Why competing for "access" is a dangerous game for VCs
(Yet another commentary on Tiger. Sort of.)
A venture capitalist’s job is complicated. First you have to identify great companies. Then you need to convince them to take your money. Then you need to do what you can to help them from blowing up, or failing to find a market, or running out of money. Then hopefully, one day long in the future, the ones that didn’t blow up eventually find liquidity and return money to the fund, which lets you distribute that capital back to your limited partners and hopefully pay yourself.
In the meantime — usually between the “convince them to take your money” and “return money to the fund” phases — you’re busy raising new funds from existing and new limited partners. In the long run every VC is graded on his/her returns performance (realized IRR, cash on cash returns) but in the medium term the firm’s ability to raise new capital and stay in business requires evidence that returns are imminent but without being able to actually show the realized returns.
So what can you show? You can show:
A portfolio of investments that sound exciting
That have increased in value since the initial investment
As evidenced by markups by well-known investors who have invested in subsequent rounds in those businesses
This is the incentive structure for many VCs, particularly the newer managers. In the long run (years 7+) we are graded on realized performance, but in the short run (years 0 through 5) we are graded on our ability to invest in companies that other notable investors will also want to invest in very soon. Have you ever wondered why the venture ecosystem sometimes seems so much like a high school teen movie? This is why.
I should note that it’s not like anybody really likes this all that much. Every VC wants to make great long term returns and do great work; most people do not go into this business to participate in popularity contests. This is just the incentive structure that is in place. Much like how senators go to congress to help their constituents but end up spending most of their time fundraising and campaigning, VCs want to support the creation of iconic tech franchises (and they do!) but have to spend a lot of their time playing signaling games with other VCs.
Now, when you take that thought and combine it with the following observation (now VC truism) courtesy of Marc Andreessen:
… “VCs are incentivized to invest in companies that other VCs will find attractive” + “only 15 companies a year really matter” = “all that matters is getting access to those 15 companies”. When you design a firm specifically for the purpose of achieving access to the top cohort of companies, what you get is Tiger Global.
Here are some of the tactics:
Make “yes" decisions faster than anyone else
Be unconcerned with entry price
Not take a board seat — which was somewhat important for winning deals but 10x more important because everybody was talking about this which meant that they were on every founder’s mind
This isn’t just a Tiger thing. Just about every major element of the last two years' run-up was designed to prioritize access. Solo capitalists. Alumni syndicates. “Fast follower” funds. The whole game became “we can get into the best companies”.
Of course, there’s just one problem: Just because you invested in great companies does not necessarily mean you will earn a great return on those investments. Getting access to the “best” deals only ensures returns if the entry price in these investments makes sense relative to the eventual exit value. Unfortunately, many of these actions taken to improve access (overpaying, under-diligencing, ignoring governance) effectively sacrifice returns rather than ensure them.
While it’s true that the best companies have a sort of gravity-defying ability to “grow into any price”, but the math really only ties out for the earliest stages of investing. Yes, if you had invested in Uber’s Series A you would have hit a grand slam regardless of entry price. But the same does not hold for Uber’s Series E (the company is trading at roughly the same valuation now 7 years later). If you are willing to pay any price to get into the “best” Series E deal, that company had better end up being Google.
This is precisely the problem— everybody paid prices these past two years that required all of these companies to end up being the next Google. Why? Because Tiger freaked us out. Tiger scared us into having to articulate a Tiger defense strategy — “How are we going to beat those guys? How are we going to get into the best companies while Tiger is out there?” The best defense is a great offense, we hope? Well, it turns out that 2020 and 2021 may end up being the worst performing vintage of venture deals in decades precisely because these were the rules of the game we all decided to play.
Is access important? Of course it is. But it’s not so important that we should de-prioritize every other aspect of the venture job (patience, prudence, price discipline, portfolio support, etc) just to optimize for it. A fund of overpriced investments in the top 15 companies in any given year may seriously underperform a peer fund composed merely of excellent but temporarily unknown companies (purchased at modest but fair prices) in places that competitive investors didn’t even know to look.
The way to drive long term returns in venture is to have a process for occasionally being extremely right. Where “extremely right” is defined as earning a very high return on an outsized amount of capital invested, i.e. having a big bet pay off. That’s it. Your “access” strategy should provide for a large enough denominator of potential deals to support the above objective, but not necessarily any more than that. There can be too much of a good thing.