Our learnings on venture funds

Time will tell how much of these will approximate any truth

We have been executing for more than two years with Nomads, trying to find and partner with the best investors. We started with a hunch of what a great investor could look like from our story with Hummingbird and some other investors we respect, and we are still early to claim any definitive truth—but it’s fair to say we learned quite a bit. While it’s not intended to be comprehensive, the below attempts to share some of these.

Dido building Carthage, J. M. W. Turner

Two ways to frame our existence

We invest in investors, a fund-of-funds is the best nominal approximation to our current strategy. It is a derivative strategy both nominally and practically. But, one can use two different ways to frame it.

1. We are in the business of buying funds. We invest in investors by buying limited partnership interests in their funds.

2. We are in the business of buying companies, in a wholesale way, unlike retail venture fund buyers. When we find a good supplier of companies (a good GP of a venture fund), we commit to buying what they bring over the investment period.

The former is our reality. It is how we execute, although one still can stretch that definition in practice leveraging many other ways like SPVs or direct investments. It is a helpful framing to recognize the limited nature of our LP involvement, but its derivative nature usually leads to derivative thinking, blinding LPs to the real value creation they get involved in.

The latter is closer to the ground truth, i.e. we indirectly participate in businesses of tomorrow through our portfolio of investors. While we don’t get to choose how much we buy from which businesses and the relevant price, eventually we should have enough participation in high-quality businesses at good prices. And, while we’re limited in our capabilities, we don’t have to be limited in thinking.

Difference to underwriting founders

An investor’s promise is usually that they’ll invest in some great companies next couple of years, which is most often what they have been doing for the past couple of years. This is different from entrepreneurs embarking on 10-12 years of singular journeys and building companies that are hopefully unique enough.

While the investor’s ideas might be original in every instance, this continuity in execution affords LPs a survey of the fund’s recent execution. Questioning an investor’s past few investments, how much they bought and at what price, which company, founders, and the reasons why is of great importance—given this is most probably what one will be buying next if one invests in the fund.

Venture funds have a pretty established business model. It is wishful thinking a new or bigger fund will change ideation or execution dramatically. And, while capital constraints are real, there are well-tested ways to overcome these like SPVs. It’s better that capital follows ideas, not vice versa.

Involved, not impressed

I’ve heard ‘being involved, not impressed’ first from Matthew McConaughey. Fortunately, like him, we meet impressive people through our work. Some of these are perceived legends of the investment world, with equally impressive track records and stories. But, we would be mistaken to mystify them and what they do, seeing them holding an ever-existent key to future truths.

Outlier returns are usually a factor of the intersection of multiple anomalies about markets and people. And, by definition, outliers and anomalies rarely persist. Over time, decision-makers, their ambition, their mental fitness, and their ideas change. The size and composition of their team change. And outside the team, entrepreneurs change, businesses change, and markets change.

This implies a need for a thorough questioning of the last few years’ strategy and investments that are often different from many years ago. We should not be as naive to extrapolate past TVPI numbers 10-12 years with all the changes in decision-makers and the opportunity set. We need to be involved beyond decks, spreadsheets, or conference calls. Related to the idea of ‘buying companies wholesale’ idea above, we need to see the visibility of how much we will own of what sort of companies at what price—and this requires getting in a room with the main decision-makers and having enough time and openness to discuss their most recent decisions critically. Indeed, some of the great investors don’t have patience for curious LPs, but this doesn’t imply that LPs should be taking leaps of faith based on decade-long numbers.

It’s easier to know ‘what is not’

The good old ‘via negativa’ of Taleb also applies to our world. It is hard to assume a pattern recognition of common threads of a great investor—we need more work to claim some approximation of it. And, to claim the ground truth is impossible if you subscribe to a rather critical school of epistemology as I do. The best we can do is to have good enough conjectures leading to a few great decisions, then give place to the better conjectures as we evolve our understanding through the test of time in ever-changing markets and people.

On the other hand, it is easier to know what doesn’t lead to an outlier fund. An outlier fund isn’t where the investor looks over the shoulder of other investors for ideas, where the portfolio construction doesn’t allow enough exposure to the best ideas, where the investor doesn’t have enough access to high-quality companies, where the fund size gets too big, where the prices don’t matter.

Venture doesn’t scale

Investment teams, ideas, and strategies are limited in the amount of capital they can accommodate and in their shelf life. While the concept of alpha decay is voiced in public markets along with a consistent need for new ideas and re-invention of core strategies possibly due to shorter feedback loops—our industry is rather optimistic and rarely paranoid about it.

From a more mechanical perspective, there are demand-side limits to scale capital deployment—i.e., availability of high-quality opportunities and founder teams and limits in their need for early-stage capital. And, there are supply-side limits—i.e., scaling deal flow and access to high-quality opportunities, building a high-quality investment team without compromising the initial judgment, ambition, and presence. This is not to say smaller is better by any means—for some strategies, $10m is too much while some others can accommodate hundreds of millions (here’s more on the specific point of fund size). Still, one needs to validate numerous assumptions to argue a particular strategy can accommodate more dollars.

From a more nuanced perspective, one needs to remember that the type of investing that yields outlier returns is often an intellectual and creative pursuit—it is about good execution of superior and original ideas, not grinding to execute what everyone is executing marginally better. In broader creative pursuits, some initial ideas, questions, and able people merge into schools and movements over time—in investing, they merge into firms. During the process, ad-hoc questions become conjectures, conjectures become investment theses—information gets recombined, grows, and endures. What is ad-hoc and fluid over time crystallize into theories. Masters give place to pupils, pupils become the new masters, and so on. Some of these schools scale well and stay relevant for a long time possibly due to the initial explanatory power of their theories of the world, success in the acquisition of new talent, critical and open-minded attitude in the face of the changing world, etc. But eventually, new circumstances and new problems require new initial conditions and schools give way to some others. This doesn’t imply a default avant-gardism as we know a few big and established teams have been outperforming most new ones for multiple vintages. But, one shouldn’t assume but question the scale and relevancy of such schools across time and different technologies.

As an analogy to music, at the peak of his creativity, Bob Dylan created a new school of music and hired talented musicians to tour and make records to increase its reach. He leveraged his position of power for a while to collaborate with the best from the next generation becoming a hotbed for best musical ideas. But, eventually, the next big musical spark came with The Beatles, taking Dylan to the follower seat very quickly. Popper¹ outlines the non-authoritarian nature of creativity well, hence why the existing schools won’t be ever-growing beds for the best of intellectuals of tomorrow, and hence for the best ideas.

…The secret of intellectual excellence is the spirit of criticism; it is intellectual independence…

…Never can an authority admit that the intellectually courageous, i,e, those who dare to defy his authority, may be the most valuable type. Of course, authorities will always remain convinced in their ability to detect initiative. But what they mean by this is only a quick grasp of their intentions, and they will remain for ever incapable of seeing the difference…

…Institutional selection may work quite well for such purposes as Plato had in mind, namely for arresting change. But it will never work well if we demand more than that, for it will always tend to eliminate initiative and originality, and, more generally, qualities which are unusual and unexpected.

Top-down trends don’t necessarily lead to outperformance

Top-down trends are usually good to guide the nose of an LP, but we see value in shifting to bottom-up quickly. Being a specialist or having a deterministic conviction on a trend isn’t necessarily a positive quality. Often, we’ve seen that being a specialist is a cover for incompetency to invest at a broader scale, or giving reasons to believe for investors and LPs in the lack of any other.

We rather see value in evaluating investors together with their opportunity set, which can be generalists or specialists with different levels of granularity, to look for a bottom-up edge to allow investors to be smarter or have better access than the others. It’s possible that a domain produces multiple high-quality companies and no funds capture outlier returns if there isn’t any asymmetry of judgment and access to these companies—or it’s possible for generalist funds to capture the bulk of the value if specialists don’t have a particular edge.

Top-down tailwinds don’t matter if they don’t translate into high-quality companies in investors’ portfolios with good ownership at the right prices. This is a factor of investors leveraging some asymmetry in the market that allows them to know more about these companies and access these companies sizeably early on at the right prices.

Labels mislead

The below is from Popper², pointing out the problems with definitions.

While we may say that the essentialist interpretation reads a definition normally, that is to say, from left to the right, we can say that a definition, as it is normally used in modern science, must be read back to front, or from the right to left: for it starts with the defining formula, and asks for a short label to it…

…For most people, when first studying a science, say bacteriology, must try to find out the meanings of all these new technical terms with which they are faced. In this way, they really learn the definition from left to right, substituting, as if it were an essentialist definition, a very long story for a short one. But this is merely a psychological accident, and a teacher or writer of a textbook may indeed proceed quite differently: that is to say, he may introduce a technical term only after the need for it has arisen.

Our industry is where narratives run ahead of truth and it’s hard to trust nominal in a crowd where definitions are arbitrary. As in the Popper example above, an investor might’ve never thought about concentration until seeing an exceptional company and not being able to bother to buy another—and only defining concentration ex-post. Some others will buy more of the wrong companies at the wrong prices just because a concentrated portfolio was the conventional wisdom in 2023. Similarly, the meaning of founder-first will be different for someone who’s been in the room with greatness vs. someone who hasn’t.

In the same way, it is unlikely contrarians would call themselves contrarian. The word contrarian has a positive connotation that does a good job of delivering about the instances where one’s deviation from the crowd appears to be right ex-post. It does a poor job though of describing the exact moment of deviation, the feelings, and the relevant impressions. Deviating from a crowd is uncomfortable, so it’s rare one does it for the sake of being contrarian. It is willing to be stupid about what one believes rather than a heroic pose. And, if there’s immediate satiation in being contrarian, maybe it’s a signal of a not-so-contrarian act in disguise as Galbraith³ puts below.

At the same time, in the higher levels of conventional wisdom, originality remains highly acceptable in the abstract. Here again, the conventional wisdom makes vigorous advocacy of originality a substitute for originality itself.

Ownership vs. valuation is another example. These are just two sides of the same coin as ownership is a factor of how much capital you put in and the price you pay—for a fixed fund size and number of companies, ownership is valuation. However, they’re arbitrarily used as two separate things, not sure if it’s because ownership connotes possession and aggressiveness and valuation connotes cheapness and stinginess. While best investors often own a lot of their companies, the cult of ownership buries the risk of paying up—blinds LPs to investors who raise funds of ever-increasing sizes to buy the same ownership at higher prices, ignoring the fact that they will have to return the bigger funds in the distant future.

Sourcing is another one where it has a social connotation of search, hustle, and network and blinds us to discuss the real question of what one is looking for. Most great investors have a very specific idea of what to look for that is different from others and they are searching companies for particular ideas not running around like a lost puppy and doing little more of what everyone else is doing.

Some of the nominal fallacies deserve their separate sections that you’ll read next.

Judgment, not diligence

Diligence could directly translate to outlier investment performance in a different world that is an open book, where the answer to every question is just a matter of looking harder, and where uncertainty doesn’t exist.

Our world is different. While diligence is table stakes, a singular focus on it rarely leads to outlier performance in fairly creative pursuits. Having original theories of the world that lead one’s nose to the right places, questions, and eventually the recognition the greatness is what makes the difference. Hence we replace the word diligence with judgment, to recognize the fact that investors are in the business of decision-making under uncertainty, not diligencing an open book.

Great judgment doesn’t singularly manifest itself in diligence, it is multifaceted. Some investors might be living in frontiers to build their models of the world accordingly to anticipate the right opportunities and ask the right questions. Some investors might be more suspicious of their theories, assumptions, and the conventional wisdom to approximate the ground truth by deeper reasoning. Some investors might have seen greatness many more times than others to extrapolate these instances to recognize future ones.

‘Emerging manager’ is a misnomer

‘Emerging manager’ is another useless definition we refer to frequently. At its core, it assumes a historicist argument that investors are born, rise, stabilize, and fade away as if we’re all living through a cyclical pattern, and where we are in the cycle is uniquely important. It’s quite similar to the nonsense label of emerging countries, including countries most of which haven’t quite emerged for 50+ years for some reason including my home country Turkey.

People take it as far as to say that Don Valentine or Peter Thiel were emerging managers once which is no different to say every human being was a kid once. But, the reality is much more messy. Every investor’s story is unique and while experience might positively or negatively relate to factors like judgment, fund, size, and ambition in many cases—the term emerging rarely has the explanatory power we attribute to it.

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We’re two years in and counting, two years where we constantly updated our existing models of the world, asked many new questions, and conjectured some answers. The article shares part of these, and we’ll be sharing many more over the following years.

1. The Open Society and Its Enemies, Karl Popper

2. The Open Society and Its Enemies, Karl Popper

3. The Affluent Society, John Kenneth Galbraith