The Extinction of Venture Capital?

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Last week, Josh Wolfe wrote about some of the trends he’s seeing around the venture industry and how that might play out in the years/decades to come. Amongst those was a prediction that 30-50% of venture firms may cease to exist. When you combine this data with the fact that 17% of venture funds make it to fund 4 and 44% of VC capital raised this year went to just 2 firms, my belief is that the consolidation and extinction of firms could unfortunately be far greater.

This is not the outcome I hope for, but rather the end state I'd like to avoid at all costs. As some know, I spend a considerable amount of my time focused on emerging managers in the venture capital community, running a peer circle of 700+ emerging funds and hosting an annual summit of leading emerging managers and institutional LPs. I’ve also personally invested (with my own money,) in nearly a dozen funds. There is nothing that I’d like to see more than a vibrant, fragmented and differentiated landscape of craft firms within our asset class.

However, that’s not what’s happening and the guilt falls on all sides. 

The large allocators are vacuuming in as much capital as they can, because they can - it’s in their incentives to do so and LPs are more than willing. While just because you can, doesn’t mean you should, I don’t think we can fault this universe of players for operating within their rational incentives when the capital is readily available to them and the asset management business provides a far superior (and less volatile) stream of income than the carry business. 

The majority of the LP landscape remains focused on these big names and they are heavily incentivized to do so.  Many of these firms have returned a LOT of money to LPs over the last two decades and there is just as good of an argument for their persistence as there is anywhere else in the venture land. When they do invest in a new emergent fund, their preference is to back spin outs of these large organizations or those with deep ties to those firms. I personally believe this is misguided (most of the best firms from the last 2 decades (e.x. USV, First Round, Founder Collective, IA Capital, Forerunner, Emergence, etc.) were not spin outs from large Bay Area venture shops), but also creates an insular feedback loop to reinforce the mega fund machine. They’re funding the same philosophy (just at a smaller scale), that will ultimately feed these larger funds with an insanely high correlation. 

Nonetheless, LP preference for this pattern has incentivized the landscape of emerging managers, pressuring managers to look more and more like miniature copies of these firms. They seem to follow a remarkably similar strategy - small fund focused on access investing alongside brand name firms with the plan to “plow” into winners and eventually scale into leading checks with a bigger fund. However, very few of these funds ever have the opportunity to lean in given the hierarchy of the larger firms coming in and they rarely will compete against those firms (dare not to bite the hand that feeds you) to lead rounds in those companies.  The investor presentations, backgrounds and even portfolios of these new upstarts look remarkably similar. While we may see range and breadth in the quantity of funds being created, the homogeneity of these firms robs the ecosystem of the opportunity for new product innovation, independent conviction or original thought. 

For an industry that prides itself on contrarianism, it’s hard to predict the consequences of such homogeneity - as IPO windows push out, reliance on downstream capital grows, leaving founders and early stage investors at the behest of what mega funds will capitalize. When a small subset of funds force the industry to uniform, consensus investing, then I think we’ve lost the essential nature of VC. At that point, smaller firms are just outsourced resources, not independent investors.

To be clear, I don’t think anyone is at fault here. Everyone is acting in-line with their incentives and it is to be naturally expected that we would arrive at that state. Nonetheless, these incentives may yield a terminal state where venture capital ceases to exist in its current form - one where our industry becomes so uniform in feeding the mega fund machine (making those firms even bigger and these incentive structures stronger) that our industry ultimately looks more like Blackrock than Benchmark. If these incentives are destined to perpetuate our industry to the point of failure, we must evolve or go extinct.

One of my LPs likes to tell me (in what I hope is a compliment) that I’m NOT a venture capitalist. I spend a LOT of my time reading the works of value investors and research reports on public companies to decipher insights on what I hope will be investment opportunities. Perhaps the most impactful of these influences is Charlie Munger. I try to bake a little of Charlie’s practice into everything I do, which might seem strange given they are a $1T organization and we manage roughly $250m of capital. One of those practices is what he refers to as a “Darwinian Approach” to my belief system. Effectively, this is asking “what do we believe to be true today, that can be invalidated?”.

As I look at the broader venture ecosystem, it rests on the laurels of best practices and pattern recognition. The long duration and volatility of return cycles permits allocators (both on the LP and GP side) to simply stay the course on what has been done (and is perceived as safe), rather than what is new. This has been gamified to feed the AUM of large scale asset managers - they have adapted and evolved in the Darwinian nature they were supposed to and I place no fault on them for doing so (it’s an evolutionary function of the free market). However, my fear is that we will see an extinction level event to the venture industry if left unaddressed. This is akin to when you see an foreign predator come into an ecosystem that they are suited to dominate and effectively kill off all other life, eroding their own feed supply and ultimately collapsing the ecosystem. Unlike in RE, PE or public investing (where small timers can win by accessing obscure opportunities and the returns are normally distributed), consolidation in venture (given power law and the needs for downstream funding) may yield a landscape where ONLY the megas survive unless thoughtful action is taken to embrace greater diversification - in terms of both capital and cognitive thought. 

With that, I press upon LPs and emerging managers to take in their own Darwinian Approach - what do they believe to be true today, that can be invalidated? How can new practices create opportunities to reinforce greater cognitive diversity in this ecosystem, rather than yield an ultimate consolidation. A decade ago, I moved to Chicago to prove that you could find and fund billion dollar companies outside of the valley (I found 4, more than 1/3 of the investments I made as either a seed investor or angel). A decade ago, the archetype of every venture firm was to look like Benchmark, but now we’re seeing solo capitalist and platform firms achieve breakout success (we ourselves have evolved away from that model). LPs long believed that fund 1s were too risky, but now are waking up to some of the perverse incentives and return atrophy that emerging funds experience as they mature and have witnessed incredible returns from the Fund 1s of emerging managers that greatly outweigh the risk. Jointly, perhaps the returns of these legacy firms (as they balloon in size and delegate investment authority to a next generation of talented, but unproven investors) are less safe than they seem. Lastly, will emerging managers and seed funds continue to thrive by aligning to these deep pocketed, downstream partners or must they discover a new “right to win” as these partners move further upstream?

What else do we believe to be true today that could be wrong? Will our industry follow Darwin’s evolutionary patterns of adaptation to thrive or will we allow the craft nature of venture capital to go the way of the Dodo bird?