Are successful VCs lucky or good? -- And can healthcare VCs be either?

Taleb: Investors Lucky>Good

A fascinating article by Steven Russolillo in WSJ late this summer focused on the skeptical view Black Swan author Nassim Taleb has of investment managers (summarized in this short white paper). 

Russolillo reports that Taleb

"says many of the best money managers earn their success based on ‘spurious performance' and these folks ‘rise to the top for no reasons other than mere luck, with subsequent rationalizations, analyses, explanations and attributions.'

Once they are at the top, though, they get the bulk of the allocations, creating a ‘winner-take-all effect' that causes distortions in the marketplace, he says."

In other words, there will be a Matthew Effect - the rich will get richer. 

In his white paper, Taleb argues "an operator starting today, no matter his skill level, ability to predict prices, will be outcompeted by the spurious tail." 

Notably, this skeptical view of investing seems to be shared by Daniel Kahneman, expressed in this wonderful NYT commentary last year.

Kauffman Foundation: A Handful of VCs Consistently Account For Most of the Returns

A recent, captivating report by the Kauffman Foundation takes a critical look at the venture capital industry, and concludes that the lion's share of returns are generated by a very small number of top-performing firms - the number seems to be between 10 and 50.  Most firms (once fees are included) fail to match the returns available in the public market (which the report argues is the relevant comparator).

The report observes, "great VC returns is entirely dependent on which funds you're in, not how many funds.  Generating great VC returns requires access to the small group of best-performing funds." 

Furthermore, "There is also strong evidence that VC performance is persistent at both the top and bottom."  (Of note, the report also presents data suggesting that performance falls as the size of the fund increases, and the best-performing funds seemed to be $500M or less.)

Rachleff: Top VCs Good>Lucky

Writing in TechCrunch this week, Andy Rachleff, Benchmark's highly-regarded founding partner (and now President and CEO of the online financial advisory firm Wealthfront) described what makes VCs successful.

Rachleff noted that in addition to the Kauffman report data, "Cambridge Associates, an advisor to institutions that invest in venture capital, says that only about 20 firms - or about 3 percent of the universe of venture capital firms - generate 95 percent of the industry's returns, and the composition of the top 3 percent doesn't change very much over time."

Rachleff continues, "Those premier venture firms succeed because they have proprietary knowledge of the characteristics of winning companies. Over the years, the knowledge of what it takes to succeed is passed down from partner to partner and becomes part of the firms' institutional memory."

Well, maybe.

Perhaps it's true, as Rachleff's asserts, that top firms continue to succeed because they're smarter.  But it's clearly not the only way to explain the data (and may instead offer persuasive support to the notion that every ruling class harbors the myth of its own superiority).

It would seem equally possible that top VCs may be advantaged simply because they are viewed as top VCs, and see more opportunities, can cut better deals, and provide a self-fulfilling signaling advantage to their portfolio companies.

As one TechCrunch commenter observed, "2nd/3rd tier VCs lose not because they lack wisdom, but because they lack deal flow and find it hard to compete against 1st tier brands."

Implications:

While I generally share the skepticism that Kahneman and Taleb so eloquently express, I also strongly believe that some VC investors are sharper and more savvy than others - even though this difference may account for a smaller fraction of their performance differential than they tend to believe. 

More importantly, I seriously doubt (and bristle at the notion) that a handful of top players have a lock on the relevant "proprietary knowledge" needed to be successful - this strikes me as the sort of desperate argument that has always been used by the dominant group in power to exclude new arrivals.

I also suspect that the profile of successful companies represents a constantly evolving target, and it isn't always possible to know how the next generation of winners will appear.

Healthcare VC seems like a particular vivid object lesson in the value of VC humility.  Many of the top players of a decade ago aren't even around today, and many of those still with us seem to be sitting on distinctly unremarkable portfolios. 

Some look at the sorry state of healthcare VC and conclude the category should be avoided - few winners today suggests there will be few winners tomorrow. 

But I prefer to believe that the leading healthcare VC firms of the future just haven't yet been identified - perhaps because the characteristics of winning healthcare companies haven't yet been defined.

 

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