If a better book on investing is published in 2022, we will open several bottles of something nice to drink. ‘The Power Law’ is rich with insight and helps the reader go to the heart of why venture capital (VC) investing transforms economies and disrupts conventional investing as much as it disrupts industries. Whilst Sebastian Mallaby’s book focuses entirely on the VC industry in the US (with no mention of Europe or India), this is the best book we have read on both the genesis of this style of investing and why it is valuable for society (because it finances activity that no other style or investing is willing to finance). Our learnings from this book can be broken into three parts.
Firstly, Mallaby insightfully explains why VC investing came up with a construct that conventional Economics simply hadn’t imagined: “The economics profession has long recognized two great institutions of modern capitalism: markets and companies. Markets coordinate activity via price signals and arm’s-length contracts. Companies coordinate by assembling large teams led by top-down managers. But economists have focused less on the middle ground that venture capital inhabits.Venture capitalists channel capital, advice and talented recruits to promising start-ups; in this way, they replicate the managerial direction and team formation found in corporations. At the same time, venture capitalists have the flexibility of the market. They can get behind a start-up with a fresh business idea; they can shape it, expand it, murmur its name into the right ears. But when a round of funding is exhausted, the market will decide what happens. If there are no enthusiastic buyers for the next tranche of the start-up’s equity, it will be forced to close, avoiding the waste of resources that comes from sticking with doomed speculative ventures. This blend of corporate strategizing and respect for the market represents a third great institution of modern capitalism, to be added to the two that economists traditionally emphasize.Venture capital challenges economists in another way as well. A huge amount of energy in government and the private sector is spent on economic forecasting; without a clear view of the future, committing resources would seem irresponsible. But extrapolations from past data anticipate the future only when there is not much to anticipate; if tomorrow will be a mere extension of today, why bother with forecasting? The revolutions that will matter — the big disruptions that create extreme wealth for inventors and great anxiety for workers — cannot be foretold because they are so thoroughly disruptive. Rather, they will emerge from the murky soup of tinkerers and hackers and hubristic dreamers, and all you can know is that in 10 years the world will be excitingly different. The future can be discovered by means of iterative, venture-backed experiments. It cannot be predicted.”
To our mind, these insights alone are worth the cover price of the book. Both, as investors and as managers of Marcellus, we can learn from these insights (and pay less attention to Economists’ forecasts).
The second learning is that the type of investors and entrepreneurs who populate the engine rooms of the VC industry are not the established business elite because, by definition, the establishment tends to be conservative (think high caste, golf club member types speaking the Queen’s English) with more to lose than to gain. The VC industry is at its vibrant, iconoclastic best when it is run by outsiders who challenge the traditional establishment and such investors tend to fund iconoclastic entrepreneurs. As former FT editor, Lionel Barber, explains: “Three of the founding fathers came from New York state: Arthur Rock, the child of Yiddish-speaking immigrants who grew up poor in Rochester; Don Valentine, the legendary force behind Sequoia Capital whose father was a trucker in Yonkers and a minor functionary in the Teamsters Union; and Tom Perkins, a child of the Depression who had grown up in White Plains on “Spam, margarine, Wonder Bread, and lime Jell-O” and whose fascination with electronics took him to MIT, Harvard Business School and later to Hewlett-Packard as general manager of their computer division in California.”
The implications of this in the Indian context are obviously immense.
And the third set of learnings are around the title of the book “The Power Law”. Statisticians have shown that because of the law of large numbers, most things in the world follow the famous bell-shaped Normal Distribution eg. the heights of each the 8 million people who use Mumbai’s commuter trains each day. However, returns from VC investing do NOT follow the Normal Distribution i.e. if a VC invests makes 20 investments, the returns will NOT follow the bell-shaped curve; instead the returns will follow the Power Law i.e. 1 or 2 of the investments will deliver 30-100x returns whilst the rest of the investments might deliver zero. Furthermore, the longer the time horizon, the more pronounced the Power Law i.e. the VC has to patiently nurture those 1-2 blockbuster investments for 5-10 years rather than flipping them at the first opportunity.
Eight years ago, we learnt about the Power Law in the context of stockmarket investing from a paper written in 1984 by Rob Kirby, formerly a fund manager in Capital Research in Los Angeles – see http://csinvesting.org/wp-content/uploads/2016/12/the-coffee-can-portfolio.pdf
– and this helped us build the “high on quality & patience, low on churn” investing style which characterises Marcellus. What we didn’t know is that Rob Kirby, on behalf of Capital Research, helped launch one of the most powerful VC funds in the world – Sequoia Capital. Kirby hired Don Valentine to build Sequoia and as Sebastian Mallaby explains, guided Valentine and gave him access to the Boardrooms of the dominant American companies of the 1970s. Over the next 50 years, Sequoia’s returns became the perfect exemplar of the Power Law. The search for the exceptional, rather than the average, is what makes VC investing such a powerful engine of change.