LPs, the investors in VC funds, have a difficult job to do, largely because they have to work with poor quality data and only a small fraction of VCs deliver the returns that make them worth investing in. The problem is made worse by the fact that LP demand to invest in the handful of serially successful VCs well outstrips supply and most LPs have to invest most or all of their venture allocation in other VC funds.
The CB Insights Investor Mosaic sets this out very well. They also describe the factors that they think LPs should use to make those tough decisions:
- Past performance – unlike most other asset classes in venture capital past performance is a good predictor of future performance. CBInsights calls this ‘Performance Persistence’.
- Network centrality – “how connected a VC firm is with other VC firms in the industry, as networks have been proven to be a critical driver of VC performance”
- Brand – “brand is important in venture capital as firms with great brands and reputations see higher quality dealflow, gain entry into emerging industries and can also achieve better economics because they are a preferred source of capital for company founders.”
- Investment discipline – “VC returns have been shown repeatedly to be tied to discipline. Discipline spans fund size as well as sector, geographic and stage preferences. Disciplined stage and sector investing fosters learning opportunities and the development of stage and sector specific knowledge and skills. Discipline also helps to keeps a venture fund’s loss ratio low which is important as they are ultimately stewards of LP investment funding.”
- Selection aptitude – “a measure of dealflow quality and selection prowess for each investor. It highlights each investor’s ability to source and ultimately select high quality investments and then shepherd them to favorable outcomes. While the platitude that 1 of 10 VC investments is a homerun is often thrown around, the reality is that some venture capital firms are significantly better at hitting homeruns then the rate of 1 in 10. Conversely, several VCs are much worse.”
- Illiquid portfolio strength – “this score measures the quality of current, non-exited companies in an investor’s portfolio and also looks at the investor’s entry point into the company.”
This is a really good list and at Forward Partners we aspire to be great on all these dimensions, but for me selection aptitude stands out above all the others as a driver of success. It is the least measurable (aside from looking at past performance) and as a result LPs often focus more on the other drivers. To my mind that’s a mistake. The analogue with VC investing is being comfortable assessing entrepreneurs without a track record of success, and getting that right is one of the best ways to get big wins.