The relationship between venture capitalists and founders is well discussed and understood. But another side is also critical in venture capital: the VC’s relationship with limited partners, or LPs—the ones providing the money that fund managers invest.
Both OpenLP and Notation Capital’s Origins podcast have done a good job shedding some light on the money behind the money. But any would-be venture capital fund manager, or entrepreneur looking for venture funding, can benefit from understanding the concept of “edge” in venture capital—the difference that makes a fund deliver above-average returns.
In my role as a fund of funds investor focused on digital asset funds at Cambrial, I’ve previously looked at deriving a VC strategy in crypto and crypto VC portfolio construction. Now in this three-part series, I will look at four key components of a VC fund’s winning differences: what makes for an informational edge, the analytical and behavioral components of edge and why structure matters as a competitive advantage.
First, let’s start with what an edge means, and why it’s so important.
The Pursuit Of Edge
An LP’s assessment of a fund manager’s durable edge is of particular importance in venture capital for two reasons: First, GPs make perhaps fifty investment decisions over a fund’s lifetime, so statistical significance can take decades to reach. This makes it difficult to differentiate between luck and skill. Second, once LPs have allocated to a particular fund, they are stuck with it for a decade (secondary transactions aside). The illiquidity of these vehicles amplifies the importance of making correct allocation decisions from the start.
Spotting Edge As An LP
As an LP, detecting superior or inferior managers earlier than others can a) help you avoid incurring opportunity costs by being stuck with a subpar manager for ten years or more and b) facilitate taking as much capacity as you like in a future home run.
While past performance is perhaps the simplest indication of edge, it is a lagging indicator and of little relevance to assessing the abilities of emerging VC managers that lack an established track record. This is of particular interest to micro VC or crypto since GPs are mostly emerging managers.
Once a positive track is apparent, allocation becomes an access game into capacity-constrained funds which is generally won by institutional LPs with enormous balance sheets and permanent capital. For the rest of us, there is an opportunity for sophisticated LPs willing to put in the work to identify edge early and in spite of a lack of quantitative performance data. In doing so, the entrepreneurial investor is able to build stronger relationships early on with such GPs. Historically, this has resulted in significant outperformance, as well as securing priority access to tomorrow’s franchises.
A GP’s Sources Of Edge
By definition, achieving above-average returns (alpha) requires making investment decisions that are both unusual and correct. An investment edge, therefore, must display two distinct qualities: 1) it has to be different and 2) it has to work.
Capital allocators usually differentiate between 4 sources of edge: Behavioral, Analytical, Informational and Structural. In this series, I will explain each of these and take examples from the venture capital value chain to illustrate them. As an LP in the crypto space, I will also look at specific considerations that are particularly relevant to this particular industry.
Having an informational edge in VC means having superior access to information relative to other market participants, particularly with regards to (1) deal flow and (2) follow-on investments.
Contrary to public markets, information in private markets is far more unevenly distributed and less regulated. There is no central database for private market investors to find every available deal and fundamental or operational data on startups is often inaccurate or outdated. GPs who sit in the flow of information can make better investments.
Preferential Deal Flow
While the idea of proprietary deal flow is something of a myth (most founders will at least take a call from most VC firms asking to write them a check), preferential deal flow is certainly a reality.
Most deal sourcing is inbound and some VC firms get the pitch before others. As a fund manager, you want to be one of the first three investors to see a particular deal in your investment universe, allowing you to pick off the best ones before others get to it.
Being the first call is an edge which is easy to exploit, but hard to develop.
As a result, it is one of the most durable (and valuable) edges in the venture business and one of the reasons brand name firms continue to post excellent returns. Benefits include being able to shape the deal terms, partnering with preferred co-investors (who will see eye to eye on matters of governance and strategy) and securing your place in competitive funding rounds or even getting access to additional allocation on the same terms after a round is officially closed.
Many established firms have been able to develop a strong signaling value, which can be leveraged into preferential deal flow. Indeed, this may be why they are still around! Founders want to take money from Sequoia, USV and Benchmark because these firms are widely known for being some of the smartest investors in the business. An investment from them signals something about the quality and desirability of the investee.
But how do you as an emerging manager develop better access to deals?
One answer is focus: it is easier to dominate a niche than an industry. That is why a number of firms have focussed on becoming thought leaders for a particular subsector, business model, technology, geography or community. Once they are the smartest GP in that segment, signaling value can accrue. Given (tech) niches are densely networked, word can spread fast and preferential deal flow can build up relatively quickly. This is already observable in crypto.
Proprietary Insights As An Investor
Once you have made an investment, there are other enormous informational edges available to you. As an investor, you will have a privileged view into your portfolio company and its development, depending on the information rights you negotiated and the relationship you built. Investors who hold a board seat going into a funding round will likely have a materially better insight into a company than outside investors, so much that the very fact that an existing investor does not follow on is seen as a negative signal.
Insights gained about the industry, business model or competitive landscape can also help you with potential future investment or divestment decisions in adjacent or comparable markets. This proprietary access to knowledge is particularly relevant for specialist funds facilitating synergetic information flow between portfolio ventures in the same sector.
The Virtuous Information Cycle
The strength of an informational edge is that it reinforces itself over time, like a virtuous cycle. Better access to deals translates to better investments and greater performance, leading to a halo effect and stronger deal flow because of it. At some point, even other funds start sending you deals. Earlier-stage funds want you to invest in their portfolio companies; later-stage funds want to invest in your existing portfolio and direct competitors want to share deals and do co-investments.
This is the flywheel that has brought today’s most prominent venture franchises to fame. A study from Yale on venture capital firms found “that the success rates of top firms flow from access to the best startups that is not available to newer or less prestigious firms.”
In venture, the data tells us that past performance at least suggests future returns.
In our world, we have observed that crypto-focused managers who have deeply embedded themselves in the community and have a technical understanding of these assets are strongly preferred by founders. The virtuous cycle of positive signaling is beginning to spin up.
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