The Power Law of Venture Fund Returns – If you ain’t first, you’re last

Follow the discussion on x.com

As we (and others) have written about in recent months, the venture market is experiencing some systemic challenges that have the potential to depress returns for some time. Simply put, there is too much capital seeking too few opportunities, particularly at the seed stage. Multi-stage firms have eliminated pricing discipline at seed stage and the proliferation of seed firms has made the task of investing at this stage as competitive as it’s ever been, leading me to believe that indexed seed investing in today’s environment will produce poor returns.

I’ve thought a lot about how these characteristics will impact return profiles for VCs and LPs. Those who know me best, know that I love graphs, so I’ve tried my best to show how this market shapes out below. On the left, we have the distribution of the returns of the market. In the prior decade, returns were fairly normally distributed. As we move forward, I think the increased competition will lead to returns concentrated in fewer funds. As we think about this in terms of the Power Law curve, represented on the right, we see a steepening of the curve. 

What does this mean? Whereas before being 20% better (i.e. going from top quartile to the top 5%) was certainly beneficial, the reward for doing so has dramatically increased. The data is showing this. In 2014, the benefit of going from top quartile to top 5% was an additional 16% for returns (a 66% improvement). As we look at that same dynamic in the most recent Cambridge vintage (2022), moving from top quartile to top 5% represents an incremental 48% points of IRR, a 1056% improvement in performance. Being the best has never mattered more.

Data from Cambridge Associates

What does this mean for today’s environment? It’s never been more important to break away from median performance. While there is risk in breaking away from the pack, the risk (at least performance wise) of staying part of the herd is simply far worse. Median returns for the recent vintages are simply terrible. One could argue that funds are still in their j-curve phases, but I suspect this doesn’t explain the divergence we’re seeing between GOOD performers and GREAT performers. 

More than ever before, it’s clear to me that playing the same game as everyone else will not work, so fund managers should question whether they are really capable of being in the top 5% of whatever strategy they are employing. From a LP perspective, allocators should likely ask the same of their managers and consider whether allocating to indexed mega funds or indexing across too broad of a portfolio of managers is tenable in achieving their return targets. 

I think the shifting dynamics of the market (and the shifting of these curves) has profound impacts on what characteristics will make venture investors/firms successful.

As famed executive coach Marshall Goldsmith says “What got you here, won't get you there”. Much of how we operate as investors (either as VCs or LPs) is formed by what we’ve seen work in the past and the fact of the matter is that the patterns of the past are unlikely to lead to success in the future. I’ll write about our own thoughts on what will contribute to success in today/tomorrow’s market, but for the time being, I would hope to establish the need for true differentiation as a right not just to win, but to exist. At Equal, we call this “being king/queen of your own island”, but I think Ricky Bobby says it even better…