We need to rethink traditional venture capital investment models to solve big problems. The traditional process tends to encourage the largest funding rounds for companies perceived to offer blockbuster returns. That can act as a very narrow filtering process for the majority of private businesses that do not seem to fit that “go big or go home” model. Many high impact businesses do not fit that model. When many people read such statements, they may immediately assume that means a bunch of do-gooders who care nothing about making solid returns who probably belong more in a nonprofit setting. Ironically, that is often more perception than reality as the old fable of the “tortoise and the hare” is a more relevant analogy. For many institutional investment managers it may seem to be more rational and less risky to stick with their more established managers that are in more traditional strategies and structures. On the surface, this may seem like the conservative strategy until you take a wider, systems-based view of the situation. What if what we think is a very conservative strategy is more risky than we understand. Following the crowd seems rather ingenious at the beginning of new exciting science and technology cycles, but eventually leads to lemming behavior, as well as over-crowded and over-valued companies. Almost no one is brave enough to get off the gravy train and when it eventually crashes, you blame the market and just move on (after the government and central banks are expected to step in and fix everything). When these bubbles correct, they have many unintended, negative consequences for many members of society that are already the most vulnerable. It is also a gross misallocation of needed resources we could be spending more wisely to solve important problems in society. What if what we have come to accept as ordinary or unchanging realities are actually more fluid than we realize. We are in the day and age of creative problem solving, new exciting science and technology, more active interaction and collaboration across wider groups of stakeholders. By applying principles and tools that enable you to better understand the root cause of complex problems, we are presented with much more transparency to better optimize how to best solve important problems. We are evolving toward a much more fluid and agile process for complex problem solving that naturally applies and imbeds prudent risk management and the investment industry needs to be an integral part of this process.
The first question we need to ask ourselves is why are we making these investments in the first place. If we only consider the financial side of things and all other considerations are ignored, the status quo will never change because a very small set of well connected people in the world make large sums of money pursuing these bubble investment strategies, especially in the early to mid stages of a particular cycle. Fortunately, more and more people these days are beginning to prefer more holistic investment and business frameworks that address “people, planet, and profit.” Taking an ecosystem-based approach to examining problems at their root cause and then slowly and carefully building solutions may not be as sexy as being one of the early investors in “Snap” but if organized and executed well, this ecosystem-based approach has the potential of making more sustainable and resilient returns for investors over the long term as well as solving many more important problems. The second question is how can we organize an integrated business and investment process that better aligns incentives and one that encourages a more collaborative model to include the necessary financial, technical, scientific, and business resources these important entrepreneurs need to be successful. Breaking down old silos is a necessary part of evolving toward this new model. The business and investment systems-based framework we follow is inspired by sustainable agricultural ecosystems and billions of years of evolution, so we happily follow Mother Nature’s lead for our process.
In the following article, Ross Baird, the Executive Director of Village Capital (http://www.vilcap.com), discusses his view of the problems with the traditional venture capital industry and potential solutions. It is extremely thoughtful and well written, so we are certain you will enjoy it. It is an article from last summer, but is more relevant now than ever and is strongly aligned with our views.
Sarah Frier and Eric Newcomer wrote the next article we found on Bloomberg. Though the article is two years old, it has some wonderful descriptions of the herd-like behavior of investors and the standard methods venture capital firms apply to structure deals to minimize risk such as preferred liquidation rights and ratchets. These financial structures become much more prevalent as the larger firms come in and valuations are higher. There are fewer and fewer IPOs and the ones that do happen tend to be very overhyped and have attracted more than their fair share of financial resources. They are also waiting far too long to come public, which is not healthy for our economy. The recent Jobs Act should help to make it easier for smaller companies to raise public capital. We need more small businesses to grow and succeed for our economy to be healthy and for jobs to be plentiful and secure. This also helps to balance out the inequities that are very extreme right now.
The risk is higher today for many of the most richly valued private investments. Unlike in past cycles where companies went public earlier, this time, the most overvalued companies are still private. Some of the better run companies may eventually earn their way into their valuations, but what about the rest when the punch bowl is taken away. When you read the following article, it is interesting how investors use their deal structures to manage risk. Ironically, rather than managing risk it may actually be increasing risk if those deal terms are what larger firms are using to justify larger valuations. It may make sense to each individual fund at the time, but the collective results are concentrated sector bets, overvaluation, and intense hubris. In a more systems-based investment approach, aligning incentives is at the heart of the process so it is hard to imagine the existing paradigm functioning to solve big problems if the existing paradigm views such strong misalignment of incentives as standard operating procedure.
We not only need more creative venture models, but we also need to find a way for a wider variety of businesses to come public at an earlier stage of development. In order for innovation to be more inclusive and work for more people, this has to be a necessary part of our strategy. We need new financial structures and educational tools to encourage both retail investors and institutional funds to invest in these smaller public businesses. The fixed costs of starting up and running investment funds are high so we need to novel solutions to create adequate incentives for investors to pursue this strategy. The current financial incentives encourage large institutional long-only funds that are too big to invest in many of these companies and are often too inflexible to collaborate effectively with management of these types of businesses. Current financial incentives also encourage the development of large hedge funds due to their rich fee structure. It is more profitable for a fund marketer, a seed investor or an investment manager to pursue the hedge fund model even if those funds underperform. Due to their fee structure, they need liquidity and have shorter investment time horizons, so smaller companies that require longer collaborations and patient capital can have a tough time in today’s public markets. It often leaves them very vulnerable to predatory investors and day traders (whether human or machine). Fortunately, that provides strong opportunity and incentives for experienced, high quality small capitalization managers. With the lack of attention to this area, it is truly one of the best investment opportunities in the global stock markets today. If investors agree to focus on longer investment time frames than the typical mutual fund formula allows, then you can run more focused funds and work collaboratively with the companies to help them unlock value in their businesses. With stronger resources and higher quality partners, the more predatory investors move on to other targets. This can help the companies build more successful businesses and also help the investors earn stronger returns. That is also a better strategy to beat the benchmark, which is increasingly difficult to do these days. Not only can investors expect solid returns, but many more important businesses can develop and thrive.
Perhaps asset allocators might consider lowering their minimum investment (often 100-200 million per fund for larger institutions) for public funds that invest in the small to mid sized companies around the world and increase the number of managers, which may mean taking more chances on new managers (which is a great way to include more diverse managers such as women, African Americans, Hispanic people…). To find true alpha returns, which are the holy grail of active management, it is much more likely to happen with a focus on smaller to mid sized companies. If a greater number of fund managers and retail investors were targeting this area, it would also encourage many more entrepreneurs from around the world to diversify their business strategies to address more big problems. With fewer and fewer mutual funds and hedge funds beating relevant benchmarks these days, it is understandable that more money is pouring into index funds and ETFs. If you used a passive investment strategy for a large percentage of your funds and decided to focus on active management for the remaining assets, it is just good business to target novel strategies for both venture investing and public investing, especially those that target high impact, emerging businesses. Some of the potential benefits may include lower fees, stronger long term, more resilient returns, and investments more aligned with society’s values. Institutional managers that use the typical excuses for not more aggressively pursuing this strategy such as these “smaller funds do not make a difference to the overall portfolio” and that “my investors are risk averse” are inadvertently increasing their risk to their own portfolios and to the global economies. It is clear the existing paradigms need to change and there is a wonderful opportunity for wealthy investors and institutional investors to be a big part of the solution.