Exceptional returns and value add in venture capital

I came across this piece in the FT yesterday that discusses at theoretical level the ways it is possible for fund managers to generate exceptional returns. It is germane to the subject of VC value add.

We have to start with a little theory:

The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha.

And it is the alpha that counts and that we all get paid for. Without alpha there is no carry. Another way of looking at this is that any idiot can get the market risk-return just by investing across all the assets, or in a tracker.

Potential sources of alpha are (I excluded the ones that aren’t relevant to VC):

having truly special abilities in identifying undervalued financial assets. Warren Buffett, the US billionaire investor, certainly has it, yet this special ability is, by definition, rare

A second source of alpha is from what one might call activism. This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. A venture capitalist who transforms an inventor, a garage and an idea into a fully fledged, profitable and professionally managed corporation creates alpha.

Thinking about this in terms of the value a VC adds to his portfolio this tells us that we can make great returns in two ways:

  • by investing in great companies that don’t need our help and (we think) are undervalued by the market, or
  • by investing in companies that are fairly valued by the market and then getting involved to make the changes that will increase that value.

Needless to say every (profitable) situation has at least a small amount of both of these elements.When we get access to the first type of deal, the undervalued type, it is typically because we are willing to bet on an emerging market or technology earlier than anyone else. These investmens require bold vision and big cojones.

When we get the second type – where the alpha is created post investment – we are into the usual areas of VC value add. I have written about these recently here and here.

By definition a successful VC must be doing at least one of these two things.