We Have Met the Enemy… and He Is (Still) Us
Or, where is our DPI?
We’re taking a pause for the holidays. In the meantime, here’s a reposting of an article we published elsewhere in April 2024. Happy New Year!
When we reflect on the state of venture capital today, we are reminded of the Kauffman Foundation’s 2012 report titled “We Have Met The Enemy… and He Is Us.”[1] It is a seminal critique of venture capital from an LP’s perspective, highlighting underperformance relative to public markets, low capital returns from realized exits, the short-term nature of the sector and the fundamental misalignment of interests between GPs and LPs. Sound familiar?
The Kauffman report could hold the cultural relevance within venture capital that Fred Schwed’s “Where Are Our Customers’ Yachts?” has held in the public markets since the 1940s. LPs might very well be asking “Where Is Our DPI?”
As such, we want to revisit the core themes in the Kauffman report to consider how the market has developed (or not) since the report first landed in 2012:
Underperformance: The report reveals that most VC funds, particularly larger ones with over $400m in committed capital, have failed to outperform public market equivalents. The most successful VC funds, according to the report, were those established before 1996, with an average size of $96m. However, subsequent larger funds have generally resulted in poorer performance and benefited the managers more than the investors due to fee-based income.
Structural Issues: It criticizes the 2/20 fee structure for incentivizing fund managers to raise larger funds rather than focusing on fund performance. The study advocates for a fee structure that aligns better with performance, suggesting that fund managers should only be rewarded after achieving a certain threshold of returns for their investors.
J-Curve Misconception: The concept of a J-curve, which posits that VC funds typically perform poorly in their early years before generating significant returns, is challenged. IRRs peak just as fund managers are raising their next funds. The report argues that this expectation may lead to inappropriate investment decisions and fund structures, suggesting instead a focus on long-term gains rather than short-term appearances.
Transparency and Alignment: A recurring theme is the need for greater transparency and better alignment of interests between GPs and LPs. The report emphasizes that LPs should demand more detailed disclosures and adopt robust benchmarks like public market equivalents to evaluate fund performance realistically and objectively.
Where Are We Today?
We will use this Kauffman report as a framework to consider the state of the industry today.
This is not all a tale of doom and gloom. In many ways, the venture ecosystem today is a more vibrant, engaged & diverse place to be than in 2012. 10 years of low interest rates had some benefits. There are more fund managers backing ever broader types of businesses & entrepreneurs across new geographies and sectors. Software is indeed eating the world.
Yet you read any form of venture literature since 2021 and you quickly see a sector where the euphoria of the AI boom masks a broader malaise about the direction of travel for the industry. No liquidity. Down rounds. RIFs. Lower fundraising targets. VCs closing up shop.
In fact, we believe it is a particularly exciting time in 2024 precisely because it is a time of significant uncertainty. This could be an interregnum period where the old playbooks of the 2010s no longer work, while the new shape of venture is yet to fully emerge. There are exciting developments as multiple trends converge across AI, robotics, manufacturing, healthcare, energy and other major industries. It is arguably the most interesting time to invest in a decade, at least since the emergence of mobile & cloud, possibly since the arrival of the internet itself. The best investors will adapt & thrive in this uncertainty.
In short, we see a window of opportunity to make some changes to venture capital.
But before we suggest some potential improvements, let’s revisit the key issues facing the industry. We will see that these are very much still the same topics as highlighted by Kauffman in 2012 (or Schwed in 1940):
1. Misalignment of interests between principals & agents
The largest brands in venture capital have switched to capital accumulation mode. The 2/20 model allows for highly profitable and durable businesses even before DPI / carry is delivered. The combined recent $16bn fundraise of A16Z ($7.2bn), General Catalyst ($6bn) and Khosla Ventures ($3bn) equals almost exactly all VC capital raised by emerging managers in the US in 2023.[2]
The current market uncertainty further favors the biggest brands, as a flight to perceived quality has taken place. You don’t get fired for hiring Goldman Sachs. You don’t get fired for investing in A16Z / Sequoia. Endowments may be permanent, but their staff are not. Musical chairs among LPs happens as in GP land. When reviewing GP managers, career risk is a consideration alongside investment risk.
These capital accumulators increasingly look like they offer top quartile beta. A promising counter development is the flourishing of emerging managers. The consensus view has become that these smaller, nimbler managers can represent alpha. The largest outperformance for LPs tends to come from emerging managers. [3] Without the luxury of mega management fees, performance of Funds I, II & III is critical.
Indeed, we see the barbellization of VC, with venture reducing from three sub assets classes (seed, traditional VC, growth) to just seed & growth. It is increasingly challenging to be a Series A & B pureplay investor, being squeezed on both sides from a more vibrant seed ecosystem and growth investors seeking ever earlier exposure to justify AUM increase. The flip side of emerging managers representing alpha is that they also have the highest variance in performance (with the worst emerging managers underperforming the worst established managers).
The barbellization of VC reflects a broader tension within the technology industry. On the one hand, value is being created and captured by tech behemoths (both the Magnificent Seven and capital accumulator VCs) who have the capital base to finance advances in fundamental technologies (across LLMs, fusion, robotics, nuclear, biotech, etc). On the other hand, the history of technology is the history of deflation, as products & services become ever cheaper. VC used to be invested in servers, then ad dollars on Google/Facebook, now NVIDIA chips. But AI LLMs will become commoditized. Less capital will be required to achieve scale. VCs are dreaming of the one person $1bn company. This view of the world suggests a smaller VC industry with better aligned smaller managers.
A slightly more nuanced perspective argues that the new moats are the old moats, as presented succinctly by Jerry Chen at Greylock.[4] Companies still need to build product, GTM, marketing, attract talent etc. This all requires capital.
2. Lack of liquidity masks underperformance
Proponents of private market asset classes like to argue that there is more valuation stability than in public markets. Quarterly / monthly valuations set by committees are preferred to the daily brutality of the public market. Yet Cliff Asness, co-founder of AQR, likes to describe this phenomenon as “volatility laundering” where the risk-return profile might not fully reflect the underlying volatility.[5] This tension has been exacerbated by the current lack of liquidity, further masking some underperformance by managers. To butcher Warren Buffett, it is hard to always know who is swimming naked when the tide goes out in slow motion.
The lack of liquidity in VC is well documented and is potentially the critical issue within VC.[6] Large scale M&A (e.g. Adobe’s proposed acquisition of Figma) has been blocked by regulators and IPO velocity remains depressed compared to historic norms. This prevents the recycling of LP capital back into future cohorts.
The ZIRP era also pulled forward fund cycles, leading to GPs to dream up ever more elaborate investment strategies to unlock LP capital. 3 year fund cycles contracted to 12-18 months. As a result, strategy drift is pervasive. The memes of investors moving from SaaS to FinTech to web 3 to AI to deep tech are real. These are not serious people. Imagine a world where AI had not exploded into consciousness at the end of 2022. The rise of AI masks serious problems within existing portfolios as very little is being funded except AI.
The combination of poor liquidity and 2020/21 pulling forward significant pools of LP capital means that VC fundraising is likely to remain challenged, at least until the recycling of capital from a few signature assets. In particular, Stripe & Bytedance are absorbing significant LP capital. The outlook for Bytedance is uncertain. And Stripe needs time to grow into its valuation vis a vis Adyen, making an IPO at least 12+ months away.
As a result of reduced liquidity, the VC industry is undoubtedly going to compress in size over time as LPs cannot re-up to as many managers. A mooted 50% reduction in the number of VCs is not necessarily a bad thing. It weeds out poor performers (eventually). The time for generalist “how can I be helpful” VCs is coming to an end. VC needs to be less prescriptive and rediscover their appetite for real risk. They should be making insane bets before the market is there. Cross the chasm themselves. Domain expertise in technical fields is likely to be required once again. We may see the reduction in platform teams as VCs refocus on seeing / picking / winning.
50% of VC funds return less than 1.0x DPI, even before the madness of 2020/21. Most LPs would be better off in the S&P 500. VC is a power law game at every level: power law LPs access power law GPs which access power law individual assets.
3. High costs
Paying 2% per annum management fees for generalist VCs in the current era is unlikely to deliver outsized returns. LPs are paying top 2% per annum dollar for generalists who are YOLOing dollars into capital intensive businesses as the low hanging fruit software markets have been gobbled up.
As well as AI, the biggest trend is companies which combine hardware and software. Sub verticals here include defense tech, healthcare & climate tech. These sectors require much more sector (and regulatory) expertise than generic SaaS investors can typically offer. Pitchbook’s data suggests that these emerging specialist funds are more likely to generate higher returns.[7]
VC may also just not be the right product for many industries that are now the darlings of the venture community. Software may be eating the world, but it needs to understand hardware to digest industries that represent the largest portions of GDP. Software alone cannot reindustrialize America, deliver national security, educate our youth and fix healthcare. It is challenging to envisage power law returns from some of these capital intensive investments. See the clean tech revolution in the early 2000s and the impact on Kleiner Perkins 1.0x. Are we watching a repeat of this in real time? Is A16Z’s $300m investment in Adam Neumann’s new real estate company Flow really going to drive power law fund returns?
We anticipate that the traditional VC fund model will continue to be hollowed out. We envisage top performers able to command ever higher carry (a la Soros / Simons in hedge funds). Then we see more passive / index type products starting to play an ever more prominent role. To borrow from Moneyball, it is hard not to be romantic about VC. And yet we see that most human VCs are delivering poor VC returns. A dispassionate (so called “boring”) quantitative capital allocation strategy should allow for more repeatable and scalable returns for investors.
The recent Destiny XYZ IPO and subsequent explosion in terms of value demonstrates demand from the broader public for high potential private companies. Access & liquidity are the big problems to solve for in VC. Maybe there is a way to combine public appetite for private stocks to also solve the liquidity problem in VC?
Some concluding thoughts
Despite the challenges currently facing the venture capital industry, there are substantial reasons for optimism. The exponential growth potential and compounding effects of emerging technologies like AI promise transformative opportunities for select VCs. The unsatisfactory key to unlocking this potential lies in patience. VCs (and LPs) should resist the sugary highs of AUM in favor of astutely deploying capital to deliver DPI from timely exits.
We see superior liquidity as critical to regenerating the venture industry. This will allow the recycling of capital and a healthy birth/death cycle of managers. We welcome the introduction of new liquidity mechanisms and innovations (from Pinegrove to Destiny XYZ).
The fundamental essence of early stage VC is artisanal. It can’t scale. Successful venture requires a deep understanding of people and their projects. This human element ensures that the early stages will require a hands-on, nuanced approach that leverages industry expertise and interpersonal skills. The best of these VCs who consistently generate alpha (DPI, not TVPI) should command premium fees for their bespoke, high-touch investment strategies. Why not reach for Renaissance Technologies’ 5/44?
At the same time, we see mid to late stage investing as becoming more commoditized and indexable. The best mid to late stage human investors who guide companies to IPO should also command premium fees. But the majority of market participants may gravitate towards lower-fee, indexed products that offer competitive returns by benchmarking against public market equivalents, thereby providing a more standardized, accessible form of venture investment.
The venture capital industry stands at a crossroads where embracing these shifts—towards patience, innovative liquidity solutions, and a nuanced appreciation of risk and expertise—could very well define the future landscape of investing. This evolving scenario has the potential to lead to a more robust and dynamic marketplace.
[1] https://www.kauffman.org/reports/we-have-met-the-enemy-and-he-is-us/
[2] https://pitchbook.com/news/reports/q4-2023-pitchbook-nvca-venture-monitor
[3] https://pitchbook.com/news/reports/q2-2024-pitchbook-analyst-note-establishing-a-case-for-emerging-managers
[4] https://greylock.com/greymatter/the-new-new-moats
[5] https://www.aqr.com/Insights/Perspectives/Volatility-Laundering
[6] https://pitchbook.com/news/reports/q4-2023-pitchbook-nvca-venture-monitor
[7] https://pitchbook.com/news/reports/q2-2024-pitchbook-analyst-note-establishing-a-case-for-emerging-managers