By David Teten, HOF Capital
A friend of mine interviewed for a job with the massively successful hedge-fund manager Steven A. Cohen. My friend sat in a conference room. Cohen walked in, looked at his resume, and asked just one question: “What’s your edge?” My friend got the job because his answer was differentiated, credible and backed up by a history of investing success.
So what edges do VCs have? They fall into three buckets: standard advantages, unsaid standard advantages, and emerging new tactics to give an advantage.
Most VCs have answered the question of “edge” with a combination of the said and the unsaid. What they most typically talk about are:
Industry expertise. Many VCs focus on specific verticals, usually based on the sectors in which they made their reputations. This model makes sense – but one limitation, in very-early-stage investing, is that 2022’s growth sectors probably won’t fit neatly into tight verticals we can define today. If you define yourself as a specialist in narrow and well-known Theme X (e.g., a bitcoin fund, a social-media fund, a nanotech fund), you’re going to raise capital from limited partners who are very focused on Theme X. The logical challenge there is that LPs are typically not ahead of the already competitive VC industry in identifying the next great theme.
Network. Social media tools like Linkedin and FullContact increase the value of network currency (reputation and access) because people with currency can spend that currency getting to a wider array of influencers. At the same time, they reduce the value of knowledge about people in your network; now anyone can find out who, for example, are the M&A decision-makers at Cisco.
Proprietary sourcing. VCs used to emphasize their proprietary sourcing, but tools like AngelList, CB Insights, Gust andCrunchbase now make the whole industry significantly more transparent. That said, we’re in an opaque industry compared with the public markets, and having the real scoop about what’s going on at a private company, and who is raising now, will be a meaningful edge for a long time. Our industry is highly noisy, and VCs use their networks to filter for signal amid the noise.
Reputation. VC is one of the very few asset classes in which past performance is predictive of future results. So reputation does have a meaningful impact on returns. The importance of reputation is why, for example, Andreessen Horowitz invested early and heavily in its own PR, adding PR guru Margit Wennmachers as a partner.
Thesis. Victor Wang, my HOF Capital colleague, observes that Union Square Ventures is a particularly good example of the power of a correct thesis. Historically, USV has been an order of magnitude better at picking winners than almost every other VC in the industry. Unlike most other elite VC firms with substantial track records, however, USV:
— is based in New York, with no office in Silicon Valley, where a substantial percentage of the world’s best startups are based;
— is relatively new, founded in 2003;
— didn’t have decades of reputation behind it at the time that it first invested in most of its current unicorns;
— has only an eight-member full-time investment team (even smaller previously), and,
— is well-known for being an especially top-down thesis-driven investment firm.
Most of the other VC firms with a history of picking unicorns have significantly benefited from being based in Silicon Valley, having much larger investment teams, and having multidecade tier-1 reputations, which have led to them seeing most of the best deals in the market. It seems reasonable to assume that USV’s investment strategy (i.e., top-down, thesis-driven, with investment theses that in hindsight have proved correct) must be especially efficient and effective if the firm has been able to substantially outperform everyone else despite what might appear from the outside to be several limitations.
UNSAID STANDARD ADVANTAGES
In addition, VC funds benefit from some differentiators that they rarely talk about publicly but that may be even more important than the differentiators noted above.
Execution. The concept of “we execute better” is unexciting and hard to prove but is in fact a critical differentiator. Amar Bhide, my former professor, wrote in the Harvard Business Review, “Strategy is Bunk.” He points out that Morgan Stanley and Goldman Sachs have virtually identical strategies. They win or lose against one another in various business lines based mainly on their skill in executing. If you can just execute competently, you will outperform a lot of people who might have a theoretically superior strategy.
Thoughtful fund management. When I talk with non-founding insiders at many alternative-investment firms, I regularly hear complaints about the quality of firm management. The people who run investment firms usually got there because they’re good investors/dealmakers. Investing requires a skillset completely different from the one required to manage well. The leaders follow the normal human tendency of focusing on what they understand and spending less energy on domains in which they are less competent. Worse, the way you get rich as an investor is when you think orthogonally to everyone else.
This then leads successful investors to sometimes think that whenever they are pursuing a non-standard management decision, they’re geniuses and everyone else is foolish. The result is a poorly managed organization. The recent sexual-harassment scandals at a number of VC firms only highlight this issue; they are a canary alerting outsiders that a given fund has substantive management weaknesses. If your fund is led effectively and transparently with clear decision-making, that itself is a differentiator.
EMERGING NEW ADVANTAGES
As our industry has become more transparent and competitive, the traditional levers I list above have become less differentiated. Some VCs have identified a number of new advantages that distinguish them in the marketplace:
Portfolio acceleration. In a prior life, I served as a consultant to Goldman Sachs’s Special Situations Group, Carl Icahn’s organization, and some other very large private equity investors. I saw “portfolio operations,” i.e., levers to enhance the operations efficacy of portfolio companies, become a standard part of the PE toolkit. PE firms used to be composed almost entirely of ex-bankers; now they much more commonly include former CEOs and consultants. Similarly, firms like my alma mater, ff Venture Capital, and Andreessen Horowitz have executed this strategy in VC. My experience has been that this lever brings three benefits: It lowers origination costs because more founders want to raise capital from you; it enhances your leverage in negotiating with CEOs; and it lowers your failure rate.
Incubating companies. An extreme example of portfolio acceleration is the approach of Y Combinator and the other accelerators. They get in early and cheap with very attractive economics. To support their companies, they offer “Community as a Service,” by tapping the community (which is scalable), not just their own staff.
Technology stack. I have published a series of research papers on how VCs are using technology to improve returns. VCs tout themselves as tech-savvy, but most are using the same infrastructure tools they have used for the past 20-plus years: Microsoft Excel and recent college grads searching Google. We’ve seen some modest progress in people upgrading from Excel to Google Sheets; use of some CRM; and a cloud-based storage service. But according to Knowledge.VC, less than 5% of U.S. VCs have a full-time team member focused on technology. We see a lot of opportunities to differentiate by using technology aggressively, e.g., Totem, an investor operating system built by some of my past colleagues at ff Venture Capital.
Quantitative investing. A quant approach is common in the public markets but used by few in the private-company-investing space. Among the VC firms pursuing a more quantitative approach are Correlation Ventures, Google Ventures, Right Side Capital, Signalfire, Ulu Ventures, Y Combinator, WR Hambrecht+Co and Venture Science. The obvious challenge of this approach is poor data quality and relatively few success stories against which you can run regressions. Quantitative, technology-enabled investing in private companies makes sense but is structurally very difficult. In venture capital, early-stage companies in particular often operate in frontier industries, where the rules are unpredictable and conventional analytic frameworks may be misleading. Even for later-stage companies with predictable financials, the lack of liquidity, audited financials and standardized metrics creates real challenges to scaling quantitative investing.
Internal diversity. According to the National Venture Capital Association/Dow Jones VentureSource, the VC industry is dominated by men (89% of VC partners), specifically white men (76% of the total). Of all VC partners studied, just 10% identified as Asian, 1% as African-American and less than 1% as Latino. Many research studies have shown the value of a diverse management team. In VC in particular, our job is to understand the diverse future, not the present. America will be a “majority minority” country by 2040. I suggest it’s helpful to have a diverse team that looks like America’s future, not its past. Social Capital’s Chamath Palihapitiya observes that the firms that embrace diversity and inclusion in a systemic way will change venture capital for the better because the minority leaders who rise up inside those firms will “rip them apart from the inside.”
Portfolio company diversity. The companies receiving venture capital do not look like the rest of America. CB Insights found that companies headed by male executives received 98% of all venture investments, totaling nearly $1.88 billion. In addition, at 83 percent of companies, the racial makeup of the founders was Caucasian, while only 12 percent of founders were Asian and less than 1 percent were African-American. Social Capital is an example of a firm specifically seeking exposure to the emerging domestic market and reducing its reliance on traditional gated VC networks. The firm’s recently launched Capital-as-a-Service arm enables it to make small investments in startup applicants anywhere in the world, sight unseen.
David Teten (teten.com) is a managing partner with HOF Capital, an international venture capital fund based in New York and London. He has particular interest in fintech, technology-enabled services, analytics, AI, sales/recruiting technology, SaaS, and international startups. Reach him at teten.com/contact.