Nothing Ventured, Nothing Gained

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December 21, 2017

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Success in the venture capital industry today is about both identification of and access to top performing venture capital firms. In the past, access was the critical piece, leading to some even referring to this segment of the market as an “access class” as opposed to an asset class. Today, we believe that a well-constructed venture program is like a good recipe that requires many ingredients, the core components of which are access and identification with a meaningful touch of allocation to your best ideas. In addition to providing access to established “brand name” venture investors, our firm was built to sift through thousands of funds to identify the promising up-and-coming managers.

In public market investing, fund managers endeavor to predict future performance based largely on publicly-available company, industry, and market data. As a result of the efficiency of the public markets, it has become more difficult for stock picking managers to outperform. Given this dynamic, it has also become more difficult for capital allocators to pick the “right” active manager. Research shows that a fund rated 5 stars by Morningstar doesn’t perform much better than a 1-star fund over the long term. Further, Morningstar’s 5-star funds are on average rated 3 stars after 10 years, whereas 1-star funds are rated 1.9 stars after 10 years - making the difference between “top-quartile” mutual funds and the lowest quartile negligible at best. Only a handful of active management firms have been able to consistently and meaningfully outperform their respective benchmarks over long periods of time.

In contrast, performance in venture capital depends largely on, and results from, information asymmetry - that is, a fund manager’s ability to understand the business models and target markets of innovative private companies that often have no corresponding public market entity or readily-available data. Proprietary deal sourcing and a greater consistency in smaller fund sizes versus mutual fund counterparts also play important roles in generating excess returns in the VC asset class. As a result, the persistence of top-quartile venture managers’ performance has been found to be higher than in other asset classes. Ironically, although venture is considered a “riskier” asset class than public equities, one might argue that the asset class is steadier than perceived if one is investing with the top-quartile managers. Research suggests that general partners (GPs) whose funds outperform the industry in one fund are likely to outperform the industry in the next. (GPs who underperform are likely to repeat this underperformance, as well.) These findings are markedly different from the results for mutual funds, for which persistence has been difficult to detect and, when detected, tended to be driven by persistent underperformance rather than outperformance.

As a result of the performance persistence, it became a generally accepted principle to invest in only top-quartile venture managers or not at all. And investing in venture capital used to be that straightforward: get access to funds in the top quartile, re-up each time they raise new capital, and capture a very high percentage of all returns generated in the asset class. This led to the creation and utilization of venture funds-of-funds since many institutional investors seeking access to the asset class were unable to gain access to the top funds themselves. This worked well for many years. In fact, recent research has concluded that venture capital funds-of-funds performed just as well as investments made directly in venture capital funds.

But, now, the wash-rinse-repeat method to venture capital investing - which really only worked well for investors with inside connections to select managers - is becoming outdated and is not the only way to generate above-average returns today. One of the reasons is the expansion of the market opportunity. The asset class has become more mature and as a result is much more nuanced. In the past decade, the number of venture capital fund managers increased by 40% compared to the prior 10 years, according to PitchBook, with new funds emerging all the time.

“New and emerging firms consistently account for 40%–70% of the value creation in the top 100 investments over the past 10 years,” says a recent report from Cambridge Associates titled Venture Capital Disrupts Itself: Breaking the Concentration Curse. “The widely held belief that 90% of venture industry performance is generated by just the top 10 firms - which our analysis shows was somewhat relevant pre-2000 - is a catchy but unsupported claim that may lead investors to miss attractive opportunities with managers who can provide exposure to substantial value creation.”

So how did the venture capital market get here? What market and economic factors have contributed to a crowded, but also less hierarchical, venture capital sector? From our analysis, the new “bigger pie” venture capital model has come about due to five key changes in the asset class over the last 7-10 years.

  • More startups launching: In the last decade, 30% more startups were created than during the previous 10 years, according to PitchBook. Because of advances in cloud computing and enterprise infrastructure, startups now need just $3-5M to get started instead of $30-50M, resulting in a surge of company creation and a correspondingly large number of new venture capital funds targeting these early-stage companies.
  • A spike in the number of new funds: As noted above, the number of venture capital fund managers increased by 40% in the last decade, compared to the prior 10 years, according to PitchBook. The largest growth has occurred in the seed and early-stage sectors; we think this goes hand-in-hand with the fact that it’s far cheaper and faster to create new companies than even a decade ago.
  • New startup exit routes: With the initial public offering (“IPO”) market still recovering in fits and starts since the Global Financial Crisis, technology startups are relying more on mergers and acquisitions (“M&A”) to exit. Concurrently, the potential buyers of startups have expanded, with not just technology companies, but also large conglomerates such as GE, WalMart, and Unilever, purchasing startups to expand their offerings. Technology is no longer a vertical sector, but a horizontal one. According to our analysis of PitchBook data, these types of acquisitions have grown at a 47% CAGR since 2011 and accounted for almost $10 billion in total value in 2016. The increased level of M&A activity has generated meaningful liquidity for venture capital limited partners (“LPs”). We believe that this, in turn, has resulted in LPs becoming more liberal with their commitments and perhaps having higher risk tolerance at a time when there are also more emerging managers raising capital.
  • The rise of data science for deal sourcing and due diligence: Data analytics software has helped the venture capital industry, like many other sectors, become more measurable and quantitative, allowing investors to choose funds or startups based on data models instead of just qualitative metrics like personal networks, founder track record, or competitive comparisons. At Greenspring, we have built an extensive proprietary database to track approximately 6,500 portfolio companies. In turn, this database informs key quantitative aspects of our sourcing and due diligence process. Some emerging venture firms take data a step further, leveraging metrics as their principal method of deal sourcing. We believe this dynamic is a differentiator for firms today, but will become table stakes for the industry in the long run.
  • Expansion of startup ecosystem: Founders are launching companies outside of the typical tech hubs like Silicon Valley, Boston, Seattle, New York, and Austin. One manager has coined the phrase, “Rise of the Rest,” to describe their nationwide effort to work with entrepreneurs in emerging start-up ecosystems. Companies like Chewy.com, headquartered in Dania Beach, Florida, and ExactTarget, headquartered in Indianapolis, Indiana are examples of high-growth companies that have achieved scale from non-traditional locations. While the tech hubs still produce the most startups, more entrepreneurs are starting to build billion-dollar businesses in other regions, encouraging venture funds to spring up in non-typical locales.

In the last seven years, Greenspring has evaluated 2,200 managers and invested in just 4.3% of them. Some of the managers we invest in are established organizations, while others are lesser known firms that we believe have differentiated models capable of generating outperformance. Regardless of their characterization, we strive to partner with firms that have deep sector-level expertise and often have hands-on experience running companies. We believe our three pronged platform - primary fund commitments, direct investments, and secondary investments - combined with our data assets allow us to generate informational asymmetries and create a model capable of identifying and accessing top-performing and high-potential managers. It’s a more nuanced and labor intensive strategy than just targeting the top-quartile venture funds, but it’s also more aligned with today’s multifaceted industry. 

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