Transforming how LPs monitor and select venture capital firms
When LPs are invested in the right venture funds, venture capital has historically produced the largest returns for LPs. In fact, the best quarter of venture funds produced returns almost one-and-a-half times those of the public markets according to the University of Chicago.
This may sound surprising given the venture capital asset class, overall, has failed to deliver returns for a consistent and prolonged period. As the Kauffman Foundation highlighted in its “We Have Met the Enemy… and He is Us” report, VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC.
While hyperbole around the VC asset class and its demise are certainly en vogue and even deserved at times, the real problem for LPs is that the methods to scrutinize and assess individual venture capital firms are broken. This has led to good money chasing bad VCs, giving the entire asset class a proverbial black eye.
Ultimately, understanding VC quality is a bit like a jigsaw puzzle. One tile, no matter how much you study it, doesn't tell you much. Once you've seen several tiles and examined them together, a picture begins to form.
What Investor Mosaic Does
Investor Mosaic uses data and predictive algorithms to help LPs analyze and identify the best venture capital firms. It offers a predictive model for better investment selection and management of VC fund investments that is diametrically opposite to the imperfect, incomplete, and time-lagged data that currently exists. With its reliance on data and predictive models, it is also the polar opposite of narratives with cherry-picked anecdotes and precise-sounding hypotheses masquerading as facts which have become commonplace in the venture industry.
If you are an LP interested in learning more, please contact us. Or call us at 212.292.3148 to speak with someone on our team.
For more background on the genesis of Investor Mosaic and how it works, we have provided some detail below:
1. The Opacity of Venture Capital
Why understanding venture capital firm quality is impossible today
2. The Implications
What the lack of insight into venture capital firm quality means for LPs and the venture capital asset class
3. Understanding Investor Mosaic
How we’re using data-driven models to understand venture capital firm quality more quickly, granularly and accurately than ever before
4. Extending Investor Mosaic
How Investor Mosaic can be applied to other alternative asset classes such as private equity or angel investors and accelerators
5. Accessing Investor Mosaic
How LPs can access Investor Mosaic
The Opacity of Venture Capital
Understanding venture capital performance is a broken process for a variety of reasons including:
Inconsistent, self-reported, and time-lagged data
Sources for fund performance data are incomplete and suffer from significant time lags. Self-reporting leads to issues such as venture capital funds overstating their own performance when fundraising. At the extremes, there have also been claims of a more untoward nature suggesting that firms have propped up portfolio valuations while fundraising.
It’s a secret
As the Kauffman Foundation highlighted in its "We Have Met the Enemy… and He is Us" report, detailed information about VC fund performance and structures is nearly impossible to obtain given the confidentiality terms in the typical limited partner agreement.
Everyone is above average
While the sources for venture capital fund performance data are incomplete and slow, more alarming is the lack of consistency among these sources. As highlighted by Ashby Monk, Executive Director of Global Projects at Stanford University, the data is so skewed that between two-thirds and three-quarters of funds can legitimately claim to be in the top quartile of funds by cherry-picking their benchmarking and criteria. Lake Wobegone at its finest.
Beyond self-reporting issues to fund performance trackers, there is a great deal of selective disclosure within the industry. Successful exits see their acquisition prices leaked while, as Shikhar Ghosh, a senior lecturer at Harvard Business School, found, VCs “bury their dead very quietly. They emphasize the successes but they don't talk about the failures at all."
The combination of poor returns and the opacity of the VC asset class have led to a few different outcomes and conclusions by LPs.
If you are an LP fortunate to be in the top decile or quartile of funds, you are very happy or are content. You are also a rarity. If you are an LP not in the top funds, you’re forced to make 1 of 3 decisions–either consciously or otherwise:
1. Stop investing in VC
This is already happening. LP commitments to venture firms are decreasing in favor of other asset classes.
2. Identify new emerging fund managers
Try to identify emerging VC fund managers who might be worth investing in.
3. Hope it gets better
Stick it out with the same VCs again and trust that their thesis, proprietary deal flow, and their belief that venture capital is undergoing a renaissance will all come to fruition.
For venture capital as a whole, option 1 above is not great as that money leaving the asset class may never return (or will take a long time to return). The shrinking size of the VC asset class highlights that this has already happened. This is a net negative for VCs and entrepreneurs most obviously and a loss for innovation and the global economy at a more macro level.
For LPs that wish to have continued exposure to venture and the high return possibilities it offers but who don’t have access to top-tier funds, their efforts turn to identifying promising VC fund managers who might be the next Greylock or Accel or Sequoia. The challenge with discovery of emerging fund managers is that it is nearly impossible to do so in any rigorous, data-driven way. And so LPs are stuck with using primarily subjective measures and cherry-picked anecdotes from new fund managers to understand emerging venture funds.
Option 3 is clearly sub-optimal given hope or prayer as a strategy is never ideal. Plus, in VC, past success IS a good indicator of future performance. In other words, historically lackluster funds have a high probability of remaining lackluster.
How does Investor Mosaic work?
Investor Mosaic is not dissimilar from the efforts of Nate Silver in political forecasting or Bill James and Billy Beane in baseball. It employs a scientific, systematic, data-driven approach to assessing venture capital firms. Investor Mosaic was built with the thesis that data-driven objectivity combined with an LP’s expertise will yield better investment selections.
Investor Mosaic builds upon and codifies a wealth of research done by academicians and industry practitioners on understanding venture capital performance. Specifically, it connects the dots between heterogeneous big data to calculate scores for each firm on a number of dimensions which taken together are predictive of firm performance as detailed below:
In venture capital, past performance does indicate future performance.
This is a measure of 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. The higher a firm’s Network Centrality, the better its access to deal flow, follow-on funding, and industry information. Network Centrality is very analogous to Google PageRank for investors in that investors who share investments with high quality investors and who have a diverse set of connections have higher Network Centrality "rank" than those which do not. In a network-driven industry like venture capital, who you know is as important as what you know.
This is a measure of the visibility and reputation of a VC firm within the industry. 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. Brand has also been demonstrated to be a good way to measure a firm’s ability to pick the right opportunities and add value to a portfolio companies.
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.
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 than the rate of 1 in 10. Conversely, several VCs are much worse. Selection aptitude provides a measure of this for VCs. It is also important as a predictor of which VCs are able to minimize capital loss ratios.
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.
The models underlying each of these measures collectively comprise our Investor Mosaic score for each venture capital investor tracked.
Extending Investor Mosaic
Investor Mosaic has applicability to additional alternative asset classes and investor types such as private equity, angel investment, corporate venture capital and even accelerator programs.
We are working with LPs to extend Investor Mosaic to other asset classes and will release news about these additional coverage areas over time. We encourage you to reach out if you have any questions or would like to discuss Investor Mosaic applicability to these areas.
Accessing Investor Mosaic
At present, Investor Mosaic is only available to limited partners – specifically family offices, fund-of-funds, endowments, pension funds, foundations, and sovereign wealth funds.
If you are an LP interested in learning more, contact us here.