What drives returns in the US VC industry (and, maybe by extension, Canada's VC industry)? Peter Rip, Managing Director, Leapfrog Ventures has a VC oriented blog, Early Stage VC. This week he published a three part essay on what he describes as "Venture Capital 2.0." Rip provides some interesting insights into the financial mechanics of the VC industry:

Success begat success in the venture business. Since venture investments have had payoff characteristics like options, i.e. limited downside and infinite upside, the key to the business has been "deal flow." Deal flow is about seeing as much of the total distribution of deals, to generate a larger set of 'long tail outcome' candidates. Success made IT venture capital business a first-order Markov process, where the probability of the getting the next hit was enhanced by having a previous hit, precisely because of the desire of all entrepreneurs to affiliate with "known winners."

Limited partners (LPs) are investors in venture capital funds. We raise money from them, just as companies raise money from us. We tell them our credentials and, to a lesser extent, our business plan. LPs usually have to make stronger commitments than VCs with even less data. A VC who loses confidence or interest in a company can choose to cease new investments in that company. The result is often that their investment gets diluted, perhaps massively, but it still remains. A LP who loses confidence in a VC fund technically still faces a legal obligation to continue meeting their capital calls. At best, they face losing all their capital. At worst, they have no choice but to throw good money after (perceived) bad.

Historical performance can only take you so far. One needs a theory of future drivers of returns to select among venture capital managers. Being yet-another-top-half-IT fund is not enough to be considered seriously by anyone. LPs construct portfolios of all private equity and venture capital investments based on their strategies, applying sound financial principles of predicting correlations of returns to maximize risk-adjusted return. The typical VC fund attributes are size, industry, stage, and geography. These attributes pass for strategies in most fund raising conversations. My next post will deal with why I think this is mostly flawed, for both VCs and LPs.

I began this series with a flippant remark about Venture Capital 2.0. I don't think traditional venture capital is going away any time soon. There is too much momentum, i.e., money. But I do think there is a real alternative model for the practice of venture capital investment as a product within a larger risk capital portfolio. It won't emerge soon. LPs decision models are still based on a demand for venture products packaged to look like they conform to portfolio construction models. However, there is enough "investment thesis drift" afoot these days that some private equity firms are going to realize that they can use this "drift" to their advantage and drift head-on into crossover forms of investing.