Branded growth funds may dominate the headlines, but an industry secret is that the best return profile from venture capital has always been produced by newcomers and in the early stages of investing. Data from Cambridge Associates shows that new and developing companies are consistently among the top 10 performers in the asset class, accounting for 72% of top performing companies between 2004 and 2016.
The early stage is where you will find the most emerging managers, due to the fact that funds <$150 million investing in pre-seed and seed companies are often earlier in their life cycle. Early funds are up: the majority are under $25 million and are backed by individuals and families who are willing to take the risk of a manager with a shorter track record. It's a smart bet, because the top three funds are where a manager has the most to prove and works the hardest. They perform a different math than late-stage funds: they optimize outsized returns to build their reputation, not management fees.
They’re also probably starting their own fund because they see an opportunity they think others are missing out on – that’s what venture capital is.
Despite outperforming established funds, emerging funds are still underinvested. NVCA and Pitchbook data show that less than 40% of venture capital allocations over the past fifteen years have gone to emerging managers. For endowments, emerging funds might not be able to meet their sizing requirements, but for family offices and new fund-of-funds strategies, this opens up a big opportunity: better returns and Easier access (through innovative manager selection, lower minimum commitments, and fundraisers that stay open longer than branded funds).
We are starting to see more and more LP strategies emerging to capture this opportunity, which certainly justifies the potential return. Even more established companies that have traditionally invested in “blue chip” funds have now raised vehicles dedicated to this vintage of seed managers.
Higher yield profiles
For career venture capitalists who are strategic about portfolio construction, the path to outsized returns is usually to gain meaningful ownership in future unicorns at the lowest possible entry point. The challenge is: how to predict the winners?
For the LPs who support these managers, the question is how to make themselves known to as many winners as possible. According to a recent report by Verdis Investment Management, the seed asset class is governed by the power law, which means that there are a small number of outliers (1-2%) that generate almost all the returns . Volume is a key part of their strategy: by gaining exposure to over 1,000 seed investments in strategic networks and geographies, they can increase the likelihood of capturing unicorns in their portfolio. Since it’s hard to invest directly in enough startups for this strategy to work, that means investing in multiple seed-stage managers who each have a portfolio of more than 50 companies.
Jamie Rhode of Verdis Investment Management explains: “We decided to create our own fund of seed funds in 2017, committing to 20 seed funds, and now have exposure to over 1,000 unique companies and 23 unicorns. with an entry point at Series A and below in this portfolio. The results have exceeded our expectations and we have now increased the pace of the funds to which we commit. »
This strategy has additional advantages when public markets experience volatility. Although seed investing is risky (a seed-stage startup has an estimated 2.5% probability of becoming a unicorn), the pre-seed and seed cycles are immune to turbulence at a later stage, as valuation entry points are generally still attractive.
Jamie shared data from a regression they performed that validates what we early-stage investors recognize on a daily basis — there is little to no correlation between current public market conditions and early stage company returns since you are investing for an exit environment 8-10 years into the future.
While the power law dynamics of seed investing mean that volume can be a hedge, the “spray and pray” strategy of exposing yourself to as many trades as possible is rightly criticized. Finding the best managers who can repeat success and consistently access the best deals is paramount.
As I’ve written before, many emerging managers have at some point wondered whether they should start their own business or join an established firm as an associate.
Once they take the leap, emerging managers have the promise of high returns, but shorter performance histories. So how do you rate a tall?
Many of the best-performing funds in the venture capital asset class are the smaller, early-stage funds, and many of them run by emerging managers,” according to Alex Edelson, Founder and General Partner. of Slipstream, a seed fund sponsor. .
Alex says he looks for managers “whose investment strategy is aligned with their unique and enduring competitive advantage, who have demonstrated that they add significant value to founders, and who founders and other investors enjoy working with.” Understanding the right ownership goals for meaningful returns is also important to him.
While there is no single experience that spells success for an emerging manager, he finds former operators who can offer founders strong domain expertise tend to have an advantage.
Winter Mead, who runs Coolwater Capital, the studio and accelerator for launching and scaling emerging investment managers, agrees. He saw VCs from a wide variety of backgrounds, “including those in finance, marketing, and public relations who each offered key skills and strategic advice that helped founders and companies scale and scale. higher level”.
Jamie takes the opposite position. She shared that “of the 38 seed funds we have invested in so far that fit our general model, most are not former traders. This is usually because building their portfolio doesn’t align with the power law thesis that we believe in plenty of shots on goal A majority of former operator VCs believe in a concentrated portfolio and board seats where they can help create the next outlier. She wants her GPs to focus on picking outliers, no create them – and certainly not by trying to save companies that are not viable.
“It doesn’t matter how much you own if you’re not a winner,” she says.
Accessing startups early is not just about favorable entry points, but about being ahead of the market on broader trends, emerging sectors and new entrepreneur profiles. Jamie notes that emerging managers “can provide differentiated and diverse access to a pool of startups that more established brands may not have access to.”
Nonconsensual alpha comes from spotting opportunities that are overlooked – often in underserved geographies and populations. Most of these opportunities are seeded by emerging managers because even if established funds see these trades, they might not be comfortable taking the risk.
Each year, Coolwater receives incoming applications from over 1,000 aspiring managers and works closely with a selection of these teams through its Build program. Winter shared, “Last year we worked closely with over 60 selected emerging managers. Sixty percent come from non-traditional venture capital cities (outside of SF, LA, NYC and Boston) and more than a third are international. Ambitious venture capitalists are finding new opportunities to seek out founding talent and build innovation ecosystems in historically harder-to-reach places. »
For seed investing LPs, backing a group of similar managers who are all exposed to the same trades is not a diverse enough strategy to win. It is much more beneficial to create an index of managers who take non-consensual bets with minimal overlap.
That being said, certain trends are correlated with better returns: according to Jamie, geography (most winners are from California and New York) and networks (the value of the network a startup is in) can skew the odds of success.
In times of downturn, be aligned with the builders
If the Great Financial Crisis of 2008 can be seen as an indicator of our current downturn, we can expect funding to slow in later stages, but new business creation and seed funding will continue unabated.
In fact, one of the most important trends of the 2008 crisis was that new companies were created and funded at an increasing rate – and the fintech and sharing economy revolutions were born out of it.
A setback like the one we’re currently experiencing can actually have positive effects for seed capital investors: Founders who want funding are forced to grow responsibly and focus on business fundamentals, as their path to profitability. Less hype will make it easier to separate the winners from those who ultimately won’t survive. It may be counterintuitive, but the best times to build and invest are often when we feel the pinch the most.
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