The Supply of Capital and Venture Returns
By: Patrick Mauel
Tags: Trends, Investing, Venture Capital

In their best-selling book Zero to One, Peter Theil and Blake Masters note that venture investment returns follow a power law rather than a normal distribution and argue that the first and only criteria to venture investment is to pick companies that have the potential to return the entire value of the fund.

To understand the intuition behind that idea, imagine an abstract example where we invest in 10 companies, each with an independent 90% probability of failure. If 9 of the 10 companies is expected to fail, the one that succeeds has to return at least 10x cash-on-cash (the entire value of the fund) for us to break even.

As you increase the number of companies from 10 to, say, 50, you need to find 5 companies that return 10x or more to fund complete losses on the other 45. Finding one company that returns at least 10x is difficult enough; finding 5 of those companies incredibly so. In that way over-diversification can bias your fund to underperformance.

This is a big departure from traditional portfolio management, where the idiosyncratic risk of individual companies is not compensated with excess returns and should be reduced through diversification. In venture investing, idiosyncrasies are the good stuff: venture firms make their money from the handful of portfolio companies that grow to dominate sectors — necessarily because they are different.

It’s interesting to think about how this return profile has changed over the past decade as a record amount of capital has been invested in young companies. Looking at the count and average acquisition percentages of Series A deals (where available) over the past 25 years, we can see that when the supply of capital is scarce, as in the 2000 dot-com bust and the 2020 pandemic rout, VC firms have more leverage to negotiate lower valuations and higher positions when investing in startups. When capital is being aggressively deployed, as in the period from 2005 until 2013, this dynamic flips as firms concede ownership in order to participate in the funding round:

Pitchbook

Pitchbook

Though at first glance the peak-to-trough difference in average ownership acquired by firms in Series A financing seems small (from a high of roughly 37% in 2005 to a low of 27%), this difference becomes very meaningful when you consider the extreme cash-on-cash returns that can be generated by venture investments. An investment that would return 10x if made in 2005 would return 10*(.27/.37) = 7.3x if made in 2015, all else equal. Applying that to our simplified 10-company portfolio above, that’s the difference between breaking even and losing 30% AUM.

The big caveat? All else is definitely not equal. Now is such a unique point in history that historical comparisons, in many cases, become irrelevant. Technology has reduced startup costs and enhanced business scalability to levels that business owners of another century could only dream of. Access to information has commoditized learning for a huge swath of the world population. Engineers have sown the seeds of private space flight, decentralized finance, carbon-neutrality, and so much more yet-unknown innovation.

All of that happened in a decade. Looking to the future, the optimist in me can’t help but feel that we’re in inning one of our most innovative century yet.

And that’s tough to put a price on.