An Allocator's Manifesto: Setting the Stage

In search of outliers

Our approach to being an allocator and investing in venture funds does not always overlap with the conventional wisdom. I will post my thoughts on these topics, some of which are already hotly debated and some of which deserve more attention, with short pieces every other week.

The Fighting Temeraire, J. M. W. Turner

Here we start with the first one, and you can subscribe below if you want these directly to your inbox over the next few months.

A market of outliers

When LPs scroll through the track record of successful GPs, they often see a first few funds that are tracking +10x, small in fund size, and often deployed in angel, pre-seed, and seed rounds. And, these funds have only been accessible to some close friends and family, founders and investors in GPs’ close circle, and sometimes a few savvy (or lucky) family offices and high-net-worth individuals.

For sure, luck plays its part, but these funds are not accidents. These are usually a blend of (i) some earned insight and/or access into a particular technological inflection point or talent pocket which seemed obscure at the time, (ii) a hungry and ambitious early-career investor who is open minded enough to take asymmetric risks earlier than others which feels uncomfortable at times, (iii) capital constraints that channel the investor to early stage opportunities and making even a small angel check quite sizeable for the fund.¹

And, we think it is an allocator’s job to create a portfolio of such funds rather than ignoring them with excuses like too risky, hard to underwrite, unproven, unsustainable, too small to write sizeable checks. The value creation in venture capital is driven by outliers, both at the company level and the fund level. And outliers, by definition, are hard to underwrite by a clear-cut model; they are unsustainable, and they are the result of an increased uncertainty in underlying mechanisms.

In an industry of outliers, many allocators have ignored outliers for a long time and preferred funds that are sustainable, process-driven, big enough to scale relationships, often to settle with 3x returns over 12 years with no clear path to liquidity.

3x is not good enough

Allocators are paid to price and take risks, as any other investor. Still, when one combines illegibility of the internal mechanics of venture capital, its inherent mathematical nature of power laws that are different from most asset classes, and many allocators’ conservative approach to risk-taking often colored by mental models borrowed from other asset classes—the result is usually not taking any risk and expecting reward.

The biggest risk as an allocator is not taking risks. While one’s downside is capped by diversification across funds, vintages, and domains—the biggest risk is not to swing big enough and to cap one’s upside as well, and to stack a bunch of 3x funds, charge fees on top, and sell 2.5x back to one’s investors.²

While that is obviously vintage-dependent, in the past decade, where investors have seen decent public returns, compounding 12% for 10 years would result in a 3.1x multiple with full liquidity vs. committing to a venture fund with the promise to pay back 3x with an unclear liquidity horizon. A venture fund needs to do better.

Some even hold the bar at 2x or 2.5x as good returns for moving a large quantum of capital, which is utterly ridiculous as this is probably a worse yield than a chocolate bar, factoring in inflation we’ve seen over the past 4-5 years.³

The venture investors aren’t measured against other venture investors but against where else one can put a dollar. Hence, independent of where you rank within your tribe, if an investor cannot add a sizeable premium on top of a passive portfolio that’s fully liquid for the relevant time period, that’s a failure.

1. See Jordan’s piece on arbitrage windows.

2. See Jordan’s piece on indexing venture.

3. Or you can buy LEGO, see Will’s analysis.