The good funds like Marc’s (his first $300 million fund returned twice the invested capital) can raise bigger and bigger funds from being good operators and benefiting from concentrated deal flow via the information cascade. Others benefit from investing in illiquid private companies for which there is no floating, transparent share price.
Eighteen months into Cowboy Partners I, they are out raising for Cowboy Partners II, but at this time there’s very little to show in terms of tangible financials for most of the companies their first fund invested in. Many of the companies will have yet to generate any revenue at all. However a lot of these investments will be in the hype stage where they’ll be the darlings of TechCrunch and Hacker News and get a lot of press.
The metrics used to raise the next fund can be gamed if early in the first fund’s life a few quick-flip exits or valuation write-ups occur. This allows ‘manipulation’ of the Internal Rate of Return (IRR) of the fund. For example, a company that is sold and returns more than twice the invested capital in two years generates a 41% percent IRR, but the same multiple generated by a sale in year ten results is only a 7.2% IRR.
Josh Lerner, a professor at Harvard Business School and leading researcher on venture capital said, “When you look at how people report performance, there’s often a lot of gaming taking place in terms of how they manipulate the IRR”. IRR together with other funny metrics like ‘vintage year’ and ‘top-quartile’ performance is then used as marketing to raise a new, larger fund. These metrics are self-referential and relative measures which compare the fund to other funds, but don’t provide any information as to whether the fund is actually hitting the performance hurdle of 3 percent to 5 percent annual returns above the public markets that most investors expect from illiquid, risky venture capital investments.
The problem at this point is you still have limited bandwidth in terms of the deals you can do. Even a rockstar like Marc can only hire a certain number of rockstars to work in his fund. As a result you’re investing in a finite number of companies because you still need to do the work to ensure the investment is as successful as it can possibly be. Also there’s only a finite number of good companies worth investing in.
The problem becomes what on earth do you do with all this money? As we know in the public markets, the ability of fund managers to generate alpha (returns above market) gets smaller and smaller as their funds under management get bigger and bigger, because the universe of investments you can make gets smaller and smaller.
It’s tricky. The Kaufman report showed that over the last twenty years that only four of thirty venture capital funds with committed capital of more than $400 million that they invested in delivered returns better than those available from a publicly traded small cap common stock index.
Given the fact that investors in venture funds (called limited partners or LPs) can’t generally sell their positions and have to wait many years for the venture fund’s positions in companies to be realised (you cut your losers early and double down on your good ones), unless you’re investing in a top fund, you’re better off just investing in the public markets.
So investing the funds is not easy. In general, you can’t give $100 million in a series A to a company, although Marc is giving this a go with deals like the $100 million Series A in Github. You can try to spray and pray into early stage companies like what YCombinator and 500 Startups are doing, but the actual cost of starting Internet and software companies is dropping quickly.
Thanks to the combination and interactions of open source, Metcalfe’s Law, Nielsen’s Law and Moore’s Law, you only need to drip feed in $20,000 or so to get a feeling for whether the team can execute and the product or service has legs.
As a result, early stage investing has become quite capital efficient; investing in 500 early stage startups at $20,000 a pop only takes $10 million. While this isn’t going to scratch the sides of a billion dollar fund, it’s certainly going to denial of service the bandwidth of the general partners in the fund to deliver good advice and mentoring to each company.
Getting a return on spray and pray investing however is tough. Returns on portfolio investments are incredibly skewed and approximate to a power law distribution. Your losers will go to zero, with mediocre ones you are lucky to get your money back and great companies return 3-10 times.
Peter Thiel describes how the maths works in portfolio of venture investments as “to a first approximation, a VC portfolio will only make money if your best company investment ends up being worth more than your whole fund”.
If you are investing in 500, or even 100 startups, this can be tricky. As a case in point, Ron Conway, a “super-angel” of Silicon Valley, had Google in his second angel fund and it’s not quite clear if investors lost money or were lucky to get it back.
Sure, Andreessen Horowitz made $78 million off a $250,000 investment in Instagram, but he would have to find 51 more Instagrams to return the $4 billion in assets under management investors have provided if they solely invested this way. If you’re savvy enough you may however be able to cut a few of your losers early on through the growing trend of ‘acquihiring‘ them off to a big corporate and stag your IRR early on (great for your next fund).
Unless you start considering private equity type deals like Marc’s well executed $1.9 billion Skype buyout from eBay, the only way to deploy capital from these billion dollar funds is to invest greater and greater amounts into later and later stage companies.
This phenomenon has seen the rise over the last number years of gargantuan rounds; $1.5 billion in Facebook at a $50 billion pre-money valuation, $1.2 billion in Uber at a $17 billion pre-money, $950 million in Groupon (of which $345 million was secondary) at a $4.75 billion pre-money and $740 million in Cloudera at a $4.1 billion pre-money.
This has meant companies funded by the top firms in the US have been delaying going public, and it has been helped by the JOBS Act which increased the maximum number of shareholders from 500 to 2,000 that you can have until you’re forced to go public.
Of course, a lot of these companies invested in can’t actually deploy all these funds effectively, so large percentages of the rounds are not primary (new) issuance but secondary sales where the founders are cashing out large amounts of money before going public. From a founder’s perspective this is smart when 99.9% of your wealth is tied up in one asset.
The end result is the general public missing out on the spectacular gains that were experienced in the listed technology companies of yesteryear. Even though eBay’s share price went up a spectacular 163% on opening day, if you bought shares on market after this rise and held on until today you’d have made over 3,500%.
If you bought Amazon the day after it listed, you’d be up over 27,000%, and if you’d bought Microsoft at IPO in 1986, you’d be up 66,500% today and 3,000% in the first eight years alone. Unfortunately for the general public, not only are these returns being kept by venture capitalists to themselves, but the chance of them being able to invest in a good venture firm is between buckley’s and none.
This article was originally published on LinkedIn.
