I believe the biggest pain point may be innovation.

The structural “challenge” with the venture industry is that most Limited Partners (the folks that provide VC firms their capital to invest) … for a variety of very sensible reasons … only really want to invest in the top 2-5 proven VC firms.

The problems here are several-fold:

  • The top firms only have room for perhaps 5% of the LP capital that wants to invest in venture;
  • Most LPs can’t get into the “top” 2-5 firms, or even best case, can’t deploy enough capital into them, so for the rest of their allocations … want a proven track record, ideally, with a fund or two that has already returned at least 100% of the cash invested and is at least 2x net on paper; and
  • It can take 6-8 years to see if a new fund and even a new GP will “perform”; and really, much longer in many cases if the criteria is > 1.5x cash returned;
  • But, bottom half funds lose money.  Many funds are 1x or less.  So you really got to get the exact GPs right.
  • At most VC firms, according to Cambridge data, only 1-2 partners are responsible for most of  the returns; and in some senses, partnerships are thus a little bit of a myth, because returns are often concentrated in 1 or 2 key GPs;
  • But … according to Cambridge data, one of the top sources of returns for LPs is new fund managers.  To simplify, the best strategy for LPs to make the highest returns appears to be to get into both Sequoia and Friends … AND … the very best new GPs and funds.

So there’s a large inefficiency in the market.  Many LPs chase prior returns (as we all do) and if it’s not Sequoia / Benchmark / FirstRound / UnionSquare … often end up really investing in one or two GPs that delivered great returns in the past in a firm with overall solid returns.  The Unicorn Guy.

But if they really want alpha … they also need to invest in the future.  How do you do that, when your main criteria are either (x) top 5 brand name fund, which may or may not represent the future or (y) a GP in non-top 5 brand name fund … with top 10% returns.

But what if that one GP is retiring?  Do great investments in the past presage successful investments in the future?  VC Firms can have a good run but almost all of them are not necessarily built to last.

To seek true alpha — you have to also find the next generation of fund managers. Who will have limited track records, maybe even angel-only track records (and it turns out, angel investing is very, very different from VC investing).  And may come from non-traditional places.  And you have to find ones that can deploy significant capital ($100m+ funds at least).  Itty bitty funds don’t move any needle for LPs.

And you’ll also see that a lot of the disruption that is occuring from firms that started with non-traditional sources of LP capital, at least initially — Andreesen Horowitz, Social+, YC, etc.

AngelList “$400m” syndicates fund is attacking a bit of this problem.  Next generation LPs are looking at it as well.

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