An LPs Guide to Venture Funds (Part 1) - The Unbundling and a Framework
Childish Gambino - liquidity flywheels - who’s the bitch - a taxonomy of moats - those who can’t do, teach - and why venture is the best-worst asset class in the world
This is the first in a series of articles helping LPs explore the GP landscape. It sets out a framework for what GPs need to do and gives examples of folk productising this. The framework is primarily around sourcing, winning, picking, portfolio construction, and king-making. Different firms specialise in different capabilities with very few being excellent at all of them.
It also brings up the unbundling: the idea that there’re a range of factors which are causing the long-tail of emerging managers to pick better, win deals more, and outperform the larger B-tier venture funds. These are access to knowledge, better tooling, the importance of individual brands, and a shift from public to private.
Follow up articles will talk inter alia about moats which VCs can build, scalability in venture, and what value-add actually is.
Venture is unbundling. Five white guys sitting in a room in Berlin are increasingly being beaten by nimbler firms more tailored to their founders’ worlds. Enterprising GPs have platformed themselves into venture-household names through tweets, substacks and podcasts. Specialists are increasingly biting at the bland, vanilla pies of the generalists, who, until very recently, were the only customers at the proverbial pie-shop.
The world of venture is tricky going on quagmire and new firms are popping up all the time. The mega agglomerates are not going anywhere but for LPs looking to avoid the increasingly commoditised access game and select from the long tail of emerging managers the landscape can be tough to navigate. I hope that for these LPs at least, this paper can be helpful.
In venture, we play in the sandpit at the bottom of the risk curve slide. We are the tail of the rising rates bullwhip and we may find soon that the liquidity-fueled flywheel of the last decade has been making our choices look far better than they really were. Now this is not a macro paper. My aim is rather to outline, through a long-form series, how and why the venture landscape is changing, and to create a framework through which to filter the ever growing swathe of emerging managers.
Many have written great pieces on all of these topics, so I’ll link sources wherever I can. Any thoughts that seem original probably aren’t, and if there’s no source then the good ideas probably came from my great team-members, co-authors, and collaborators.
The GP framework
Because the investor picks the asset and the asset picks the investor, venture managers often find themselves having to sell their money. When money is worth little, it’s easier to get it from LPs, and tougher to sell it to founders. Here, GPs who “win” will win. When money is worth a lot, it’s tougher to raise it but easier to sell it, and so GPs who “pick” will win. This is the core of the framework I’ll spread over this essay series.
A GP fundamentally needs to do eight things:
Source companies to invest in.
Pick companies which outperform.
Win access to those companies.
Value a company well and enter at an appropriate valuation
Construct a portfolio of these companies sized to maximise LP reward and minimise LP risk.
King-make their portfolio companies.
Raise capital for subsequent funds.
Sell positions to Return capital to LPs*
It is a rare VC who can do all eight exceptionally - h/t Sequoia. Most funds can do two or three fairly well and the rest only averagely. If a fund is among the best in the world at even two of these, that fund will likely yield top-decile performance. For example, certain funds are renown pickers (Union Square Ventures), others are prolific sourcers who move fast and seem to have a little bit in just about every great company (Tiger Global).
Many ”company XYZ mafia” GPs specialise in sourcing and have a ridiculously good network for a particular vertical or region. Tencent’s venture arm can king-make by funnelling WeChat data and traffic to their portfolio companies. Sequoia, Tencent, USV, Tiger Global… all have built big brands playing to their strengths.
As my non-English-native friend once put it: there is more than one way to peel a cat.
Thinking in Product
VC’s buy and sell money. They buy money with a service (generating returns) and sell it for equity. They are the middle man in a deal between LPs and founders, and they need to have a convincing product for both. Harry and Oren have a great couple lines around product-building VCs around 34 min in to this podcast. Their point is basically that VCs need to think product-centric before they think picking-centric.
Productised capital can come in many forms. It can come through media and storytelling, or distribution power through existing portfolio companies, or brand, or structured networks (think YC’s book face), or a bunch of other things. Sometimes, as in the case of NFX, it’s actually a suite of products. Ann (their head of IR) explained the suite to me as such:
“We created Brieflink [like Docsend but just for pitches] to help founders raise, and Signal [an investor-investee matching tool] to help them find out who to raise from and connect with investors. The combination puts us in the middle of the early stage startup data flow in ways no other VC firm has, and more importantly, it raises our brand amongst founders. Whether we end up investing or not, founders want to work with us partially because of the software we’ve created… Internally, we offer to the founders we invest in an exclusive platform that houses a library of strategic advice for commonly faced founder problems, allows founders to schedule meetings with our founder success team and also provides engagement with the wider NFX founder community, as well as access to discounts from common vendors.”
NFX also posts frequently, has written the canonical bible on network effects, and has GPs who are very active in cultivating their personal brands.
Let’s use media as a deeper example. In chats with Harry of 20VC and Mario of Generalist Capital, both brought up this idea of the intersection of media and investing as a VC product. a16z has Future, First Round has their Review, Redpoint is getting into TikTok. Per Mario:
“The idea of a media-first investment firm is pretty new. Not many people have thought about what it’ll look like in five or ten years. It’s a really powerful thing - controlling a story. If you can write about a company in a way that shapes their hiring, fundraising, and acquisition, you can really do quite a lot to put them on the map… But more than that, [The Generalist] is a compounding advantage. It gets more valuable over time with each reader and each piece of content. It’s a distribution channel not everyone can access, and a way for me to reach more people than a traditional investor could.”
So now do all investors need to go start substacks and podcasts and write software? Not necessarily. Understanding where you fit into the capital stack, which entrepreneurs you want to serve, and which LPs you are targeting can guide how you think about productising your sourcing/winning/picking/king-making edge.
A reason for this is because LPs all have different weightings of these factors. Some LPs will place zero importance on a few of these, and others will vary their weightings depending on the macro. Some may heavily weight the ability to co-invest or join on SPVs. Certain funds will sell their fund-of-funds product as subservient to their co-investment strategy. Endowments or institutional LPs will more heavily weight traits that help the GP stay in the game (e.g. capital raising) than a family office. Their rationale? An endowment is looking to deploy large tickets consistently and for a high IRR, where a family office is looking for TVPI (cash returns) to fund the spend of their resident billionaire.
Founders too, place different weightings on these factors. A founder doesn’t care much about your track record. Founders care about the signalling that track record brings. Founders care big time about your ability to king-make, what value you will put on their business, and how easily you’ll be able to raise capital to support them for the long run. Your network, your “value add”, your portfolio involvement - these are all elements in how you’re going to make them royalty. But your portfolio composition or ability to return capital? Doesn’t really effect them.
Recall that the value of money had an impact on which factors were important. In a bull market, most companies get markups, but the best get marked up more. This is why we’ve seen GPs with distribution, networks, and more diversified portfolios do well in recent years. These are the collaborative, good-karma guys who everyone likes at their cap tables. These guys win well, get small checks into the hottest companies, and generally have fairly lax valuation formulae.
In a bear market, things look different. Far fewer companies get marked up. Cash is scarce and people are sour. It is the pickers’ market when there’s blood in the streets. Winning is less important because cash is worth more and deals are easier to access. The winners here are the calm, stoic, Burry-esque ones. These are the wartime generals, and a surprising amount of them are on the spectrum.
Within the context of this framework, I’ll unpack below how the unbundling effects it, and - in the next article - how GPs can position themselves with defensible, differentiated competitive advantages: or moats.
“I’m not a businessman. I’m a business, man”
Shawn Corey Carter, Jay-Z
Gambino’s 2013 album Because the Internet is an ambitious, snarky, off-kilter piece of storytelling. Donald Glover - the artist behind the moniker Childish Gambino - is one of the most versatile success stories today. He’s done standup comedy, written plays, acted, sang, rapped, directed, and has won multiple Emmy’s and Golden Globes across multiple categories.
Dude’s a legend.
But back in 2013, Glover was coming off some questionable sketch comedy and a b-tier debut album. His Because the Internet album - and life since - has completely flipped the tide on his trajectory. Over the past several millennia, we’ve praised (and benefited from) the specialisation of labour. Exceptional polymaths aside, Glover bucks this model by being world-class successful across verticals that usually take decades of practice to nail. To what does he owe his success? He says it’s Because the Internet.
Glover’s industry is probably the best example for the cycle of bundling and unbundling. Typically, when products unbundle, businesses unbundle. In the early days of CDs and LPs, record labels bundled musicians. Internet based products like Napster, with their track-by-track download allowed for folks to unbundle the product (CDs) and the entire music industry soon followed suit. There were entirely online record labels, companies focused solely on merch sales, or touring, or distribution.
Of course this is a cycle; the bundling re-occurred in the form of Spotify, Apple Music, and Youtube Premium built atop Internet-based tech. This cycle of bundling-unbundling is often driven by developments in the underlying technologies beneath the products. Today, because of the internet, the tech underpinning the capital markets is evolving at a pace we’ve not seen prior. This evolution includes the fact that know-how is easy to come by, the importance of personal branding, better tooling, an influx of capital and talent to private markets,
Knowledge is an Easy Thing
Trade secrets once reserved for multi-year apprenticeships (like blacksmithing techniques) are now a YouTube search away. For industrious wannabe GPs, the problem is now more with filtering information than with finding it. The information edge VCs of the past relied on is rapidly shrinking.
There’s a wikiHow to Start a Hedge Fund (with Pictures).
YCombinator’s standardisation of legal templates has massively reduced the negotiation workload of GPs and fund CFOs.
There’s a YC for GPs.
Social Media and Hero Brands
Beyond just best practices, the internet also lets artists like Glover carry street cred from one platform (YouTube) to another (Spotify). Venture is a very common way to indirectly monetise a well-tailored social media presence - Julian, Packy, Turner, and Mario have all done this to massive success. Mario and Packy even wrote blogs on how to do this. Twitter and Substack have created a swathe of new finfluencers and are giving traditional firms new ways to distribute and brand-build.
Speaking to these guys, a common sentiment that’s come through is that the good founders want to deal with individuals. Julian Shapiro put it well the other day: You can carry a hero brand within a firm (such as Chris Dixon in a16z crypto), or you can carry a firm on your hero brand.
The current meta (if you’re not born white, rich, and willing to slug through an Ivy League + pod shop combo) is to build a following through a combination of shitposting, podcasting and writing substacks, create some private communities of LPs, GPs, and successful founders who can help source for you, seed a fund and then use your platform to plug your portfolio companies and brand-build your fund.
Venture is a people-centric business, and if you’re not individually relevant then you’re likely commodity capital. While there’s a compounding advantage in having the right people know you, this is really not the only way of being individually relevant. Good founders will always pick a suite of VCs for their cap table. They’ll optimise for a variety of domains here, with brand or distribution only being one of them. They may pick a VC who gets them publicity, one who can open distribution channels into a specific region, and one who may help them rope in the best people in a particular industry.
Many emergent managers know this. They aren’t sector specialists, and don’t have the best networks in the toughest regions, but Because The Internet, they can leverage their personal brands to carry individually relevant hero brands.
Supporting this wave of entrepreneurial VCs is a suite of tools for fund management. Moonfare, Tactyc, Carta, AngelList, bunch, and Odin are all designed to increase access and decrease the opacity of private markets across various value-streams that a fund has to manage. This tooling stack has been getting shedloads of funding from the industry in recent years.
Tooling which automates the back-end for fund infrastructure, or which allows retail to invest in pooled SPVs and access blue chip funds, is increasingly common. The pooling of capital into a fund like Sweater’s is only possible because of Internet-driven distribution. Doing this little over a decade ago would have been a logistical and regulatory nightmare. There’s also DAOs hovering somewhere on the horizon, but that’s a little way away still.
From Public to Private
These Gloverian trends are coupled with a seismic shift in the capital markets from public to private. In 2012, venture capitalists invested roughly $60 billion. In 2021, that figure reached $643 billion. In part this is massive institutional allocators moving into riskier investments to find returns in a low-yield market to satisfy a widening liabilities and assets gap. But it is also because of a range of other factors:
there is a principle-agent incentive around illiquid performance that encourages managers to measure based on the less volatile markups of private companies,
the fact that venture has been derisked by best practices, growth capital, and frequent buyouts or acquisition,
the rising complexity of the public markets (competition is now incredibly algorithmic and flow-driven) relative to the private markets,
The rise of intangible assets leads to less capital being needed to produce the same amount of result. So companies can stay private for longer without needing to tap the public markets, and
Relaxing regulation around private markets and increasingly strict regulation around publics.
The net result? More companies stay private, and more money goes to private, so more people want to invest in private companies.
Simply, GP number go up.
One way to look at traditional VCs is as bundling money, advice, and control. The rise of angels bundled just money and advice. The rise of incubators and accelerators: advice only. Money is available without control from growth funds like Milner’s DST. We’ve seen it in private equity, media platforms, and management consulting. Now we’re seeing it in venture. When there is an abundance of capital, diverse demand, and a fragmented consumer base, unbundling is inevitable.
Each emerging manager looking to raise from LPs should have a very clear raison d’etre. In the same way GPs expect from their founders, they should be able explain their clear differentiation in a sentence or two. How durable is your advantage? How did you build this? What’s your product to LPs and founders?
To compete against the mega-firms, GPs are moving earlier stage, embracing more complex sectors and regions, leaning more into their exclusive networks or audiences, or backing weirder and weirder founders. For sure, such specialisation has limits. It is not incredibly scalable, and it is not an impregnable defence. It is still the way we seem to be heading.
Specialisation, solo-GPs, a separation of advice, money, and control, these are all traits of an unbundling industry. Through this series I’ll touch on all these topics and suggest some ways LPs (and GPs) can navigate this. I certainly don’t have all the answers - this is a complex adaptive system after all. Ours is a livelihood dependent on successfully being able to predict the future. And in a world so dominated by fat tails, randomness and optionality, this is a very hard thing to do.
CDF and predicting the future
The painting at the beginning of the article is by the Romanticist Casper David Friedrich. A lot of Friedrich’s paintings carry the theme of wonder in the face of nature’s ferocity. The sea is dark. The monk is small. The clouds loom icy and large. We are drawn to feel the smallness of man and the awe of not-man.
A core theme in the 19th century was man’s control over nature - in a sense venture is predicated on this too. “The best way to predict the future is to invent it” and all that. This is good, and right. But it is incomplete. At the birth of the industrial revolution, Friedrich is painting, Mary Shelly is writing Frankenstein, man is inventing machine and creating life, and progress is inevitable. For the first time since fire, man is getting a sense of his own power. So just as the human colossus is stirring, Friedrich stands as the monk in the image and offers his work as a question mark over this view of ourselves. Maybe the world is actually wild, and complex. Maybe predicting the future is tougher than it’s seemed over the past decade. So shoutout to all the GPs who’re doing it in this macro, plus fund-building, plus trying to be different from everyone else.
This is not a macro paper. I’m just writing it to propose that venture is unbundling. However, venture is unbundling at the very time that rates are rising and the world is entering a recession. The last time there was stagflation, Arthur Rock and Thomas Davis were starting Davis & Rock, Apple was mostly a dream, and lava lamps were having their heyday.
Now, as Friedrich, we (and GPs more than most) stand on the shores of a stormy mass. Because of the internet, the way GPs source, pick, win, raise, and firm-build is changing. Five white guys sitting in a room in Berlin may well return several years from now to find their porridge eaten, their chairs askew, and a whole set of strangers asleep in their beds.
Narrative capital — Blume Ventures’ Sajith Pai: “Narrative Capital is my term for a trend that has accelerated lately in venture capital; one where media creators purveying tech and startup content have raised funds/vehicles to invest in startups. Effectively, they are leveraging their large and growing fanbase of followers and consumers to launch an investment vehicle… What explains/underpins the rise of Narrative Capital, and what implications does it hold for venture capital’s future?”
Solo Capitalists - Generalist Capital’s Mario Gabriele: “As the old Jim Barker chestnut goes, there are only two ways to make money: bundling and unbundling. Which is to say that where venture capital began, perhaps it is returning. An industry founded by solo virtuosos like Arthur Rock developed into a team sport as it matured. Firms grew and established themselves, thriving thanks to their unique expertise, better information, and rich set of offerings. The new cadre of solo investors challenges this norm. Rather than indexing on research and portfolio services, these rogues win through speed, empathy, and by treating the venture asset class like any other – capable of being refined and disrupted. It represents a great unbundling, one that seems to have only just begun.”
The Unbundling of Venture Capital - Contrary’s Kyle Harrison: “Over the last 10 years there has been a shift in most ambitious venture funds. Funds recognized that the world was getting larger and the types of companies and founders was growing ever more diverse. And a monolithic brand wasn't going to have enough influence to be everything to everyone. So they started to modularize. Open up fiefdoms… In just the last few years you've seen an increased number of renegades emerging in venture. These renegades are people who know the value of their own brand and reputation. They recognize the fundamental disruption going on in venture and are leaning into the opportunity it creates.”
* The HR, operational and legal back-end of a fund is important, but as it is often outsourced or handled by a dedicated ops team who interface with an LP’s ops team, there is little chance that this weighs heavily into any LP or founder’s perception of a fund. It is something that cannot be a pain, but is also not a selling point.