I wrote a series of blog posts about venture capital fund performance on my personal weblog several weeks ago. One of the things that came out of that series is the fact that the top quartile of fund managers performs significantly better than the rest of the pack.
There's a saying on wall street that I've heard over the years about asset managers, "buy the 10 best and forget the rest". And that is certainly true of the venture capital asset class. If you had bought the 10 best and forgot the rest in venture over the past 20 years, you'd have netted at least 25% annual rates of return, including the ugly years from 1999 to 2003.
So that begs the question about past returns being an indication of future performance. In fact I got a lot of comments on my series of posts about this specific issue. Nik said:
I could guess some of the reasons of why past performance is an indicator of future performance. E.g. self fulfilling prophecy i.e. Sequoia has backed successful companies and I could be successful as well if I were backed by them. As a result, these firms almost get a ROFR on the best plans...
But wanted to hear from you on what else there could be...
Why is it that past performance is such a strong indicator of future performance in the venture capital business?
First, it's largely true in all asset classes. Someone who has been a top performer in the hedge fund or real estate business over the past 10 years is likely to be a top performer for the next 10 years. Just like there are some who are amazing at sports or writing books or playing music, there are some people who are simply great investors. They have that special something that allows them to be better than everyone else. And like great athletes, writers, or musicians, great investors can have slumps. But if you look at the performance of great investors over the long haul, you will see that they can put up long term track records that are consistently better than the average investor in their asset class.
Second, Nik's guess is a big factor in all private markets. Successful investors create an aura of success around them and their firms. It's true of firms like Blackstone, TPG, KKR, and Providence in the buyout business and it's true of firms lik Sequoia, Kleiner Perkins, and Matrix in the venture capital business. Successful deals are associated with the firms that were the primary backers. The success of the deals builds the firm's brand. And entrepreneurs want that brand association as much as they want the money that comes with it. It doesn't give the venture firm a "right of first refusal" as Nik suggests, but it sure makes it easier to beat the competition, often with a lower price (as long as it's not too much lower).
These two reasons are not specific to venture. And they are the two most commonly cited reasons that past performance is a strong indicator of future returns. But there are a few things that are more specific to the venture capital business that play an important role as well.
If you look at the most successful venture capital firms, you will see that they are usually early stage investors who often are the first institutional money into an investment, the way Kleiner and Sequoia were in Google. Getting that place in the capital structure in an early stage investment is important because it provides access to the management and business that later round investors don't get. Look at the role Accel now has at Facebook. They are involved deeply in the strategic and business decisions that the management of Facebook makes. What comes with that kind of access is a level of knowledge and understanding about an emerging market that you just cannot get sitting on the outside looking in.
The best venture capital investors/firms use their engagement with their portfolio companies and all the entrepreneurs they meet to become smarter about the markets they invest in. Kleiner and Sequoia certainly got to see the search marketing business developing before most other investors did. Accel (and Greylock and Peter Thiel) will certainly understand how social advertising is developing better than most of us on the outside. These insights are incredibly valuable and should lead to a host of additional investments.
Another effect of this close association with portfolio companies is management talent. Look at PayPal. The PayPal alumni network is legendary, having spawned dozens of companies, many of them leading venture investments in the past five years. If you were an early and significant investor in PayPal, as Sequioa was, then you'll know all these talented entrepreneurs and ideally will be able to back them before others get the chance.
A related aspect of this management issue is the subject of "franchise entrepreneurs". Some firms will develop relationships with entrepreneurial teams that allow them to back them again and again. We have that kind of relationship with several of the teams that are in our current portfolio. There isn't any kind of "locked in relationship" like a 5 record deal in the music business. But the best firms treat their entrepreneurs well and the entrepreneurs will come back deal after deal as long as they feel they are being treated fairly (and visa versa).
So you can see that there is a virtuous cycle of knowledge and relationships that come from being one of the best venture capital firms. Good deals and good teams lead to more good deals and good teams. It's frankly hard to screw it up.
But you can screw it up. There are two common ways I have seen great firms "screw it up".
The first is getting too big. When you raise too much money in the venture capital business, two things happen. The first is you have to hire a bunch of partners to manage all the capital. And not everyone will be a world class athlete. So you end up with mediocre investors on your team. And that is a bad thing. Even more problematic is that it's hard to be the first institutional money into a deal when you are managing billions of dollars of venture capital. So other firms come in underneath you in the capital structure and take that pole position with management, and get all the relationships and insights that come with that position.
The second screwup is "style creep". It's often related to getting too big, but can be caused by other factors as well. A firm that is a great biotechnology investor may not be a great clean tech investor. A firm that is a great communications equipment investor may not be a great web applications investor. The best firms are known for certain kind of investments and stick to them. They often have partners who have specific market expertise. When firms expand their areas of interest beyond what they are good at and what they know well, it often leads to reduced performance. And their brand can get hurt. Which can have a snowball effect for the same reasons that great performance and great brand produces a virtuous cycle.
So what would I look for if I was investing in venture funds? First, I'd look for investors who have a track record of success over a long period of time. And I mean people, not firms. Then I'd look for a firm that has a small group of such investors. I'd expect that firm to have produced top quartile returns for a series of funds. Then I'd make sure that the investors who were responsible for those returns were still actively engaged in the firm and would be making the majority of future investments. And I'd want to know that the investment strategy of the firm was not changing and that the capital being managed per partner was in the manageable range for first round/lead investments which I believe is around $50 million per partner per fund. If you find that profile in the venture business, buy that fund. Only problem is you can't get into funds that look like that. Unfortunately, I don't have an answer to that problem.