Tuesday, August 23, 2011

The Next Step in Disrupting Venture Capital: Emerging Manager Funds

The Venture Capital industry is ripe for disruption. Too many firms, too few returns, and an industry predicated on investing in disruption that fails to disrupt itself.

Over the last few years, super angels offered new capital to the market and groups such as Y-Combinator provided young entrepreneurs new avenues to success. The venture industry, however, lacks a very common model that the hedge fund industry has mastered - the emerging manager strategy.

Emerging managers are young, smart, and successful analysts or portfolio managers who cut their teeth with a major hedge fund. After 3-5 years of stellar returns and performance, they often leave and raise small funds from their former employers, hedge fund leaders, or limited partners who specialize in identifying and seeding up and comers.

For example, Julian Roberston is not only the founder of Tiger Management, but he is also the "father" of the so-called Tiger Cubs. Many of today's hedge fund leaders got there start working with and then being seeded by Julian Robertson - including, John Griffin, Lee Ainslie, Andreas Halvorsen, and 40+ others. Paul Tudor Jones, another leading investor, continues to seed deserving managers, including Two Sigma.

Why don't we see a similar model at play in the venture industry? Having spent six years in venture, I know there are many talented young investors chafing to rip up the playbook and disrupt the market. 

Sadly, it is virtually impossible for them to raise capital. Why?

Venture returns take years to produce, while the hedge fund industry is marked to market daily and over a year or three, one can build up a track record and demonstrate "alpha," the holy grail of alternative investments. Moreover, given venture investments are illiquid, redemption and getting your money back is much, much harder than in the hedge fund asset class.

Recently, I had the pleasure of visiting Tiger's NYC offices and spending time with a senior executive. Tiger, you see, does not solely rely on alpha. Over the last twenty years, all hires and prospective Tiger Cubs have been given a IQ, personality, and logic test. With twenty years of results, Julian is able to benchmark any new candidate against the industry's very best. The combination of investment strategy, results, test results, and in-person interviews allow him to allocate capital to an emerging manager with a system and then to measure and watch.

So, in order to pull of an emerging manager strategy, one would need to be able to identify talent independent of cash on cash returns and solve the redemption problem. I believe that both limitations are solveable.

We all know who the rising stars are in the industry and I am confident that a decent share of them would be willing to hang their own shingle and create their own destiny. Moreover, with the rise of secondary markets and innovations that I can only imagine exist, the liquidity/redemption issue seems workable as well.

Will we see an emerging manager strategy work in venture? Will a lion of the industry emulate Julian Robertson and seed the next generation of top firms? There is a capital allocation problem in venture today - bad firms are getting allocations at the cost of new firms starting with hungry GPs ready to kill it.

Until the industry can allocate capital to the future stars and not to a 10 year old investment track record, I don't think we will see the disruption in our asset managers that the technology industry deserves. 



  1. Will makes a thoughtful and compelling argument.

  2. I suspect that part of the reason that emerging managers (including myself, although I'm not as young as my West Coast counterparts) have trouble raising funds is reflective of a general level of disfunction in the VC industry. Established firms place most emphasis on raising funds rather than growing talent. Future stars aren't groomed by current stars - they head out on their own because there is no other career path. If "growing human capital" were as big a goal as "increasing my personal upside", we might see lots of interesting business model innovations emerge, and new managers would absolutely be part of the equation!

  3. Will,

    Thanks you for your very intelligent post. This is an issue I have also discussed with emerging hedge fund managers in New York and the partners who have helped seed them. The time it takes to see real returns and the illiquidity of these investments are the two largest differences that seem to consistently come up in these conversations.

    The better allocation of capital you spoke of would in my opinion take the form of small funds focused on seed stage deals. These funds would right now enter a very competitive environment, currently full of traditional VC firms that are doing deals earlier in a company’s life cycle, “dumb-money” that is inflating valuations and “smart” spray & pray investors who are not as active as a VC could be in their investments. The reason emerging manager VC funds would be part of the 5 – 8% of VC funds that make attractive returns is that they would be able to get into the right deals for the stage that they focus on. Partly based on the fact that they have less investments and can therefore pay more attention to each individual company. Assuming that entrepreneurs want to work with them to begin with, they would legitimately be able to say that the 6 seed investments they have is where they are focusing all of their time and will therefore provide more value than folks with 10 seed investments and 3 series A board seats. This focus may be why smaller funds do better as pointed out by the data here; http://redeye.firstround.com/2010/05/the-money-chart.html

    This outcome also appears optimal in the long-term, since if these smaller funds are allowed to win out on seed deals then larger funds can focus on their series A investments and spend more time helping build those companies where they have invested substantial amounts of capital.

    Though I cannot see how this or other scenarios with emerging managers would result in the disruption of the venture capital industry here in the U.S.; It is very likely that I am missing something here and I would be thrilled to understand what you mean by disruption in this case.

    The place where I do believe emerging VC managers can disrupt the status quo is in emerging markets. One of the most attractive aspects of emerging markets for these managers is the lack of “smart-money” competitors when compared to developed markets; this allows them to see the top 10% of companies in that geography while getting better valuations, better terms and therefore better returns than they could in a developed market. Emerging managers from developed markets like the U.S. will be disruptive in emerging markets because they would bring “western term sheets”, a different mentality of how an investor relates to a startup (collaboration rather than ownership), as well as other best practices that currently don’t exist in many emerging markets. They would also be able to add greater value than domestic investors for companies that are copying a company in the developed market (eg: eBay, Groupon, etc…) , selling to a developed market like the U.S. and/or planning to become acquired by a company from the developed market where they were a rising star.

    There are multiple issues in emerging markets that don’t exist in more developed ones, but if emerging managers from places like the U.S. are willing to deal with them then they can truly be disruptive and reap real returns as a result.

    Thanks for taking the time to consider my response to your post. Any feedback on my perspective would be greatly appreciated.

    Please keep writing, I am a big fan of this blog.

    Wishing you all the best,