Why Power Law Portfolio Construction Will Always Be Dead on Arrival in the Venture Capital Industry
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Let’s begin with a baseline truth. Statistics are subjective to the data used to generate them. A person can skew stats to make something factual, relevant, or a source for truth by highlighting specific data sets and hiding others. With enough effort, you can put lipstick on any pig. This is a good place for readers to start. I don’t want them to waste their time trying to justify what I consider a failing/failed idea.
Building a portfolio using “Power Law as a source for truth in early-stage investing (i.e. Venture capital is not only absurd, but it is also lazy and ignores fundamental facts. It is dangerous for investors who trust their money in GPs (General Partners), who “invest” using this portfolio building logic. Let’s get started.
How investing works
Let’s begin by understanding how investing works in ideal cases. The ultimate goal of investing is to maximize capital appreciation and reduce risk to its lowest common factor. Simply put, make as much money as possible while taking as little risk as possible relative to the annual return you desire. The way a person, company or fund invests in their money is generally through diversification. seeks to accomplish this goal is through diversification.
Essentially, you want to spread your investments across various asset classes in order to achieve your target rate of return annually. This will also protect you from huge losses when markets are not performing well. If you have a well-constructed portfolio, you can adjust your allocation percentages to match market conditions. This will help you to hedge against losses while still making some gains.
A good example would be the inverse relationship between equities and fixed-income investments. In general, when the equities markets is doing well, fixed-income is not. Therefore, you would have a greater percentage of your investments in equity to capture higher returns during a strong market. In a down market, the reverse would be true.
I have provided a basic example to illustrate what most investors strive to achieve long-term. The exciting thing about investing this way is that with the advent of mutual funds, ETFs and professional money management firms like Fidelity, Charles Schwab, etc. Passive investing is possible for most investors. This means that someone else manages your portfolio and you can relax and enjoy the returns.
Venture capital firms VC offer similar passive income-earning options. The difference is in the nature of what is being invested in. When you invest in stocks via a mutual fund, ETF, or similar, you are investing in mature, proven companies that are publicly traded and have often stood the test of age. Venture capital is different. Venture capital invests in startups with little or no track record. This is important to understand because the dynamics between a startup business and a mature company are very different. The challenge here is that the VC firms themselves are taking passive positions in early-stage companies using the Power Law as the core methodology for justification.
The problem with the Power Law model
Venture capitalists call the Power Law. It states that investing in more early-stage companies increases the chances of investors generating large returns. It is believed that a VC firm will invest in more early-stage companies (i.e. 35-50 per year) they have a higher probability of finding a company that will scale to the level of a unicorn (a company with a 1B valuation) or a decacorn (a company with a 10B valuation). The argument VCs make is that finding a unicorn or decacorn will allow them to create returns for their investors that will make up for the losses the VC firm has incurred along the search for a Unicorn and provide a nice profit for investors.
This sounds great in theory and looks even better when you add a lot of math to it. Math always makes things seem smarter that they actually are. This is due in large part to the fact that most people don’t know much about math. When you boil down this “investing” style to its simplest form, it’s just throwing stuff against the wall in the hope that something sticks. This is the basic premise, regardless of how complex the math involved, and no matter how smart the models are built to make it look smarter,
In general, the masses of the VC community over time have essentially convinced people that this approach is somehow something far more savvy, smart and that they should be trusted to invest other people’s capital this way, because it’s the best way — so just “trust them on that.” If you look at the BS models and math formulas, and keep it simple, you will see that VCs who invest in this way have no better chances of finding a unicorn and decacorn than blind men picking random companies from a hat.
That is not investing. That is speculating. It’s gambling. You can take all your money to the casino and play at the roulette table. 94 percent of venture capital-backed companies go on to fail! They either fail and the investors can’t recoup their capital or they are able to return the principal investment, but not the returns above the initial investment. Investing is about getting more money back than you invested. If a company is unable to give you back the amount you invested, it might be a good idea to just save your money and return the money later. A failure grade of 6% is not something that you need to be a math genius to grasp.
Why are investors still using this model?
How can VC firms invest like this? And why do investors continue to believe in these funds? The better question is: Why do VC firm GPs insist on this “investing” approach? Here is what I’ve observed: First, studies show that it takes the average venture capital-backed company a minimum of three years to mature into failure. It is easy for a company’s image to be rosier than it actually is. This is because it is flooded with investor capital. VC firms use the narrative created by their portfolio companies’ PR campaigns to demonstrate to their investors that they are making good investment decisions. LP investors, who don’t generally know much about the business or how it works, are fooled into believing the narrative and end investing more money with VC firms.
Regarding GPs, here is what I’ve observed: To raise capital, they often tout their “Ivy League” education and limited experience as a way to demonstrate their bona fides. It is not unusual to see phrases like “Harvard educated,” Ex-Googler,” Goldman Sachs alum,” etc. It would appear, at first glance, that the person or people who will manage the fund are highly qualified. The truth is that a college degree is almost irrelevant when it comes building a business. College won’t teach you how build a business. You learn that concept through trial and error. It’s a long and exhausting process of trying again and again, learning from your mistakes, and applying those lessons until you have enough experience and knowledge to make the right decisions. You can’t learn your way to experience. You have to actually work in a real-world setting.
You don’t know how many times I have discovered that the “Ex Googler” was actually an intern or had a title which sounded great but was really just the most junior member of the team. This is also true for many of these “Goldman Sachs alums”, who boast these credentials in the VC sector. Many GPs working in the VC sector spend between one and three years on Wall Street. This is not enough time to become an expert in any subject matter. Outliers by Malcolm Gladwell lays out the fact that it takes approximately 10 years to become a subject matter expert in anything.
This is why many VC firms support the “gambling approach” to investing in early-stage companies. They lack the necessary knowledge and experience to do more than just give money to someone else and hope for the best. It is not a good idea to invest in early-stage companies passively. It should be done actively. Venture capital firms should be active in investing in early-stage companies. They should bring their real-world experience and knowledge to the table to help founders, who are often inexperienced, create a viable company and product that can scale and thrive. I call this “accretive value proposition,” and accretive value is the only way you can de-risk early-stage investing and increase the number of companies that go on to exit.
It doesn’t matter how many companies you invest in. It’s about the time that you spend helping founders turn the companies you invested in into great companies. This can only be achieved if you have the right mix of real-world experience. IPO, LBO and M&A. How can you add value at the beginning if you haven’t seen the end? Successful exits share common themes. The only way to identify this is if you have actually been involved in exits. You can help founders build their companies to exit by understanding the common themes. This is what I call “Bringing the end to the start”. When you approach it that way, the company has a much greater probability of going on to achieve an exit, which is how we all make money in the venture capital space.
Investing is not about hitting a home run every single time you play. This is the mindset that many VC firms have. Because consistent base hits lead into runs, the goal is to score more runs. My honest advice (and this comes from almost 16 years of experience in the requisite areas above) to all investors in this space is not to place capital with a VC firm filled with GPs who have never experienced a business failure, overcome the failure and gone on to find success as an operator.