RandomnessVenture Capital

The Black Swan remembered: Have VCs become yield hogs?

By June 27, 2011 2 Comments

I read Nicholas Taleb’s The Black Swan about three years ago and loved it for the way he calls out how many people mis-understand risk.  He argues persuasively that the natural human condition is to see predictability where there is none and as a result many of us give away our chance of a big upside while keeping exposure to unpredictable events with massive downside like stock market crashes (this last sentence is mostly in the words of my 50 Questions co-author Nicholas Lovell, another big fan of The Black Swan).

In The Black Swan and its less famous precursor but more helpfully titled Fooled by Randomness (i.e. don’t be….) Taleb pours scorn on his former investment banking colleagues who blindly follow investment strategies they don’t really understand for the twin reasons that everyone else is following them and they have been working for recent history.  He describes these people as ‘yield hogs’ because they are addicted to predictable small returns (the yield) but he despises them for the way they radically and persistently underestimate the downside risk of their investments such that when there is a crash all their profits are wiped out and wider society is damaged.

I was reminded of Taleb when reading this interview with Bruce Gibney, COO of upcoming San Francisco venture capital outfit Founders Fund.  In it he lambasts other VCs for not being willing to take big risks and make big bets on truly transformative technology:

A lot of the flashiest investments are taking place in companies that appear to be good ideas and are very popular, so the valuations appear very high …. Sort of a thought experiment for readers to go through is to walk up and down a road mentally and ask whether the GPs there would prefer to back the latest round of Twitter or any of the sort of great VC companies of the 60s and 70s, your Intels, your Apples, your Microsofts, your Genentechs.

and then he piles in with this hilarious kicker:

I believe that if you live on a street where at least one person wins the Powerball lottery every so often, you tend to buy more lottery tickets than if everyone was a hardworking engineer at Apple.

There you have it.  In Bruce’s view it appears most VCs are piling into consumer internet companies in the hope of finding the next Twitter/Facebook/LinkedIn and not understanding that the odds of success are lottery odds.

My view is that there is a bit more to the story, and that a lot of VCs have a second justification to their investments based on the chances of a quick flip for a lowish multiple but high IRR return – which is a bit like Taleb’s yield.

Put these two together and VCs are sounding like Taleb’s yield hogs – chasing small returns and not really understanding the risks they are taking.  The irony is that Taleb singles out VCs for praise because they are supposed to understand risk and are supposed to be set up to maximise their chances of getting lucky and finding a black swan.