Evaluating Venture Capital Performance, Persistence, and the Unicorn Bubble in the 21st Century

This podcast episode delves into the evolution and current state of the U.S. venture capital (VC) industry, highlighting its declining share of global VC despite remaining the largest national market. It emphasizes the U.S. data's reliability due to its limited partner (LP) reporting, contrasting it with self-reported data elsewhere. A central theme is the skewed distribution of VC returns, characterized by a power law, where only the top decile (10%) of funds consistently outperform the public market, a statistical fact echoed in historical high-risk domains like the whaling industry. The discussion introduces the Public Market Equivalent (PME) as the gold standard for private investment evaluation and notes the strong correlation between VC returns and the public market, particularly the NASDAQ index, suggesting that market conditions, rather than 'learning by doing,' have driven performance.

A critical insight is the unique persistence of venture capital returns, meaning a firm's past fund performance predicts its future fund performance, a characteristic not found in buyout funds. This persistence leads to a significant risk of adverse selection for LPs: the best-performing funds don't need new capital, while those actively seeking it are often the ones to avoid. The episode then examines the fundamental shifts in the VC landscape post-2008 Global Financial Crisis, marked by a flood of new investors, private companies staying private longer, and a substantial decline in the number of Initial Public Offerings (IPOs). This environment, coupled with persistently low or negative real risk-free interest rates and regulatory changes like the JOBS Act, has fueled the 'unicorn bubble,' where institutional investors, driven by FOMO, invest unconventional capital into mega-rounds at extreme pre-money valuations.

The speaker challenges conventional wisdom with two theorems of venture capital: "cash and control" and "corporate happiness is positive cash flow." He argues that while VCs today have cash, they often lack control, leading to predictable consequences with unicorn startups. The unicorn bubble is characterized by investors paying premium prices for unregistered, illiquid securities, an anomaly given the typical illiquidity discount. This phenomenon is exacerbated by the exponential increase in the net present value of distant future cash flows due to low discount rates. The episode also highlights the perverse incentives created by the standard "2 and 20" compensation model, which encourages VCs to raise larger funds, invest rapidly with less due diligence, and choose safer investments, often leading to underperformance and potentially undermining the innovation economy.

Finally, the analysis points to concerns raised by leading scholars, including the disproportionate role of a few deep-pocketed investors, the lack of diversity among venture capitalists impacting funding decisions, and the critical issue of cash and control. The fundamental driver of capital into VC has shifted from outsized returns (pre-2000) to the meager returns available elsewhere, even as the industry's assets under management approach $500 billion. The pandemic, while insulating the bubble from rising interest rates for now, has brought micro-level business model scrutiny, underscoring the enduring relevance of sound financial principles and regulatory oversight.

u.s data is the gold standard for evaluating venture capital because it is the only data that is not self-reported it comes from the limited partners the ones who put up the capital not the general partners the ones who invest it

only the venture capital funds in the top decile of performance that's the top 10 percent outperform the public market

the skewed distribution of profit echoes with remarkable precision the distribution of profits from another domain of high-risk investing the whaling industry

uniquely among asset classes venture capital returns are persistent that means that the performance of fund 1 from firm a predicts the return for fund 2 and so on

a blind alec allocation to venture capital just allocating a fixed proportion to venture capital runs the major risk of what's known as adverse selection the funds you want to invest in the persistently successful ones don't need your money the ones who want your money are the ones you want to avoid

investors are paying premium prices for unregistered illiquid securities this is an extraordinary anomaly there should always be a discount for illiquidity

my first theorem of venture capital is what i refer to as cash and control the venture capitalists joint hedge against the radical uncertainty of funding startups at the technological frontier

corporate happiness is positive cash flow when customers pay more in cash than it costs to deliver the service or product they are both demonstrating the economic value of the venture and they're liberating it from dependence on external funding

the fundamental engine driving the venture capital industry has shifted from the narrow focus on a hot ipo market to the systemic consequences of the secular decline in real risk-free interest rates to zero or negative levels

the larger the fund the more likely it is to underperform the industry as a whole and the public markets