Business

Venture, the “power law”, and family offices

In the decade to June, venture capital returned 16% a year, beating rival asset classes and developing sufficient skill to stay on top, according to economist Sebastian Mallaby. 

Over three years, median returns came top with 29%, according to PitchBook. Over one year, it trounced all-comers with 65%. 

Top endowments, with longstanding access to the best managers, saw 87% from VC in the same period. It didn’t come top over twenty years, but it still beat the S&P 500 index. 

The VC sector’s use of intangible assets and networking skills have been reinforced by hubs that offer access to skills and networking opportunities

Even now, family offices remain loyal to VC. Deals, tracked by Family Capital in January and February did not materially fall away. Global funding inflows, across the board, hit a record $628 billion in the year to June 2021, double 2020.

Rising inflation and Ukraine have brought out the prophets of doom, who argue too much money has been chasing the wrong deals at the wrong price. 

They probably have a point. But tech-driven disruption remains a powerful driver to returns, spreading deeply into corporate affairs. Companies are leaning on AI to make decisions; biotech continues to cure; nuclear fusion may yet offer clean energy, forever.

The VC sector has itself developed techniques that scale opportunities with a ruthless efficiency the sector has never experienced before. 

Large family offices like Pritzker Private Capital, Willoughby Capital and Moore Strategic Ventures have the wherewithal and the technology to develop co-investment opportunities. It has helped the next generation build their own family offices. Investment platforms are taking over from wealth advisers.

On a broader front, Sebastian Mallaby has published a book – The Power Law: Value Creation and the Making of the New Future which shows how VC has become a global power.

In a podcast conversation with academic Tyler Cowen at George Mason University, Mallaby said VC had revolutionised its prospects by deploying all the intellect it needs to organise, and finance, disruption.

The initial impact is small, but it becomes massive, as returns get compounded over succeeding years. No less than three-quarters of the constituents of equity indices have benefited from VC funding, according to Mallaby.

Since inception, Sequoia’s clients have seen their investments multiply twelve-fold.  Amazon’s market value was less than $500 million when it went public in the late 1990s. Now it is worth $1.5 trillion.

Sequoia, and several VC rivals, are now using its cash flow to invest in companies, as they continue to grow, thus reducing their need for stock market exposure in the future. 

Rather than expensive machinery, today’s company founders use their intellect, and coding skills, to develop scale. And leverage comes cheap: “The marginal cost of serving one more customer is pretty much zero, once you’ve built the Google search engine.”

Founders avoid the corporate sector’s long tradition of hierarchical systems, meetings and backward-looking decisions: “The past isn’t necessarily a guide to the future. The fun thing about venture is that you have to be watching to see where basic science is generating innovation that can be commercialized.”

Founders mix, and match, in-house or third-party expertise. They only offer stage payments to limit their risk exposures. Mallaby stresses: “Just because it’s small, it doesn’t mean it has a low impact.” 

The VC sector’s use of intangible assets and networking skills have been reinforced by hubs that offer access to skills and networking opportunities.

Mallaby says” “If you’re talking about coding, and a company wants to hire a particular database engineer in a particular database software, in Silicon Valley, there will be the precise type of engineer that you want. Whereas if you’re in a less deep pool of labour, you won’t find that. The same argument goes for suppliers.”

The Bay Area of San Francisco became an early hub and others are fast developing, often around a few successful companies. Stockholm has benefited from the growth of Spotify. Mallaby thinks Graphcore, based in Bristol, may offer similar possibilities to the South of England.

He notes that it was San Francisco which was prepared to risk capital, rather than East Coast bankers: “They were about stewarding capital and not losing it.” 

VC investors have tended to syndicate each other’s deals, diversifying risk by investing in people they respected: “Venture capital needed to be clustered to be most effective. That’s why you got Silicon Valley dominance.”

Investors, and their family offices, whose views are respected by company founders, have become increasingly important at the seed stage. 

Corporate venturing has also played a role in encouraging the growth of VC in Europe. The UK Government has tried to emulate the US in providing loans and capital to make its VC offerings attractive.

Mallaby says financial support has been crucial to attracting talent to VC. Thought leaders at VC firms have played the kind of role in shaping deals that used to be the preserve of investment bankers.

John Doerr (Kleiner Perkins) persuaded Eric Schmidt to become Google’s chief executive by promising to find him a job, if he were fired by its founders. Mike Moritz (Sequoia) adapted his VC model for China.

According to Mallaby, Peter Thiel (Founders Fund): “Articulated more fully the idea of the power law than anybody else before in venture capital.”

The power law means investors can only expect outsized returns from a small number of deals. 

Investors need to concentrate their firepower, rather than trying to diversify across a range of opportunities, which reduce returns to mediocrity. They need to accept eccentricity, if talent exists. Otherwise: “You won’t have a moat around your company, and you won’t make supernormal returns.”

Thiel wants his founders to be talented and adaptable. He wants to see technical expertise. But, crucially, he strives to see whether there will be a need for the products a founder is building. According to Mallaby: “You’ve got to skate to where the puck will be, which means you have to think forward.”

Thiel looked through the personality quirks of Mark Zuckerberg, and co-founder Sean Park to back their insights into social media at Facebook.  He fell out with his former colleague at PayPal, Elon Musk, but later invested in his SpaceX venture, whose notional value is now $100 billion.

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