Long read: Venture Capital & Free Lunch

After a pretty strong run in the latter half of the last decade, the venture capital (VC) industry has come in for some flak, even becoming the subject of plenty of memes of social media when a lot of bets especially those made during the go go days immediately following Covid went horribly wrong. Here’s a particularly strong note in defence of VC as an asset class, very passionately argued.

The author begins by presenting data on returns across asset classes that shows VC coming up trumps both on the basis of dispersion of returns as well as risk adjusted returns (risk measured in standard deviation).

But he acknowledges the shortcomings as well:
“The data isn’t super clean. Depending on the time horizon and whether you’re talking risk-adjusted returns, venture capital may or may not be the best performing asset class. And investing in venture capital requires locking your money up for a decade, unlike stocks or bonds which you can go sell right now.”

But more than the returns, his biggest defence is in VC’s role as perhaps the only private funding source for innovation in the economy.

“But the fact that venture capital is even in the running, and wins on some time horizons, means that the world gets all of that innovation – from failures and winners alike – for free.”

Venture capitalists can fund the wildest ideas in the world, many of which won’t work, some of which will work bigly, and their returns as a group end up being pretty great.

And on top of that, we get the fruits of innovation, because venture capital is the only asset class that funds truly new things.

Take the current hype cycle in AI. Venture capitalists are pouring stomach churning amounts of money into foundation model companies. Billions of which will, for all intents and purposes, be lit on fire. The problem is: it’s hard to tell which billions until you put the money up and watch it play out. Venture capital is designed to put those chips on the table and see what happens.

If history is a guide, most AI companies will go to zero, and a small handful will generate enough returns to carry the rest. Those returns will go to venture funds’ limited partners, the charities, endowments, pensions, and other individuals and institutions who invest in venture funds, who will take that money, reinvest some into the next generation of venture funds, and operate their institutions with the rest.”

He backs up with a quote from Marc Andreessen the founder of the one of the world’s leading VC firms a16z:

“The best VCs get to improve society in two ways: by helping new companies take shape and contribute new technologies and medical cures into the world, and by helping universities and foundations execute their missions to educate and improve people’s lives.”

He reckons VC’s getting sucked into the hype is in some sense by design:

“I think hype-buying is one of venture capitalists’ most endearing qualities.

Hype is usually an indicator that there’s something there, even if that something is a long ways away. As I wrote in Capitalism Onchained, “Any technology that is sufficiently valuable in its ideal state will eventually reach that ideal state.” But it takes years, sometimes decades, of winding experimentation, and millions, sometimes billions, of dollars to reach that state, or even to reach a pre-ideal state in which the technology can be built and sold profitably. 

Who’s going to fund that experimentation period? A bank? The public markets? Nope. Venture capitalists.

Take the clean tech bubble that Kleiner Perkins helped kick off in the mid-2000s. In 2007, Kleiner Perkins Partner John Doerr said, “Going green is bigger than the Internet. It could be the biggest economic opportunity of the 21st century.”

Kleiner and other venture capitalists ended up investing a tremendous amount of money investing in clean tech – on the order of tens of billions of dollars. They lost money on the vast majority of those investments. But their investment attracted talent to the industry and provided an incentive to improve clean technologies that helped lay the groundwork for the dramatic increase in renewable and storage capacity we’re benefiting from today, nearly two decades later. And Tesla, which at a $626 billion market cap is worth multiples of all of the money invested in clean tech.”

The enjoyable rant goes on to defend the industry from other perspectives including fees but with objectivity and data to substantiate.

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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.