Market makers need consensus to function, explaining why Valley groupthink isn't a bug but a feature. Though unlike commodity traders, VCs become evangelists for their positions. Maybe because wheat doesn't need storytelling, but the future always does.
"wheat doesn't need storytelling" is such a great way to phrase it! Though in a way, what the CBOT and CME did is create a shared story / belief / trust system around wheat. VCs have to do that individually, hence the evangelism.
I read this multiple times. As much as I appreciate the role of Keynesian Beauty Contest in investments (and life in general), I am unclear on one part - is one of the implications that the early-stage-only firms have no agency on their future? Their role in the value chain is to find cos which late-stage funds will like and to underwrite the risk to the extent of those cos hitting PMF. So their investment strategy is a net reduction of the late-stage funds’ strategy? Would love to know your thoughts here.
I think there are two strategies you can follow as an early-stage-only fund: alpha or beta.
What you describe is the beta strategy: "your role in the value chain is to find cos which late-stage funds will like and to underwrite the risk to the extent of those cos hitting PMF". (except it's not even PMF -- what you're really underwriting is the ability of the companies to close their next round, which may or may not entail PMF).
The alpha strategy is what I describe in footnote 12: "Invest in outsider founders, unglamorous markets, immature geographies, hard-to-understand technology, and atypical business models, that often don't even need outside capital."
The beta strategy is "safer" but will never deliver outlier returns (that's what beta is, after all). It's also more vulnerable to competition -- from other beta-chasing funds, and from venture majors moving upstream. Beta is a commodity.
(You could even argue that irrational valuations at early stage are a reflection of this commodity nature. The way to win in a commodity market is to price aggressively.)
Meanwhile the alpha strategy is riskier, but offers the potential of true venture returns.
These are two different products! No right or wrong; just a choice of where you want to be on the risk-reward spectrum.
There is however one misalignment in the market, and that is that the returns for individual LPs and GPs are better in the beta model. GPs get to charge 20% carry on beta investments (which makes no sense at all!). And both LPs and GPs benefit from the short-term career legibility that markups offer -- much better for your resume than a 15-year, uncertain, illiquid holding in a true alpha portfolio.
Fantastic post! So refreshing to read truly original thinking.
"More precisely, it identifies, decomposes and then allocates the risks of the sector to people who want to take those exact risks — early stage investors seeking 100x returns on 1 out of every 20 investments and okay with seeing the rest fail…”
Does the analogy with wheat hold here? Does Kim the Kansas trader have hundreds of wheat routes to choose from? Is she expecting most of them to fail? What’s always stumped me about the consensus-driven venture model is that it encourages a proliferation of the largest possible number of startups so that 1 in 20 provides returns, and so floods the market with hundreds of startups doing exactly the same thing. This does not strike me as being good for the ecosystem (and wouldn’t Peter Thiel agree?).
Really interesting and thought-provoking comment. I will have to think about it a bit more. But here's an initial take:
The traditional venture capital model was designed to finance startups solving "genuinely hard problems" where there was no clear pathway to, or certainty of, success. Breaking down that hard problem into smaller, more legible steps, was the key innovation.
But the very success of that model meant more capital entering the market. So now in addition to solving the hard problem, founders have to compete with 10 other startups attacking it. The odds go from 1-in-20 to 1-in-200 or worse. Which in turns means you need ever bigger outcomes to make the math work, which means more capital deployed along the way, and more space for the venture majors to play in.
Another dynamic is that many, perhaps most, investors are simply not technically qualified to evaluate truly "hard" startups with big asymmetric payoffs. So instead they tend to invest in "easy" startups in supposedly "winner takes all" markets, which tend to have the same risk-reward profile. But now you're no longer underwriting startup risk, you're financing GTM growth. That's a very different game. (And again, it's something the venture majors prefer).
I loved the Minsky Moments article. And, this one clearly lays out incentives of different types of VC market players. As a seed stage VC, analyzing whether the startup has a credible plan to make it to Series A is a part of any diligence process. But it's not the only factor.
If you analyze the outliers that "return the fund", it cannot be, because many of them *were* contrarian at the time that they were seed stage. This is easy to forget later on. A seed stage VC needs a systematic way of selecting for founders that have long-term defensibility strategies that will lead to outsize exits at the end, in order to make up for the larger number of failures at seed stage than at later stages. It is precisely the heavily funded consensus seed stage startups that can likely purchase their way to a Series A through sales/marketing/PR that don't have the evolutionary pressures to develop such a strategy.
Very true. I think the very best seed investors try to find companies that are contrarian at the time, but will become consensus later on -- surfing just ahead of the consensus wave, as it were. That way they can be part of the ecosystem (and take advantage of late-stage cash) while still generating alpha versus the market.
Love your point about "evolutionary pressure"! Nothing like constraints to force creativity and healthy habits.
I wonder if the "venture is the Keynesian beauty contest" phenomenon is also a function of how large and institutionalized venture funds have gotten. It's no longer an industry where general partners are making decisions but there are hundreds of analysts, associates and principals who don't have the same level of skin in the game as partners. Their performance is more measured on short-term metrics such as markups on investments they led, and therefore they are more likely to identify exactly what downstream investors are looking for and front-run them. The average tenure at many of these large funds is short (2-4 years) so many of the analysts, associates and principals may just be optimizing their metrics over a shorter time period.
Agree 100% and this is definitely part of what's going on. Funnily enough I made the exact same comment to another reader, in a private email:
[There's a] principal-agent problem between the individual investors at the fund, and the fund itself. The "fund" cares about realized DPI, hence final outcomes, hence the entire lifecycle and viability of the investment. But the individuals making the investment decision care much more about markups, because that's what matters to their careers. Average tenure at a fund keeps decreasing: unless you're a senior or founding partner at a firm (or a big part of the firm's brand), it's very likely that you'll move to another opportunity at some point -- and statistically, that point is likely to happen *before* your investments actually come to the end of their lifecycle. (This is made worse by startups staying private longer) (which in turn is caused by the rise of the venture majors and late stage capital -- it all hangs together). So if your investments haven't reached fruition (exit), then the only remaining signal is markups, and hence your incentives change.
Great read as always. It feels like the VC market is still in the same stage as the wheat market was prior to the introduction of futures contracts, that brough liquidity and hence arbitrage between stages. What would be a similar financialization product in the VC industry? Or does the lack of legibility in the underlying companies prevent this step from happening altogether?
I think it's a lack of homogeneity more than anything else. Wheat is fungible, early stage tech startups less so. The best you can do is impose (artificial) homogeneity via round benchmarks and valuations, but that's a far cry from true fungibility which is what you need for futures to work.
Great essay - curious to hear your thoughts on how these large venture managers will expand beyond their core product, which is equity financing. Like you said, this product is playing a dual-role of market making. But what's the next logical step from here? Debt funds? M&A advisory? FoF?
I think one obvious candidate is new financing structures, beyond vanilla preferred shares. VC financing is pretty basic compared to (say) their PE counterparts. SAFE notes and token-based financing are the only real innovations I can think of in the last decade or so. (There's a good theoretical argument that venture debt is better suited to the growth stage than equity capital, but it hasn't taken off).
M&A advisory is kind of already happening, at any rate it's part of the implicit value-add that the venture majors pitch, to win deals. The portfolio approach also means that FoF is kind of baked in as well.
But it's a really good question. I'm also very curious about the answer...
Thanks for this, Abraham
Market makers need consensus to function, explaining why Valley groupthink isn't a bug but a feature. Though unlike commodity traders, VCs become evangelists for their positions. Maybe because wheat doesn't need storytelling, but the future always does.
"wheat doesn't need storytelling" is such a great way to phrase it! Though in a way, what the CBOT and CME did is create a shared story / belief / trust system around wheat. VCs have to do that individually, hence the evangelism.
I read this multiple times. As much as I appreciate the role of Keynesian Beauty Contest in investments (and life in general), I am unclear on one part - is one of the implications that the early-stage-only firms have no agency on their future? Their role in the value chain is to find cos which late-stage funds will like and to underwrite the risk to the extent of those cos hitting PMF. So their investment strategy is a net reduction of the late-stage funds’ strategy? Would love to know your thoughts here.
I think there are two strategies you can follow as an early-stage-only fund: alpha or beta.
What you describe is the beta strategy: "your role in the value chain is to find cos which late-stage funds will like and to underwrite the risk to the extent of those cos hitting PMF". (except it's not even PMF -- what you're really underwriting is the ability of the companies to close their next round, which may or may not entail PMF).
The alpha strategy is what I describe in footnote 12: "Invest in outsider founders, unglamorous markets, immature geographies, hard-to-understand technology, and atypical business models, that often don't even need outside capital."
The beta strategy is "safer" but will never deliver outlier returns (that's what beta is, after all). It's also more vulnerable to competition -- from other beta-chasing funds, and from venture majors moving upstream. Beta is a commodity.
(You could even argue that irrational valuations at early stage are a reflection of this commodity nature. The way to win in a commodity market is to price aggressively.)
Meanwhile the alpha strategy is riskier, but offers the potential of true venture returns.
These are two different products! No right or wrong; just a choice of where you want to be on the risk-reward spectrum.
There is however one misalignment in the market, and that is that the returns for individual LPs and GPs are better in the beta model. GPs get to charge 20% carry on beta investments (which makes no sense at all!). And both LPs and GPs benefit from the short-term career legibility that markups offer -- much better for your resume than a 15-year, uncertain, illiquid holding in a true alpha portfolio.
Fantastic post! So refreshing to read truly original thinking.
"More precisely, it identifies, decomposes and then allocates the risks of the sector to people who want to take those exact risks — early stage investors seeking 100x returns on 1 out of every 20 investments and okay with seeing the rest fail…”
Does the analogy with wheat hold here? Does Kim the Kansas trader have hundreds of wheat routes to choose from? Is she expecting most of them to fail? What’s always stumped me about the consensus-driven venture model is that it encourages a proliferation of the largest possible number of startups so that 1 in 20 provides returns, and so floods the market with hundreds of startups doing exactly the same thing. This does not strike me as being good for the ecosystem (and wouldn’t Peter Thiel agree?).
Really interesting and thought-provoking comment. I will have to think about it a bit more. But here's an initial take:
The traditional venture capital model was designed to finance startups solving "genuinely hard problems" where there was no clear pathway to, or certainty of, success. Breaking down that hard problem into smaller, more legible steps, was the key innovation.
But the very success of that model meant more capital entering the market. So now in addition to solving the hard problem, founders have to compete with 10 other startups attacking it. The odds go from 1-in-20 to 1-in-200 or worse. Which in turns means you need ever bigger outcomes to make the math work, which means more capital deployed along the way, and more space for the venture majors to play in.
Another dynamic is that many, perhaps most, investors are simply not technically qualified to evaluate truly "hard" startups with big asymmetric payoffs. So instead they tend to invest in "easy" startups in supposedly "winner takes all" markets, which tend to have the same risk-reward profile. But now you're no longer underwriting startup risk, you're financing GTM growth. That's a very different game. (And again, it's something the venture majors prefer).
You had me forever at “To Wheat, To Who”. Utter genius.
:) :)
Brutal and beautiful
I loved the Minsky Moments article. And, this one clearly lays out incentives of different types of VC market players. As a seed stage VC, analyzing whether the startup has a credible plan to make it to Series A is a part of any diligence process. But it's not the only factor.
If you analyze the outliers that "return the fund", it cannot be, because many of them *were* contrarian at the time that they were seed stage. This is easy to forget later on. A seed stage VC needs a systematic way of selecting for founders that have long-term defensibility strategies that will lead to outsize exits at the end, in order to make up for the larger number of failures at seed stage than at later stages. It is precisely the heavily funded consensus seed stage startups that can likely purchase their way to a Series A through sales/marketing/PR that don't have the evolutionary pressures to develop such a strategy.
Very true. I think the very best seed investors try to find companies that are contrarian at the time, but will become consensus later on -- surfing just ahead of the consensus wave, as it were. That way they can be part of the ecosystem (and take advantage of late-stage cash) while still generating alpha versus the market.
Love your point about "evolutionary pressure"! Nothing like constraints to force creativity and healthy habits.
Excellent read!
I wonder if the "venture is the Keynesian beauty contest" phenomenon is also a function of how large and institutionalized venture funds have gotten. It's no longer an industry where general partners are making decisions but there are hundreds of analysts, associates and principals who don't have the same level of skin in the game as partners. Their performance is more measured on short-term metrics such as markups on investments they led, and therefore they are more likely to identify exactly what downstream investors are looking for and front-run them. The average tenure at many of these large funds is short (2-4 years) so many of the analysts, associates and principals may just be optimizing their metrics over a shorter time period.
Agree 100% and this is definitely part of what's going on. Funnily enough I made the exact same comment to another reader, in a private email:
[There's a] principal-agent problem between the individual investors at the fund, and the fund itself. The "fund" cares about realized DPI, hence final outcomes, hence the entire lifecycle and viability of the investment. But the individuals making the investment decision care much more about markups, because that's what matters to their careers. Average tenure at a fund keeps decreasing: unless you're a senior or founding partner at a firm (or a big part of the firm's brand), it's very likely that you'll move to another opportunity at some point -- and statistically, that point is likely to happen *before* your investments actually come to the end of their lifecycle. (This is made worse by startups staying private longer) (which in turn is caused by the rise of the venture majors and late stage capital -- it all hangs together). So if your investments haven't reached fruition (exit), then the only remaining signal is markups, and hence your incentives change.
Great read as always. It feels like the VC market is still in the same stage as the wheat market was prior to the introduction of futures contracts, that brough liquidity and hence arbitrage between stages. What would be a similar financialization product in the VC industry? Or does the lack of legibility in the underlying companies prevent this step from happening altogether?
I think it's a lack of homogeneity more than anything else. Wheat is fungible, early stage tech startups less so. The best you can do is impose (artificial) homogeneity via round benchmarks and valuations, but that's a far cry from true fungibility which is what you need for futures to work.
Wow!. I couldn't stop reading this once I started. It distills some profound observations in the form of an easy to read essay :)
Simply the clearest explanation for "why are things the way they are" in the world of venture investing.
“The more the increase in valuation [from the previous round], the more under-valued the company is likely to be.”
I am 70% confident - but cannot prove - that this was Peter Thiel. Not on Twitter, obviously.
That sounds extremely likely actually!
Great essay - curious to hear your thoughts on how these large venture managers will expand beyond their core product, which is equity financing. Like you said, this product is playing a dual-role of market making. But what's the next logical step from here? Debt funds? M&A advisory? FoF?
I think one obvious candidate is new financing structures, beyond vanilla preferred shares. VC financing is pretty basic compared to (say) their PE counterparts. SAFE notes and token-based financing are the only real innovations I can think of in the last decade or so. (There's a good theoretical argument that venture debt is better suited to the growth stage than equity capital, but it hasn't taken off).
M&A advisory is kind of already happening, at any rate it's part of the implicit value-add that the venture majors pitch, to win deals. The portfolio approach also means that FoF is kind of baked in as well.
But it's a really good question. I'm also very curious about the answer...
Wow 🤩
Exception Utter Genius & Original thought 💭