Persistence as a function of discipline in VC

Venture is a tough game to be in, for both investors/LPs sifting through the endless stream of new venture capital (VC) funds launching each quarter (see chart) and the fund managers/GPs competing against each other to win the chance to back the brightest founders.

Network effects drive persistence

So, how can a LP consistently back GPs that are consistently better than average?

The answer lies in identifying fund managers that can deliver high-quality returns across many funds even as innovation trends and business cycles change around them. The venture ecosystem is dominated by the power law, where only a few venture funds truly outperform, having backed a typically even smaller number of successful founders. Therefore, gauging a fund manager’s ability to repeat strong performance - persistence - is crucial.

What drives persistence? Most obviously, it is driven by a consistent edge in a manager’s ability to identify and invest in successful founders. Venture capital investment being a two-way street (i.e., as much a founder’s decision on with whom they wish to work as it is the fund manager’s decision which founders to back), a significant factor in this ability is how a manager is perceived by founders.

This dynamic makes persistence more plausible in VC than in other asset classes: founders often flock to previously successful fund managers, thereby creating a self-reinforcing network effect.

The importance of discipline

Our chats with experienced venture capitalists suggest that one factor is more important than others for attracting the best founders - discipline. This is applicable in terms of both being purposeful in constraining fund size and being known for having strong, first-principle views of markets and the types of founders with which they work.

As mentioned in our prior piece around dispersion, managers that succeed over the long term typically keep new fund sizes similar to previous funds. If it ain’t broke, don’t fix it.

The data highlights how important it is to not grow too quickly in VC: Since 2000, across all venture funds, returns have generally weakened for firms that raised much larger follow-on funds. Returns were typically stronger for managers that did not seek rapid expansion of their remit.

This is potentially because a larger fund size can make managers’ drift from their previous investing niche, and may create a sizing mismatch in their target strategy. Funds investing in early-stage VC, for example, should naturally be smaller. AUM bloat can lead to missteps in terms of check size - writing unnecessarily large checks - and selection - as the necessity to deploy more capital may dilute quality.

The second driver of persistence we identify - strong first-principle market and founder views - may help mitigate against these selection issues. In our chats with some leading early-stage managers, a theme was that they won deals because founders understood that they as a firm had what Accel Partners coined as a “prepared mind” - knowledge advantages in either the market in which the founder operated or in the types of founders they back, or both.

Post-2021, early-stage founders seem to understand a perceived truth in VC: who you partner with matters more than the amount of money you raise. Partnering with a manager known for expertise in their specific niche can benefit founders in terms of knowledge and connections with other companies, potential customers, top talent, and other investors.

Focus on fund size and strategic discipline

For investors looking at venture funds, an assessment of fund manager discipline should be incorporated into selection criteria. Even some of the most famous fund managers have gone awry when they drifted from a successful formula.

One of the most famous stories of persistence is Benchmark Capital, led by Bill Gurley (who recently retired) and Peter Fenton. Benchmark made a name for themselves with concentrated early-stage bets that set records for some of the best early-stage investments ever - notably eBay (627x) and Uber (800x) - and establishing themselves as a leader in two-sided marketplace investments. 

Even with these successes, they almost entirely resisted the urge to raise a megafund (with one, non-repeated deviation during the 1999 boom - see chart below). Their general discipline in fund size and principles around the markets and founders they would back were a great forcing function for Bill and Peter to keep them focused on their primary skill set and on delivering outperformance for their investors.