What does great really look like
Unraveling the enigma: A voyage across the globe in search of the golden fleece of VC funds
Investing in Venture Capital (VC) has often been likened to searching for diamonds in the rough. With an eye for identifying the next Apple, Amazon, or Google, investors have to sift through countless opportunities, a process that can be both time-consuming and error-prone. For many, the alternative has been to invest in multiple VC funds, which allows for diversified exposure to an assortment of promising startups. Yet, that’s a dangerous game to play on your own!
A narrow lens can limit the breadth and depth of your portfolio: the VC landscape is a global field, brimming with hidden gems hard to benchmark.
Good is not enough in a power law game
Lack of a global view
Imagine this typical scenario: An investor looking to enter the VC world has ties with some local VC firms. Despite these firms' reputable track records, this strategy does not necessarily secure the investor a spot in the next 'unicorn's' victory march. Simply put, a narrow field of view fails to capture the true picture of global opportunities. VC investments do not abide by local boundaries - they are a worldwide phenomenon, with leading-edge firms emerging from every nook and corner of the planet. By focusing solely on a local network, an investor is inherently limiting their portfolio's potential - ‘availability bias’ is a treacherous phenomenon: just because it’s top of mind or close to you it doesn’t mean it’s the best out there.
The top 1% enigma
Next, there's the crucial issue of accurate benchmarking. Public databases and disclosed performance reports fall short in providing a comprehensive picture of the VC world.
Here’s an intriguing enigma: The top 1% funds, much like the elusive Bengal tiger or the secretive narwhal, operate in the shadows, far from public scrutiny. Their stellar performance and impressive track record are often unknown outside a select circle, giving them a somewhat mystical aura. Why’s that? Well, these elite funds are not incentivised to share their performance data in the public domain. Nor do they need to proactively seek out new investors: their LPs are often more than willing to re-up their commitments, often with even larger capital infusions. As they start producing crazy high returns, they also frequently metamorphose into family offices, further reducing the need for external publicity: they have the luxury of choosing their investors, making it a Herculean task for a newcomer to get a foot in the door (think about that: can you invest in Founders Fund?).
So what does this mean for you as an investor seeking to deploy capital? The odds of you stumbling upon the data of an underperforming fund are astronomically higher than encountering the golden fleece of the top 1% funds. The disparity is akin to finding a common pebble versus unearthing a rare, uncut diamond.
Inaccurate benchmarking
Back to the data - more than simply being incomplete, they can also be misleading if not properly interpreted. Investors could inadvertently compare 'apples to oranges', so to speak, if they do not account for the nuances inherent to VC investment data. For instance, comparing funds across different vintages can skew perceptions of performance. A VC fund's returns are heavily influenced by macroeconomic cycles - a fund launched in a boom period may show stellar initial results, while one started in a downturn may appear less promising.
Consider the phenomenon of different vintages in the recent crypto space, for instance. A crypto fund that started just ahead of the 2020-2021 bull run could have experienced a significant early boost, but it’s value probably collapsed over the following two years, whereas one established right during the bear market of 2017 may have initially struggled to then get a stellar performance after 5 years. Benchmarking these funds against each other without considering the context could lead to misguided investment decisions.
You need great
Getting to a global perspective
Enter the Fund of Funds (FoF) - the player with an edge. Operating within an extensive global network and fortified with connections to a multitude of funds, they have the means to survey investment landscapes far beyond local borders and dive into the dynamic throes of international markets. This amplified vision, akin to standing on a global lookout tower, serves as their first move towards maximising returns. Casting a wider net into this vast ocean of opportunities cultivates a larger catchment of potential victors, mitigating the risk of over-reliance on a single geographic region or sector.
Take this scenario for instance: A FoF manager, using their insider knowledge and relationships, makes contact with a top-performing VC firm tucked away in the bustling metropolis of Bangalore. As they peel back layers of data, they uncover invaluable insights about the fund's performance, their unique positioning within the local market, their promising portfolio companies, their visionary founders, and the powerhouse backers who believe in them.
This engagement is not a one-off event. As the manager encounters more Indian funds, each interaction enriches their understanding, providing additional touchpoints for evaluation and comparison. It's akin to piecing together a complex jigsaw puzzle; every new piece - every new insight - adds definition, clarity, and depth, ultimately revealing a comprehensive and unique picture that few other investors can see. The result? A strategic, well-informed investment decision that's backed by in-depth knowledge and insights, paving the path towards potentially higher returns.
The top 1% solution
As for tracking down the top 1%, how does one navigate this labyrinth? The solution is threefold: becoming an insider, employing aggressive outbound sourcing, and maintaining a meticulous, extensive screening and benchmarking process (more on this below). It's akin to being an intrepid explorer, tirelessly journeying through uncharted territories, scouring hundreds of potential sites before discovering the prized treasure. By sieving through the sand of mediocrity and digging deeper than most, the FoF approach allows investors to unearth these hidden jewels - the top 1% funds, the true powerhouses driving the VC industry's extreme power law returns.
Accurate benchmarking
When it comes to benchmarking, it’s all about getting benchmarks that aren't derived from generic public reports, but are based on real, on-ground data from the top players in the market - the ones that usually stay off the public radar.
Back to the example of crypto funds - To compare these gunslinging investments accurately, we must match them with their contemporaries. Even a few months gap in their launch dates can ripple out vast differences in performance, just like the go-getters that sprang up during the dot-com bubble around 2000. Geography focus is critical too - now, it's not just about the breadth of your global reach, but rather the depth of your understanding of regional VC ecosystems. From Silicon Valley to Nairobi to Rome, each area presents a different stage of maturity. Imagine pitting a 2010 vintage fund investing in emerging African or Italian markets against a veteran fund geared towards the tried-and-true US market. It’s like putting a rookie player in the ring with a seasoned champion (and what they can gain and lose is completely different). Likewise, the focus of the fund — whether it's zeroed in on a specific sector or stage — requires a comparable benchmark. Fund and portfolio size are other metrics to consider as well: it’s hard to expect the same performance from a $10M and a $1B funds - To get a clear picture, these factors (and many more!) must be evaluated to establish a valid benchmark. After all, proper comparison isn't just about looking at the numbers, it's about understanding the story behind them.
This approach not only offers more accurate benchmarks, but it also allows to allocate capital strategically. You're not just spreading investments across different funds, you're carefully picking the ones that can deliver superior performance, sizing investments and dynamically managing your portfolio with co-investments and secondaries based on solid, validated data. This approach has more than just theoretical appeal; it's the engine driving tangible growth in investment performance. It's not about crafting a sales pitch - it's about creating an investment strategy that's grounded in reality and fine-tuned to deliver exceptional results. The proof, as they say, is in the pudding.
Diversification? No thanks
Some may posit that the essence of selecting and investing in multiple funds (or a FoF) historically lied in diversification - trading potentially high returns for a predictable, low-risk future. Isn’t that the case anymore? Well, even even in this case one must not fall into deception, comparing again apples to oranges.
The ideal strategy for an investor isn't just about spreading bets across a variety of VC firm. Rather, it's about leveraging the principles we've previously discussed to find the true outliers amidst the cosmos of venture capital. The elite funds identified become the engine that drive outlier returns. By investing in them, and doubling down on outlier companies, an investor can achieve not only diversification, but also unlock an upside potential that probabilistically far surpasses the reach of a single fund investment. Actually, Jordan recently wrote about the fallacy of thinking that a FoF strategy, investing in multiple funds, simply mirrors an index1, and we’ll soon deep dive into the mathematic foundation to that.
In conclusion, while direct investing in multiple VC firms can offer high returns, it carries significant risks and limitations. You have to think hard whether it’s a game you want to play on your own! A well-executed multi-fund investment strategy can be likened to an artful chess move in the grand game of venture capital, promising a globally encompassing and strategically honed method to back the outliers in a world where the power law reigns supreme.
In the quest for the next big return, the strategy of casting a wider, still more fine-grained2 net could be the key to striking 'venture gold.'
PS: Yes, a FoF structure adds another layer of fees, but this should be viewed in light of the value it delivers. Paying e.g., 1% more, can lead to exponentially better return even if one is even just 10% better at selecting managers - Yavuzhan and I will soon write an in-depth analysis on this.
Interesting bunch of thoughts, but it has me wondering who the audience is for these insights? Founders? LPs? Not clear, at least in my reading of it. But, I could be wrong.