A couple of years back we first coined the phrase “subprime Venture Capital” (short: subprime VC), and many of our blogs since have followed, describing its foolishness and demise. Recently Limited Partners, the investors in VC, have become more interested in the definition of “subprime VC” jazzed up by the temporal resurgence of IPOs (remember: IPOs are just another promise of value) juxtaposed with reduced access to an even smaller group of Venture Capital firms that seems to benefit from them. The pool of confidence for LPs, driven by negative 10-year average VC returns has gotten smaller and smaller.
So, I get the question more often as to what exactly “subprime VC” is, how to recognize it and how to steer clear from it as an LP. Obviously “subprime VC” is more than a simple curse to describe the more than 95% of the Venture Capital firms that do not produce consistent Venture Capital returns for their LPs, and the destructive effect the creation of many false-positives and false-negatives has on the perceived state of innovation.
The Venture Capital sector and the asset class (or sector) returns are only meaningful to LPs when they scale and consistently outperform others. And after many years of financial tinkering the question for many LPs remains why the financial system of Venture Capital that is supposed to support the still massive 80% greenfield of technology adoption, cannot scale along with it.
The term subprime
Wikipedia describes the term subprime in great length in relationship to the subprime mortgage crisis, in which a large amount of mortgages were doled out to subprime borrowers who under financial duress ended up in default. But the problem with the subprime mortgage crisis was not as much with the quality of its borrowers as with the massive deployment of uniform risk to those borrowers.
In financial terms, subprime simply refers to the uniform deployment of risk.
The mortgage crisis would have been avoided if the investments of a mortgage bank were not uniformly deployed, and investment risk would have been deployed proportionate to the variety of borrowers and a variety of assets. So, the mortgage crisis is the result of flawed risk management in the asset diversification strategy of banks, rather than the cumulative fault of borrowers who were made to believe in the “American Dream”.
Not the size of banks made them too big to fail, but the application of uniform risk was too large. That distinction is crucial in the explanation of the term “subprime VC”.
Subprime VC explained
Venture Capital suffers from the same deployment of uniform risk that was discovered in the mortgage crisis. And we are blowing the whistle on Venture Capital for the sake of securing viable LP returns and preventing further damage to the detection and monetization of groundbreaking innovation. We believe outlier entrepreneurs deserve better than to be shoved through a uniform funnel of risk arbitrage.
As a former (part-time) Venture Partner operating in Silicon Valley I could divulge many stories about specific investors and companies, but I care more about working on a fix than to embarrass those who take it for a selfish ride. And thus my focus on explaining subprime VC here is on its structural incompetence and deficiencies.
Subprime VC refers to the uniform deployment of investment risk to innovation.
Uniform investment risk in Venture Capital is perpetuated by:
- Uniform compliance to economic principles in Private Equity that are not free. A financial system that is not a free-market system, in-transparent to all marketplace participants and violates many other free-market principles by economic principle gravitates to the deployment of uniform risk.
- Uniformly unaccountable Private Placement Memorandums (PPM). Most Private Placement Memorandums from VCs fall short in the analysis of plausible investment risk, contain no tangible performance metrics, nor a well-defined investment strategy that sets it apart. Many PPMs (we’ve seen) are a carbon copy or a personalized version of the PPM from one of the few prominent VC firms on Sand Hill Road. The newly proposed Private Equity principles by the ILPA is a nice step to tighten up some of the controls, yet does not touch the flawed economic principle underlying private equity and as such is effectively not more than dining room etiquette.
- Uniform investment structuring. Every groundbreaking idea has a unique path to upside and therefore a unique funding trajectory. Yet the investment staging applied by VCs reflects nothing but a uniform protection of downside risk.
- Uniform valuations. Every idea that is unique enough to obtain funding requires a valuation that is calibrated to the upside unique to the idea. Funding companies based on relative valuations by default classifies every investment as a commodity and therefore applies uniform risk.
- Investor collusion. The uniform freedom of VC firms to deflate risk, freely fragment and syndicate investment stages, and engage in the excessive investment socialization (and price-setting) we can all witness at the popular innovation conferences is opposite to the fundamental discovery of outliers, and uniformly applies attraction to those who are not.
- Uniform technology risk assessment. The majority of VCs deploy risk associated with technology waves we can all see in our rearview mirror, while technology production is far from the most precious risk of a technology company.
- Years of funding tiny first rounds attracts only entrepreneurs with predominantly trial-and-error technology ideas, of which only a few can produce $1B companies. And thus the financial rewards in Venture are artificially restricted by its self-induced uniform investment thesis. Big thinkers are encouraged to find refuge for their ideas elsewhere. No surprise corporations have become better custodians of innovation. Uniform wannabes (on either side of the investment equation) comprise the maelstrom that remains.
Venture Capital risk should be deployed non-uniform and thus the opposite way it functions today in order to attract, find and recognize the prime talent that can build lasting social economic value the public can trust again.
Great time to be an LP in Venture
New institutional investors in Venture have the opportunity to easily recognize and avoid subprime VC by – for the first time – deploying economic principles that are compatible with the needs of the underlying asset, innovation.
Innovation relies on the discovery of outliers to which only a free-market financial system can assign merit. So, now with still a massive adoption greenfield on the horizon and the internet as the technology foundation for free-markets is a great time to benefit from the innovation subprime VCs with their socialistic capitalism will never be able to discover.