The title of this article was the exact Internet search query that led a Limited Partner directly to our web site recently, and made me think about similar discussions I have had with other asset managers.
Such a sense of helplessness indicates how Limited Partners (for example as the investor in Venture Capital funds) feel a lack of control over the capital they put to work after a commitment for a ten-year(+) investment cycle is agreed upon.
Legally of course there is little intervention that can take place beyond the investment committee construct agreed to in the closing agreement. But even with more frequent investment committee meetings the question remains as to what pertinent topics they should cover. Because any General Partner with half a brain can douse the curiosity of a Limited Partner with the complicated and mysterious “voodoo of innovation”, or temper it with soothing references to the me-too of hot potatoes in the industry.
So, the real question for a Limited Partner is not how to become more informed but to become better informed considering the asset manager’s holistic area of expertise.
The deep-dive temptation
Since the Venture Capital sector has underperformed for the last twelve years (it shouldn’t have) and produced negative returns for most, the natural temptation of many Limited Partners who righteously still believe in the massive greenfield for innovation is to become more involved, and interject themselves into the investment decisions more aggressively. In the same way a Venture Capitalist will request more board meetings from a CEO of a portfolio company when things do not go well. But Limited Partners do not have the same expertise as General Partners, in the same way most Venture Capitalists have no experience or merit to question a CEO of a portfolio company adequately to induce corrective measure.
So, to maximize the quality of information a Limited Partner receives to judge the performance of his asset management portfolio we need to go back to the original premise of the relationship structure between Limited Partner and General Partner and the roles and responsibilities of each.
We need to go back to the start.
A bad start makes for a worse ending
Almost fifty years of life experience has taught me that a bad start almost always leads to an even worse ending.
Having seen many a Private Placement Memorandum (PPM) of Venture funds on Sand Hill Road, void of tangible performance metrics, void of detailed risk deployment parameters, the omission of a contrarian investment thesis and the omission of lasting social economic impact in the “business plan” of many a Venture Capital fund screams at my experience that many are doomed to fail. And they have. Only about a handful of the 790 Venture Capital firms (post 911) make any(!) Venture money monolithically and consistently for Limited Partners. The remainder are embroiled in cunning and in-transparent risk escapism.
The engagement in such an investment plan says something about the time in which it was blueprinted. Pre-911 many new Limited Partners were desperate to expand their asset management strategy with a piece of the glorious returns provided by the pioneers of Venture Capital, and subsequently General Partners of virtually any descent obliged and jumped in to take their money and become “the expert” of the sector’s newfound glory.
Since then, not the lack of greenfield but the overwhelming subprime nature perpetuated by these uniform agreements deflated the arbitrage needed to detect outlier innovation and stopped it from producing prime investment returns that were promised. Only a handful of innovations that escaped the wrath of subprime Venture Capital continue to prove their value worth – despite not because – the “best practices” of Venture Capital.
So, with these ill-formed agreements in market, how do we now correct the aloof relationship between Limited Partner and General Partner? How do we realign the Limited Partners and General Partners from subprime to prime?
New rules of engagement
In the marketplace of innovation the Limited Partners and the entrepreneurs are the primary asset holders, as explained in our innovation primer. And money from Limited Partners is exchanged with innovative ideas from entrepreneurs by Venture Capital as the arbiter.
The public has spoken; deliver tangible social economic value post IPO or you will lose my trust and support. And support for the Venture sector by the public is already waning, not just by the public as a public investor.
Innovation can only remain a renewable asset class if the public agrees with the assessment of value purported, and some delivered, by the Venture Capitalists. And thus the public as a consumer (user), public investor (stock market) and private investor (institutional fund allocation) needs to be in agreement with, and a beneficiary of the realization and upside of a gating innovative idea.
Hence, the merit of innovation arbitrage (Venture Capital) is a direct corollary to the health of the ecosystem that can then feed the returns achieved to Limited Partners and entrepreneurs. Treat either asset holders badly and their assets, money and outlier ideas, will start to diminish in quality even further. For great Limited Partners and entrepreneurs always have other options.
The above realization sets some new standards to which Limited Partners can hold Venture Capitalists accountable, even if the formal agreements are already locked in place. Renewable innovation is the only way for Venture Capitalists (with merit) to stay in business.
So, the above identified uninformed Limited Partner should not indulge in and become an accomplice to the decision-making by a General Partner for a specific innovation. For the Limited Partner has no credentials to do so. He should instead validate that any investment made by the General Partner complies to the asset management philosophy that generates and perpetuates a renewable investment sector, secures a profitable long-term investment commitment and warrants the investment of developing the necessary experience associated with its unique risk profile.
The only reason why a Limited Partner would engage in Venture to begin with is to reap the massive rewards available to no other asset class but Venture, with its underlying 80% technology adoption greenfield, and thus worthy of incurring well tuned and proportionate risk.
The economics of risk
Successful investing in Venture Capital rests on a simple economic principle: prime risk can produce prime returns, subprime risk can only produce subprime returns. Lest risk not by default be money.
We know what constitutes subprime investing, we coined the term and diligently spelled out the discovery of it in Silicon Valley with its trending attributes. And since the majority of Venture Capitalists have deployed subprime risk for quite a long time, subprime returns and a subprime pipeline should come as no surprise.
Beyond the damage caused to Limited Partner assets and confidence, subprime investing seriously hurts the underlying asset. Just imagine the amount of false negatives underperforming Venture Capitalists have left in their wake. Some forty years of Venture Capital investing has not made a serious dent in the size of available technology adoption greenfield. And frequently corporate innovation beats Venture driven innovation, proving its arbitrage wrong time and time again.
The success of Venture is directly related to the fundamentals of investing and the pursuit of a prime thesis therein.
The pursuit of prime
While subprime investing is easily identifiable, prime investing is not. In fact, the opportunity for a prime investment can only be established by the discovery of a unique innovation, driven by the agreement on achievable upside between the investor and the entrepreneur. The merit of that upside ultimately validated by the public will determine whether the arbitrage and marriage constituted by the Venture Capitalist is indeed recognized as prime.
So, the uninformed Limited Partner must act like the referee in a football game. He can establish what violates the rules of football, but he cannot preempt who wins. Conversely, subprime investing in violation of the economic principles needed to drive outlier innovation should therefor be aggressively ruled out by the Limited Partner as referee. And then, in accordance to the economic rules of innovation, clear the way for the best prime Venture Capitalists to win.
The merit of the Venture Capitalist is no longer based on meaningless quartile accreditations meant to reward the one-eyed in the land of the blind, but is ultimately determined by a more relevant and absolute standard by the public, and whether the early investments consistently produce the returns that were promised. Only then can Limited Partners consider Venture prime and a renewable asset class worth investing in.
Three new disciplines
So, the most important role of a Limited Partner post close is to ensure the investments made by Venture Capitalists do not default to subprime and predicate the deployment of a prime risk profile (that earns the classification of Venture) that can produce outlier performance.
Below are three new disciplines aligned to meet the core competency of an asset manager, that enables him to make a start in becoming better informed about the degree of prime economic risk deployed in Venture.
The disciplines below do not protect the economic outcome of Venture as a whole, for that we need to incur more fundamental change in the workings of our financial systems we alluded to elsewhere on our site.
1. Establish social economic upside
Regardless of the opportunity for intermediate exits, every investment must have the potential to independently produce tangible social economic value. Meaning Venture Capital investments must have economic upside asset managers can grasp, unfazed by the complexity of underlying technology du-jour. Keep questioning an innovation’s upside supported by technological elasticity and the monetary requirement to do so.
2. Measure contribution to runway
Investments by Venture Capitalists must be made as a contribution to upside, not to protect downside. To avoid the mediocrity of investment socialism, Venture Capitalists must be able to demonstrate how they can contribute to build economic upside and its runway without heavy dependencies. The spray and pray of “capital efficiency” is a popular investor methodology that frankly is responsible for much of the negative trailing performance in Venture. Reality is that the production of any kind of social economic value worth Venturing into still requires some $25M to build. Ensure the planned contribution to each portfolio company is at least half of that ballpark, to avoid excessive fragmentation and collusion.
3. Validate non-uniformity
Outlier performance is non-uniform and hence the risk deployment and investment staging cannot be uniform. Meaning if the investments by Venture Capitalists are staged the same, rely on the same technological trending and use the same syndicates, they are in violation of their unique investment thesis and have submitted to uniform (and thus subprime) conformity. Measure instead how and why non-uniform investments in innovation contribute to the unique risk profile associated with the economic objective of every portfolio company.
Exercise your right to become informed
Limited Partners with their Venture Capital funds already deployed in-market may not be able to affect the change required to turn the majority of Venture Capital from subprime to prime, in the same way a portfolio company if doomed can seldom be rescued.
People’s unique foresight, the most important attribute of differentiation for a Venture Capitalist, does not change simply because they are managed more closely or even when their monetary incentives are changed (up or down).
But close monitoring of Venture Capitalists based on the economic criteria mentioned above will explain why some of them succeed and many don’t. And it offers valuable clues as to which Venture Capitalist has the born spirit and proven merit to produce the renewable returns at the horizon of a still massive technology adoption greenfield.