Month: February 2024

VC is a Home Run Derby with Uncapped Runs

There’s an old saying that goes, “Know the rules of the game, and you’ll play better than anyone else.” Let’s take baseball as our example. Aiming for a home run often means accepting a higher number of strikeouts. Consider the legendary Babe Ruth: he was a leader in both home runs and strikeouts, a testament to the high-risk, high-reward strategy of swinging for the fences.

Yet, aiming solely for home runs isn’t always the best approach. After all, the game’s objective is to score the most runs, not just to hit the most home runs. Scoring involves hitting the ball, running the bases, and safely returning to home base. Sometimes, it’s more strategic to aim for a base hit, like a single, which offers a much higher chance of advancing runners on base and scoring.

The dynamics change entirely in a home run derby contest, where players have five minutes to hit as many home runs as possible. Here, only home runs count, so players focus on hitting just hard enough to clear the fence, rendering singles pointless.

Imagine if the derby rules also rewarded the home run’s distance, adding extra runs for every foot the ball travels beyond the fence. For context, the centre field is typically about 400 feet from home plate. So, a 420-foot home run, clearing the centre field by 20 feet, would count as a 20-run homer. This rule would drastically alter players’ strategies. Not only would they swing for the fences with every at-bat, but they would also hit as hard as possible, aiming for the longest possible home runs to maximize their scores, even if it reduced their overall chances of hitting a home run.

This scenario mirrors early-stage venture capital, where I liken it to a home run derby with uncapped runs. The potential upside of investments is enormous, offering returns of 100x, 1000x, or more, while the downside is limited to the initial investment. Unlike in a derby, where physical limits cap the maximum score, the VC world is truly without bounds, with numerous instances of investments yielding thousandfold returns.

This distinct dynamic makes assessing VCs fundamentally different from evaluating other asset classes, where protecting the downside is crucial. In the VC realm, the potential for nearly limitless returns makes losses inconsequential, provided VCs invest in early-stage companies with the potential for exponential growth. The risk-reward equation in venture capital is thus highly asymmetrical, favouring bold bets on moonshot startups.

For illustration, let’s consider two hypothetical venture capital firms: Moonshot Capital and PlayItSafe Capital.

Moonshot Capital approaches the game like a home run derby with uncapped runs. They aim for approximately 20 companies in their portfolio, expecting that around 20% will be their home runs—or “value drivers”—capable of generating returns from 10x to 100x or more. 

Imagine they invest $1 in each of 20 companies. One yields a 100x return, three bring in 10x, and the remaining are strikeouts. The outcome would be:

(1 x 100 + 3 x 10 +16 x 0) x $1 = $130

Their $20 investment becomes $130 (or 6.5x), a gain of $110, despite 17 out of 20 companies being strikeouts. Yes, you are correct. 85% of the portfolio companies failed!

PlayItSafe Capital, on the other hand, prioritizes downside protection, ensuring none of the portfolio fails but also avoiding riskier bets. In the end, one company generates one “10x” return, five companies return 3x, and the remainder is equally split between breakeven and failing.

(1 x 10 + 5 x 3 + 7 x 1 + 7 x 0) x $1 = $32

Despite several “successes” and very few “losses,” the fund’s return of $12 pales in comparison to Moonshot Capital’s. Even increasing the number of companies generating a 3x return to 10 with no loss (which is almost impossible to achieve for early-stage VCs) only yields a $29 gain from a total investment of $20:

(1 x 10 + 10 x 3 + 9 x 1) x $1 = $49

No one should invest in the early-stage VC asset class with the expectation of such a paltry return.

As illustrated, success isn’t about minimizing failures, nor is it about the number of “3x” companies or even the number of “unicorn logos” in the portfolio, as how early when the investment was made to these unicorns is crucial as well. One needs to invest in a unicorn when it was a baby-unicorn, not after it became a unicorn.

In summary:

Venture funds live or die by one thing: the percentage of the portfolio that becomes “value drivers”, i.e. those capable of generating returns of 10x, 100x, or even 1000x.

At Two Small Fish Ventures, we are the IRL version of Moonshot Capital. Every investment is made with the belief that $1 could turn into $100. We know that, in the end, only about 20% of our portfolio will become significant value drivers. Yet, with each investment, we truly believe these early-stage companies have the potential to become world-class giants and category creators when we invest. 

This is what venture capital is all about: not only is it exhilarating to be at the forefront of technology, but it’s also a great way to generate wealth and, more importantly, play a role in supporting moonshots that have a chance to change how the world operates.

P.S. This is Part 1 of this series. You can read Part 2, “Winning the Home Run Derby with Proper Portfolio Construction” here.

This blog is licensed under a Creative Commons Attribution 4.0 International License. You are free to copy, redistribute, remix, transform, and build upon the material for any purpose, even commercially, as long as appropriate credit is given.

Assessing Different Asset Classes

Diversifying a portfolio across various asset classes is the first principle for enhancing returns without significantly increasing risk from an investment standpoint. Traditionally, the go-to formula has been a 60/40 split—60% in stocks and 40% in bonds, a practice primarily due to the limited accessibility of alternative asset classes. However, recent years have seen a democratization of access to a wider array of asset classes, including private equity, venture capital and numerous alternatives, opening doors for more investors to explore areas once reserved for the privileged few. This broadening of opportunities is undoubtedly beneficial to many.

Yet, it introduces a new challenge: How do we assess fund managers across different asset classes? This task can be daunting even for seasoned investment professionals, as investing encompasses a vast range of specialties. A common mistake is posing the wrong questions, as assessment criteria are not interchangeable across asset classes. It is akin to comparing athletes from different sports—evaluating NBA players is not the same as evaluating MLB players since each asset class is akin to a distinct sport. For instance, inquiring about the batting average of an Olympic gold medalist swimmer is as illogical as expecting an NBA MVP to be proficient with a baseball bat. 

It’s also unwise to question a fish on its ability to skate!

This blog post is the first in a series designed to demystify this process. I do not claim expertise in all asset classes—no one can. However, I hope to share my experiences to help you sidestep common mistakes and empower you with the basics to evaluate investment opportunities in unfamiliar territories, especially early-stage venture capital, which is my swim lane and relatively few people have the experience to assess. Please note, this blog post does not constitute investment advice or a comprehensive guide across all asset classes as we only cover a handful for illustration purposes. 

Here is a chart that highlights the key differences:

How should you interpret this chart? Let me use early-stage venture capital, or simply referred to as VC, as an example.

Assessing VC is more art than science and more qualitative than quantitative. It offers far higher return potential than almost any other asset class. On the other hand, the risk of losing money is also higher than in other asset classes, with the predictability of the potential target return being low and its variance high.

Individual investments within a fund portfolio have a very high failure rate, even for the best funds. This is by design because VC is a home run derby. Strikeouts, singles, or doubles don’t impact the return at all, as only the home runs count. This is unique to VC and counterintuitive to managers from other asset classes.

The dispersion among fund managers is also much higher, as the top decile funds generate significantly better returns than the rest. Vintages also make a far more significant influence, as market downturns have an outsized impact on fund returns, even for the best funds. However, the best funds still generate very good returns during bad years. These funds simply generate enormous returns during the good years!

VC takes a decade or more to generate returns. The first few years usually have nothing to show for because it takes a few years to find the startups to invest in, and they take time to grow and realize the gain. Because of this, VC funds are usually illiquid.

On the other extreme, fixed income is more science than art. It is number-driven, much more predictable, and has lower returns, but any default is a cardinal sin!

Each row on the chart deserves a separate blog post. Stay tuned for subsequent posts in this series, where we’ll dive deeper into these topics.

This blog is licensed under a Creative Commons Attribution 4.0 International License. You are free to copy, redistribute, remix, transform, and build upon the material for any purpose, even commercially, as long as appropriate credit is given.