VC needs to be Sharpe-r
>>> Quick Picks - January 2022
Hey readers - I’m learning how to be helpful in Miami (insert laser eyes) this week. I’ll be in SLC and SF around the end of the month. Drop me a line if you’re around!
Stuff I’ve been thinking about:
Loss ratios in VC matter
Stuff I liked lately:
✏️ BNPLs: Businesses Needing Provided Legibility - superb deep-dive on how buy-now-pay-later works
✏️ Wordle is a Love Story - ICYMI, the story of wordle (91% win rate checking in 😤) is cute and captures the magic of the internet. Also loved the short series of tweets below (bring back Geocities!!)
📚 Red Roulette: An Insider's Story of Wealth, Power, Corruption, and Vengeance in Today's China - the memoirist frequently rambles on about how much he loves himself, but I’d still recommend flipping through it if you’re interested in some CCP-power-politics-inside-baseball
Sharpe-ning the pencil
Benchmarking investment fund performance is a funky art.
The most basic way to do it is to compare your fund’s returns to relevant benchmarks (e.g. the S&P 500) over a given period of time (see the plethora of “active stock pickers suck” articles that emerge at the end of every year). But as professional investors will definitely remind you, looking at returns alone provides an incomplete view of fund performance: investors are judged by both returns and risk.
This is intuitive when comparing asset classes. As investment strategies layer on incremental forms of risk (e.g. illiquidity, duration, subordination), investors want to see more returns to compensate for the increased risk.
Within an asset class, comparing investment fund performance based on risk and return is most relevant to public equity investing. Two public equity investors could have the same returns but arrive at them in very different ways. This is super important because “past performance is not indicative of future results.” Incorporating risk provides a view on durability of alpha generation over time. The guy/gal who happened to have a great year going all-in on a crazy high-volatility strategy like betting the farm on $GME is probably not going to repeat YoY.
To compare the performances of two different investors, a common industry metric is the Sharpe ratio (here’s a great primer on it).
The Sharpe ratio makes sense for public markets because they are liquid and marked-to-market on a real-time basis. That enables a measurement of standard deviation of returns across an observable period.
Private equity markets don’t really have a comparable metric. That is because it is impossible to come up with a measure for the standard deviation of returns in a PE portfolio - PE investments are not marked to market consistently across observable periods (they’re just marked once on entry and once on exit). Also, to some extent, the inherent volatility in a PE portfolio could skew standard deviation to the point of rendering a risk-adjusted return metric useless - i.e. returns in PE are often driven by big positive or big negative outcomes. Consider venture capital, where standard deviation is a “feature not a bug” built into investment strategies. LPs probably don’t care about the volatility of a VC fund’s underlying portfolio because by leveraging the power law, VC funds can still achieve attractive returns.
The people who should care about a fund’s volatility are arguably the most important folks in the venture ecosystem - founders/mgmt teams. As I’ve written before, traditional VC strategies introduce a massive misalignment of incentives between founders and investors. This is exacerbated by the increase in dry powder across the industry, leading investors to push companies to take more capital than they need (e.g. YC increasing its target allocation in its companies).
There are real advantages for founders partnering with investors who seek to limit write-offs. Over time, I think some calculation of loss ratio will become a critical metric in venture capital. Not for LPs, but for winning deals. VCs with low loss ratios can show founders that their companies have greater consistency of outcomes. High loss ratios could promote caution from partnering with investors that are looking for binary, fund-returning outcomes at the expense of individual portfolio companies.
This is all predicated on the notion that you can actually run a low-loss ratio strategy in venture. Most VC firms would argue you can’t, but that’s demonstrably false. It is possible but it requires a re-jiggering of the venture model which almost certainly has lower capital velocity/throughput. That’s not attractive for funds that are engineering their organizations to become asset managers and collect mgmt fees.
The range of outcomes that are life changing for a company’s founders and employees is much greater than the range of outcomes that are of interest to most VC firms. Eventually, I believe that there will be much greater scrutiny on the way the venture firms achieve returns, to the benefit of funds running low-loss strategies.
Disclaimer:
This content is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as investment advice, an offering of advisory services, or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. The author believes that the sources from which such information has been obtained are reliable; however, the author cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
Nice Vik