Podcast Summary: "Is Venture Capital entirely Based on Luck? University of Chicago and Oxford Study" (E124)

Host: David Weisburd
Guest: [Speaker B’s Name Not Provided]
Release Date: December 27, 2024

1. Introduction: Persistence of Returns in Venture Capital

The episode opens with a discussion on the persistence of returns within the venture capital (VC) asset class. Host David Weisburd references a University of Chicago study indicating that over half of the top 25% performing funds continue to rank within the same quartile in subsequent periods.

Quote:
A (David Weisburd) [00:00]:
"One of the interesting characteristics of the venture asset class is this persistence of return. University of Chicago had the study that over half of funds that were in the top 25% continued to be in the top 25%. Have you found that to be the case and why is that the case?"

B:
B [00:15]:
"Yeah, we absolutely have. I know I've seen similar research from Tim Jenkinson at the University of Oxford who said... there's a 45% chance of having success at top core... it's not just at the top quartile where that persistence plays out, it's also at the bottom quartile."

Key Points:

• Persistence both at the top and bottom quartiles of fund performance.
• Greater performance persistence in VC compared to private equity.

2. Survivorship Bias in Venture Capital Data

The conversation shifts to the concept of survivorship bias, particularly in the context of smaller venture funds.

Quote:
A [03:04]:
"Based on PitchBook data that shows that 0 to $99 million funds, only 5.1% have actually shared the data..."

B [03:38]:
"Survivorship bias is something that, you know, that we have to contend with in the venture industry because a lot of the data sources... managers that have a really unsuccessful fund or poor performing fund, then that data tends not to get submitted."

Key Points:

• Limited performance data is available for smaller funds, leading to skewed perceptions.
• Survivorship bias results in an overstatement of VC performance, as unsuccessful funds often do not report their data.
• Carter's dataset mentioned as an exception, offering more comprehensive performance reporting without survivorship bias, albeit limited to the last five to six years.

3. Vencap's Analysis on Fund Size and Performance

David Weisburd discusses a controversial LinkedIn post challenging the belief that smaller venture funds outperform larger ones.

Quote:
B [00:59]:
"There definitely seems to be a common belief that smaller funds and emerging managers will outperform... you can't really use the publicly available data to draw those sorts of conclusions."

Key Points:

• Vencap's research utilizing PitchBook data from 14,000+ funds, with performance data available for only ~1,000.
• Small funds (<$99M) have a mere 5% reporting rate on PitchBook, making performance conclusions unreliable.
• Public data limitations highlight the necessity for investors to rely on more comprehensive data sources.

4. Power Law Dynamics in Early and Growth Stage Funds

The discussion delves into the power law distribution affecting both early and growth-stage funds.

Quote:
B [07:03]:
"60% of companies don't return capital. Around 1% of companies are ultimately fund returners."

Key Points:

• Early-stage funds typically see only 1% of investments becoming significant returners.
• Growth funds, contrary to expectations, also experience high failure rates (40% losing capital) but have a slightly higher incidence (1.6%) of fund returners.
• Power law consistency across fund stages, indicating that even growth funds are subject to significant risk and concentration of returns.

5. Vencap's Strategy in Fund Selection and Portfolio Concentration

Vencap's investment strategy emphasizes selecting top-performing managers and maintaining a concentrated portfolio.

Quote:
B [11:48]:
"90% of the capital we've invested over the last decade has gone to 12, 13 managers."

Key Points:

• Historical Evolution: Transition from a diversified approach to a concentrated investment in consistently top-performing managers.
• Criteria for Selection: Managers who have demonstrated the ability to back companies that return their entire fund.
• Rarity of Outperformance: Only a small cohort of managers consistently achieve top quartile performance.

6. Impact of Political Climate on Venture Capital

The conversation explores how changes in political leadership, specifically the 2024 U.S. election, influence the venture market.

Quote:
B [20:06]:
"Venture is about can you get the best managers backing the best founders... Trump is not going to be President of the United States when companies that are founded today ultimately exit in 10 to 15 years time."

Key Points:

• Long-Term Focus: Political changes are seen as short-term noise; the emphasis remains on long-term investment strategies.
• Regulatory Environment: Potential improvements in regulatory conditions for sectors like crypto and blockchain, anticipating a more supportive landscape under new leadership.
• Caution on Future Policies: Uncertainty regarding protectionist measures and tariffs that could impact tech innovation and growth.

7. Perceptions and Reality of Fund Valuations (TVPI vs DPI)

Addressing concerns about venture fund valuations, Weisburd discusses the relationship between Total Value to Paid-In (TVPI) and Distributed to Paid-In (DPI) metrics.

Quote:
B [26:46]:
"We looked at how DPI or even TVPI in year five, how does that correlate to where a fund will ultimately end up and the answer is it's not really a great predictor."

Key Points:

• Early Metrics Misleading: DPI and TVPI do not necessarily predict long-term fund performance accurately.
• Portfolio Valuations: Established managers tend to write down valuations more aggressively, potentially leading to undervalued portfolios.
• Undervaluation Concern: Suggests that current portfolios may be undervalued on aggregate, indicating a cautious outlook on fund valuations.

8. Following Vencap Leadership Online

For listeners interested in following Vencap’s insights and updates, Weisburd provides his online handles.

Quote:
B [29:06]:
"I'm on X@daveclark85. I'm also on LinkedIn as well... we prefer to have a very strong foundation of why we do things and recognize the data is not perfect."

Key Points:

• Social Media Presence: Active on platforms like X (formerly Twitter) and LinkedIn.
• Data-Driven Approach: Emphasis on backing opinions with data rather than relying on unverified industry myths.

9. Conclusion: Emphasizing Data-Driven Investment in VC

David Weisburd wraps up the episode by reinforcing the importance of a data-driven approach in venture capital investment strategies.

Quote:
B [30:06]:
"When someone says well it's common knowledge that this is the case in venture we say well common knowledge venture is usually wrong... you need to go and really examine the underlying data."

Key Points:

• Challenging Myths: Encourages investors to question commonly held beliefs and validate them with robust data.
• Long-Term Commitment: Advises maintaining a consistent investment strategy amidst market volatility and short-term political or economic changes.
• Focus on Excellence: Stresses the importance of investing with top-tier managers who can consistently deliver superior returns.

Key Takeaways

• Persistence of Returns: Top-performing VC funds tend to maintain their ranking over time, more so than in private equity.
• Survivorship Bias: Significant gaps in performance data due to underreporting by unsuccessful funds skew the perception of VC performance.
• Power Law in VC: Both early and growth-stage funds exhibit a power law distribution, with a small percentage of investments driving the majority of returns.
• Vencap's Strategy: Focused investment in a concentrated pool of consistently high-performing managers.
• Political Impact: Long-term venture strategies are largely insulated from short-term political changes, though regulatory environments can have sector-specific effects.
• Valuation Metrics: Traditional metrics like TVPI and DPI may not reliably predict long-term fund performance.
• Data-Driven Decisions: Emphasizes the necessity of basing investment strategies on comprehensive data rather than anecdotal evidence or industry myths.

Notable Quotes with Timestamps

• On Survivorship Bias:
  B [03:38]:
  "Survivorship bias is something that... has to contend with in the venture industry because a lot of the data sources... managers that have a really unsuccessful fund... that data tends not to get submitted."

• On Power Law Dynamics:
  B [07:03]:
  "60% of companies don't return capital. Around 1% of companies are ultimately fund returners."

• On Vencap's Strategy:
  B [11:48]:
  "90% of the capital we've invested over the last decade has gone to 12, 13 managers."

• On Political Climate Impact:
  B [20:06]:
  "Venture is about can you get the best managers backing the best founders... Trump is not going to be President of the United States when companies that are founded today ultimately exit in 10 to 15 years time."

• On Valuation Metrics:
  B [26:46]:
  "We looked at how DPI or even TVPI in year five... and the answer is it's not really a great predictor."

• On Data-Driven Approach:
  B [30:06]:
  "When someone says well it's common knowledge that this is the case in venture we say well common knowledge venture is usually wrong... you need to go and really examine the underlying data."

This episode provides a comprehensive analysis of the factors influencing venture capital performance, highlighting the importance of data integrity, the challenges posed by survivorship bias, and the strategic approaches needed to navigate the complex VC landscape effectively.