partners have been taken for ride, not just because they themselves deployed insufficient investment discipline.
- Endless Fragmentation
In order to make their entry in Venture worthwhile against the other asset classes Institutional Limited Partners invest in, no less than $1B needs to be put to work. Both Limited Partners and entrepreneurs (the asset holders) are taught to believe by Venture Capitalists (the derivative) that small is beautiful, blissfully ignoring the outcome of the false promise of their definition of capital efficiency and extreme fragmentation of dollars and risk. So much so that Venture Capital has turned into micro-private equity (or what we coin subprime VC).
So, in the end Limited Partners who thought they invested in Venture Capital have instead invested in (micro) private equity with the (micro) private equity returns as a result. Venture Capital the way it is deployed today yields incompatible risk/return ratios.
- Defunct innovation arbitrage
Technology does not create markets, it facilitates marketplaces. Technology is merely a distribution mechanism and a piece of the puzzle that enables the electronic facilitation of (in most cases already) existing macro-economic behavior. So, the reason why Venture Capitalists cannot generate significant returns is because their investment thesis centers around the development of technology, and fewer innovations rely solely on technology to become successful.
The investment thesis of Venture Capital from 40 years ago is simply no longer valid and yet the private placement memorandums (PPMs) have not fundamentally changed. Entrepreneurs with a more sustainable and economic approach to innovation are automatically rejected and Venture Capitalists have become stuck in their self-induced subprime maelstrom.
- Improper investment theses
Not just the lack of relevant operating experience lies at the bedrock of improper arbitrage of innovation but more importantly the improper assignment of risk to technology innovation. Unlike many Venture Capitalist may want you to believe, the risk of a technology Venture has nothing to do with the development of technology.
The risk of the Venture is associated with the propensity of the idea to attach to (ideally existing) macro-economic need. Hence the investment thesis in the private placement memorandums of VCs should state their ability and merit to recognize massive market pull, rather than technology push.
As a Venture Capitalist it means you now need to be a (macro) economist, with leadership operational startup experience and a technology background to assess the appropriately assess risk that will yield large Social Economic Value at the right price and time.
- Unnecessary new risk
Collusion and price-setting is not only prevalent with Angels (as Mike Arrington from TechCrunch alleged recently), it has been a daily practice of Venture Capitalists on Sand Hill Road for the last twenty years. While that is not only morally wrong, syndication of deals using those schemes not only violates free-market principles and hurts entrepreneurs, it also focuses rather than diversifies the risk Limited Partners meant to deploy by spreading investments across multiple VC firms.
Venture Capitalist have created new unnecessary risk by getting away with a soft and improper investment thesis in the PPM, and the deployment of an impromptu investment cartel (I can write a book about what I have witnessed here) for every deal they encounter, knowing full well that entrepreneurs have no other way than to obey to the cartel as their only path of securing a funding runway consisting of several rounds of spoon fed investments, or else be deemed and echoed in the Valley as "impossible to work with".
Because of the systemic dysfunction mentioned above Venture cannot and will not automatically recover. The improper deployment of risk can never make up for the passing of time, or the miraculous recovery of public markets, or the perpetuation of fear which increases protection of downside.
Venture can make an instantaneous recovery when it is reinvented (we have), from top-to-bottom, so its foundational principles are in line with the free-market principles we boast about so often but we implement so poorly.
The reason why we have not performed in Venture is because we lie to ourselves, and those lies only serve the derivative in Venture well. But unless we meet the needs of the real asset holders in Venture, Limited Partners with money and entrepreneurs with ideas, nothing will change for the better.
Are you with me?