An attempt to determine what "risk-adjusted returns" in PE and VC actually are

All investors seek strong risk-adjusted returns—some use Excel to try calculating this, others just stick their finger in the air. For starters, there’s not much agreement on the best way to measure returns in the private markets (though the flaws of IRR seem to be bemoaned more than others). And, the standard deviation of those returns doesn’t measure the risks investors accept (i.e. the potential for losses on our investments). The pursuit of alpha across private equity, venture capital, and the broader private markets remains fraught with underperformance amidst those debates.

One issue is the lack of data limited partners receive from general partners. Private funds (and their underlying portfolio companies) are valued quarterly, not daily like public market assets. Additionally, GPs are constrained in their ability to provide information to the LPs—their bandwidth is not unlimited, and they have to worry about making new investments (while helping the existing ones). What’s interesting to LPs can be distracting for GPs.

However, based on the data GPs provide, LPs can easily measure the following three types of risk:

  • The amount of capital invested in portfolio companies marked below cost;

  • The amount of capital impaired in those companies marked below cost; and

  • The amount of debt those companies carry (which is more relevant in private equity than in venture capital).

Of course, LPs also receive return data from the funds in which they invest (and from prospective GPs who aren’t afraid to send their performance [you’d be surprised]). With this data, LPs can see how much capital is invested in companies marked above cost, and what the gain is on that invested capital.

With this information, I created another framework to think about the risk-adjusted return proposition—or at least I haven’t seen anyone post it before, so maybe it’s new ¯\_(ツ)_/¯? The goal was to create a framework to apply across the entire private asset spectrum—outperformance can come from anywhere, whether it be private equity or venture capital or something that defies simple categorization, and investors shouldn’t be overly-wedded to any one source.

Risk in this framework is the ratio of capital impaired to total invested capital, the measure of how much of an investor’s capital is ultimately lost.

Returns are presented… differently. “Slugging percentage” would be a more accurate description, which I define here as the ratio of the dollar gain on investments marked above a 20% IRR to the dollar loss on investments marked below cost. I used IRR instead of the multiple on invested capital, as money does have time value, and IRR better allows for like-to-like comparisons across different strategies.

In the example above, PE GP 1 and VC GP 5 are exceptional at managing risk—they generate massive outperformance with minimal capital incineration. Credit GP 10 delivers less outperformance, though that’s expected given their credit investing focus. As one moves away from the left side of the chart though, the evaluation becomes more interesting: an efficient frontier emerges. One can argue whether or not PE GP 2 is a better investor than PE GP 3, but PE GP 4 is better at protecting capital while outperforming. Credit GP 9 may outperform slightly more than Credit GP 10 but does so while impairing much more capital (which is not ideal in credit investing). VC GP 6 may impair a lot of capital, but they do so while generating sizable outcomes. VC GP 8, however, sits in the “here be dragons” section of the chart, impairing capital with reckless abandon and little to show for it (which is also not ideal).

As with everything everywhere, there are caveats. Though I think IRRs greater than 20% are strong, that specific benchmark is still arbitrary. Like all models, it’s “garbage in garbage out”—including unrealized investments places an extremely high reliance on how specific GPs value their portfolios. Past performance also doesn’t predict future returns, and performance can erode over time as organizations change shape with additions and departures. Lastly, it doesn’t account for qualitative information, like the actual interactions LPs have with GPs, or what LPs learn about GPs and their portfolio companies through backchannels.

That said, I think this goes further towards answering the question of risk-adjusted returns than simply slapping IRR and standard deviation onto a chart. Despite the clear imperfections it does account for the dollars at risk, the dollars returned, and the degree of outperformance, while also evaluating a GP’s skill in portfolio construction. Applying some version of this framework could help an LP build a better mosaic in diligence on a GP, and maybe even lead to more artistic investing.

Hopefully, you made it this far—this edition was drier than most. Enjoy the rest of the weekend.

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"Solo capitalists" in venture capital & the fundraising game behind the investing game

For more than a decade now, successful angel investors have been encroaching further into the realm of venture capital. Whereas in the (slightly) more distant past individual investors only had the scale to play at the earliest stages of company formation, the more successful and connected ones have been leading larger and later rounds of venture financing.

Nikhil Basu Trivedi calls the latest evolution of this trend The Rise of the Solo Capitalists, describing them as follows:

They are the sole general partner (GP) of their funds

The solo capitalist is the only member of the investment team

The brand of the fund = the brand of the individual

They are typically raising larger funds and writing larger checks than super angels - i.e. $50M+ funds, and able to invest $5M+ in rounds.

They are competing to lead Seed, Series A, and later stage rounds, against traditional venture capital firms

In the 2010s, several successful angel investors scaled their activities into full-fledged firms (e.g. Jeff Clavier with Uncork, Kirsten Green with Forerunner). But others would keep an even more individualistic streak, leading investments on their own rather than creating institutions with distinct brands (e.g. Chris Sacca and Suhail Rizvi purchasing pre-IPO Twitter stock from existing shareholders). Today, these “solo capitalists” are raising more and more capital for funds and singular transactions, moving beyond those earliest stages of company formation and competing with the well-known institutional venture firms. These people, like Lachy Groom and Elad Gil, are neither building investment teams nor creating separate brands—they’re playing the investing game their way. Unfortunately, they’re also playing another game, one that isn’t well-equipped to serve these solo capitalists—that one being the fundraising game.

For GPs, the game of fundraising exists atop the game of investing. It’s one designed to benefit both under-resourced institutional LPs and well-resourced GPs—however, despite fundraising being so critical to the survival of investment firms, most GPs aren’t well-equipped to fundraise. The largest firms can sink tremendous resources into their fundraising and investor relations functions, creating products (i.e. funds) that are easy for institutional LPs to buy. Smaller firms will have fewer resources for this purpose, requiring them to pull their investment professionals away from investing. And, the solo capitalists will have only themselves.

That’s not to say solo capitalists are unable to fundraise—they are, or else we’d be discussing something else. The challenge they face (assuming they have such aspirations) is scaling both their investing and their LP base while remaining solo. Funds do solve problems for larger institutional LPs: they allow for those LPs to commit large sums of capital every few years across a diversified set of companies. Committing smaller amounts to smaller funds or investing transaction by transaction is much more difficult—it would effectively prevent an LP from spending time on other opportunities. Issues like key person risk and the lack of team or infrastructure will also push LPs away from solo capitalists (or search funds in the private equity realm), and towards the easier option of funds.

Funds should continue to unbundle, and the rise of the solo capitalist should happen. But, we don’t live in a vacuum where institutional LPs can commit to individuals with ease through a platform like AngelList. Instead, the fundraising game is both laden with technical debt yet functional enough for the players involved, those under-resourced institutional LPs and well-resourced GPs. Until that technical debt is removed solo capitalists won’t be the option for LPs and entrepreneurs alike—but that’s okay. There just need to be more options.

As always, enjoy the weekend.


Emoji-driven movements & creating momentum in fundraising

Throughout Thursday and Friday, the emojis 👁👄👁 and the phrase “it is what it is” flooded the news feeds of tech Twitter. A new Twitter account @itiseyemoutheye linked to 👁👄👁.fm, which at the time only featured a sign-up that said: “give us your info”. I assumed it was another exclusive, private invite-only social media app, like Clubhouse’s launch several weeks prior, but I had no idea. Neither did Forbes. Neither did The Independent.

It wasn’t an app though. At 7 pm PST on Friday the website launched, with calls to action of donating to several non-profits, as well as a statement with the following quote:

In a strange way, this sort of became an anti-statement against what we’d all seen on tech Twitter. We’re a diverse, ragtag group of young technologists tired of the status quo tech industry, and thought that we could make the industry think a bit more about its actions. Despite calls-to-action like that “It’s Time to Build” essay we’ve all read, most of the industry (from product teams to VC) still stays obsessed with exclusive social apps that regularly ignore — or even silence — real needs faced by marginalized people all over the world, and exclude these folks from the building process. As an industry, we need to do better.

Since Thursday, the creators of 👁👄👁 .fm have helped raise over $200,000 for causes like Loveland Foundation, The Innocence Project, and The Okra Project. They dominated the attention of many—venture investors included.

The creators of 👁👄👁 .fm proved they could generate momentum more effectively than those same venture investors and other GPs do when raising capital from LPs. To paraphrase a friend, every investment requires two champions on either side, and it’s a lot easier when the party fundraising can either remove friction or generate momentum from a standing start. Granted, GPs don’t have an LP-only forum that allows them to broadcast their thesis and then raise their funds in days (e.g. “here’s why the future of work is on the blockchain and oh by the way sign up for my fund”). But, they can still do better building interest in how they’re investing, while finding the true believers who make their fund more of a movement rather than just another fund.

I don’t believe there’s a one-size-fits-all playbook to fundraising, but that instead, every pitch requires an approach specifically customized to each potential investor. However, there are similarities among the opportunities where we rapidly gained conviction and became true believers. The people raising already had the credibility to carry out their thesis—we wouldn’t be meeting otherwise. From the very first meeting, they demonstrate this intensity and sense of conviction in how they invest. And lastly, they allowed us to feel like the decision to invest was optional. They allowed us to feel like if we invested it would be a collaboration (to a degree), as if we would be a part of a movement together.

What the creators of 👁👄👁 .fm accomplished doesn’t translate perfectly to fundraising in cottage industries like institutional investing. And in their words:

a lot if you are really overthinking this there was no elaborate planning and marketing strategy we were literally just vibing

So yes, I know I’m over-thinking it. It still takes a special type of natural intensity to do what they did in so little time though. It’s also true that many GPs have successfully fundraised with elaborately-planned, less natural strategies. But, it is what it is.

Enjoy the rest of the weekend. Here’s what I’m listening to.


When to use our platforms & VC's capacity constraints & aligning LP-GP incentives

I’ve been asked a few times who my audience is. Ultimately, I do write for myself. The time spent re-working sentences and paragraphs and entire posts helps me crystallize my thoughts and beliefs. However, I don’t want to write only for myself—if I can provide an investing perspective that’s helpful to others, then it’s my duty to share it.

This past month, there wasn’t a perspective I could share that would add to the discourse. Any attention whatsoever paid by my audience to LP-GP minutiae would take too much attention away from thinking about police brutality and systemic racism. Stepping back seemed right.

I believe those with platforms have to consider whether their voice needs to be heard at that moment. And if their voice doesn’t add to the discourse, then they should choose to step back and allow more important ones to be heard. Maybe this makes me a hypocrite—I’ve participated in panels that were entirely white and male, whose perspectives are too easy to find. But, if I don’t start now, then when?

The past two weeks I’ve been thinking a lot about Reggie James’ post, The Myth Of Blackness In Venture.

It wasn’t until reading it and listening to Kanyi Maqubela’s episode on the Notation Capital podcast that I realized how many of my reference checks on GPs were with other GPs.

“I’m surprised to the extent in which LP’s relied on other GP’s. For context, for perspective, for reputation. And in retrospect it makes sense. Because it’s an access controlled industry. It’s a capacity constrained industry…”

Aside from other LPs, GPs are the most accessible nodes within the networks of LPs. Founders, CEOs, and other connections are likely outside the networks of most LPs—and when an LP has to triage their time and opportunities, they’re going to head to the nodes they already know and trust. And, if an LP doesn’t recognize the biases those references have and doesn’t choose to turn over every stone in sourcing new opportunities, then the industry will continue to be capacity-constrained.

Reggie’s commentary on Andreessen Horowitz’s Talent x Opportunity Fund (TxO) also resonates.

I have always said that to really change things, Black founders need to return the fund.

However, carve-out vehicles and charity funds, remove us from direct relationship to the performance of fund managers.

LPs entrust their capital to GPs, and in turn, they’re incentivized with carried interest. This aligns their outcomes with ours—the GPs are only generating life-changing wealth if the LPs are profiting as well. This financial motivation underpins the LP-GP relationship because it works.

Much more so than boilerplate public statements, programs like TxO could be really powerful opportunities for GPs to align both theirs and their LPs’ performance with the outcomes of underrepresented entrepreneurs. That’s why Andreessen Horowitz needs to invest in TxO from their early-stage fund, rather than through a donor-advised fund as it’s currently structured. Even though donor-advised funds allow their donors to be involved in how their donations are invested, these donations are charitable, tax-deductible gifts. The financial success of Andreessen Horowitz, and their LPs subsequently, will not be affected by TxO’s outcome.

If Andreessen Horowitz invests in TxO from their early-stage fund it would show the entire ecosystem, and their LPs, they believe that investing in the program’s participants can generate fund-returning outcomes. Otherwise, the incentives will be misaligned, and neither Andreessen Horowitz nor their LPs will be invested in TxO’s outcome in a way similar to their other carried interest-generating funds. Align the incentives, and make the outcome really matter.

Enjoy the rest of Father’s Day weekend. Here’s what I’ve had playing on repeat today.


LPs as remix artists & "hype" in fundraising & the investor playing field

“I’d like to say that it’s a hopeful sign that the art market still has hunger for innovation, and that, as much as buyers reward artists for churning out the same thing year-over-year, there’s still room to branch out,” says Kevin Wiesner, a creative director at MSCHF.

Several weeks ago the art collective MSCHF bought a Damian Hirst print, cut out its 88 spots, and sold the now hole-filled print for multiples of its original cost. This “new” piece is derivative—and yet, it somehow became more valuable with every missing spot. The destruction was just a remix though. It’s still art.

I believe limited partners underestimate their ability to make art through their investing. It’s an easy mindset to fall in—we’re just limited partners, with little-to-no influence with investment firms and their portfolio companies. However, by making the effort to meet investors who think differently and showing the conviction to invest with them, one will build a portfolio of styles that otherwise wouldn’t be replicable in a single opportunity. Thus, art.

This art isn’t so different from the kind painters and singers and writers make. The investor canvas just happens to be a spreadsheet, the portfolios their product. And like all art, the portfolios are never finished—they’re ever-changing as positions fall in and out of favor, and as new opportunities branch out. Or spring anew.

What I’ve read recently:

Clubhouse, Hype & Startups. For those of you who productively spend your free time off of Twitter, you may not know about the new/exclusive social app Clubhouse. Despite not being one of the cool kids on the platform (c’est la vie), what’s interesting to me about their story is how they created hype among potential investors. To quote Fred Destin:

It’s quite the shortcut, creating a hype wave within the circle that’s going to fund you. I can only admire the marketing prowess.

It’s amazing how few investors (both emerging and established) understand this—raising capital from limited partners is much easier if there’s some sense of hype around the process. Otherwise, potential limited partners won’t feel the pressure to invest. This doesn’t mean an investor should use high-pressure sales tactics (please don’t, you’ll just pressure me into a quicker “no”). The pitch and the interactions still need to be authentic to the investor. That said, if a fundraising process doesn’t generate hype, that investor should probably examine their chosen approach.

The Playing Field. I wish I’d discovered Graham Duncan’s post sooner. To single out just one quote:

“The critical challenge for Level 3 investors is to find a way to be exposed to Level 4 investors. If their world consists of only Level 2 and 3, they may stay where they are for the rest of their careers.”

This quote still works if you replace “investors” with any other profession: athlete, musician, TikToker, etc. Being exposed to the best in any field shows you the real benchmark to strive for (and exceed).

I remember the last time I met with an investor who fit Graham’s definition of “Level 4”. By the time of that meeting, I was already familiar with this investor’s firm: the performance, the team, the strategy, the vast majority of the information that plays into an investment decision. It was my first time meeting the founder however.

Most pitch meetings follow a similar path. We easily could have defaulted to that path and re-hashed information in their pitchbook, but instead we took a different route. We talked about the firm’s direction to that point, the way forward over the coming years, and each of our approaches to investing. The game being played wasn’t the rehearsed fundraising pitch—it was the conversation itself.

It brought me back to my experience as a boxer in college, how the punches themselves were only a piece of the action. The real action was the dance: the in-between, the movement in the ring as each fighter decides how and where and when to engage and disengage. Questions and answers calculated in the moment, thrown back and forth—the text of the conversation may have been about investing, but the subtext was the dance.

Leaving that meeting, I realized I was probably following the right path. That combining creativity and conviction could maybe separate me not just from other limited partners, but investors in general. And, that leveling up further would require me to find more of those “Level 4 investors”, to partner with the masters in the field, and to continue learning from them over and over and over again.

This was a much longer post than usual. Apologies. Enjoy the final two episodes of The Last Dance. And here’s a painting that used to have 88 spots.

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