If the U.S. economy were a company, the VC industry would be the R&D department. The financing for the VC industry comes from so-called LPs (Limited Partners) – mostly university endowments, pension funds, family funds, and funds-of-funds.
These LPs wield tremendous power, yet very few of them understand how startups or venture capital actually works. I was reminded of this recently when I saw this quote from a prominent fund-of-funds, justifying their investment in a 30-year old venture firm:
“As the amount of money raised by venture firms shrinks, older firms that were around before the dot-com bubble will benefit,” said Michael Taylor, a managing director at HarbourVest. “These firms have track records, brand names and knowledge about how to avoid making mistakes that younger firms do not necessarily have,” he said.
These older firms do often have track records – they’ve survived precisely because at one point they delivered good returns. But it’s a mistake to assume that — because VC brands and institutional knowledge persist – past returns will predict future returns. Here’s why.
VC brand names do not persist. From the perspective of VCs and entrepreneurs, VC brands rise and fall very quickly. Given the excess supply of venture dollars, top tier entrepreneurs are frequently selecting their investors, not vice versa. The VCs most sought after are mostly new firms: big firms like Andreeson Horowitz, Union Square Ventures, and First Round, and micro-VCs like Floodgate (fka Maples), Betaworks, and Ron Conway.
VC firms don’t accrue institutional knowledge. VC returns are driven by partners, not firms. Studies have shown this, as will a quick perusal of the big exits at prominent VC firms. When key partners switch firms or become less active, VC firms retain very little residual value. Some service firms — for example consulting firms like McKinsey — invest heavily in accruing institutional knowledge by developing proprietary methodologies and employee apprenticeship programs. VCs develop no real IP and rarely have serious apprenticeship programs.
There is an old saying among big company CIOs that “no one gets fired for buying IBM.” It’s much easier for a fund-of-fund partner to defend investments based on a VC’s track records. It’s a safe but bad strategy.
To intelligently invest in VC firms, you need to roll up your sleeves and dive deep into the startup world. You need to learn about the startups themselves, assess the entrepreneurs, use their products, analyze market dynamics – all things that good VCs and entrepreneurs do. If you want to understand a VCs brand and abilities don’t look at their track record in the 90s – ask today’s entrepreneurs. The answer will likely surprise you.
Unfortunately, very few LPs do this. As a result, a massive amount of R&D capital is being misallocated.