I recently tweeted two charts from a Preqin report on Venture Capital. Since that tweet got a lot of interest (relative to the amount of interest my tweets generally get) ranging from celebratory to cynic, I thought I would dissect it further.
The top chart (Fig. 1) shows the performance of first-time funds and non-first time funds compared to the venture industry as a whole, by vintage year (2006 through to 2013), measured by the median net IRR as of September 2016. The bottom chart (Fig. 2) plots the performance (again measured by net IRR) of first-time funds vs non-first time funds from all vintages from 2003 to 2013 relative to the standard deviation of that performance (standard deviation in statistics is a measure of the dispersion of a data set around its mean, and applied to the financial world is a common proxy for risk). I can infer the size of the bubble represents the size of the population for each bucket.
Since the measure of performance is net IRR, this is all to be read with a LP hat on.
The point I was trying to convey in the tweet is that while first-time funds do outperform non-first time funds on an absolute basis (over that period), the outperformance is (in part or entirely?) a function of first-time funds being riskier than non-first-time funds, as measured by the standard deviation of their returns. In crude terms and as a way of example, a first-time fund is more likely to return <1x than a non-first time fund, but equally more likely to return >5x, while the returns from a non-first time funds are less disperse and more concentrated around the mean of the distribution. That is, the distribution of returns from first-time funds are more “fat-tailed“.
The relationship between risk and expected return should ring bells to anyone who has taken portfolio management class at school and recalls what the efficient frontier is: investors only accept higher risk if it is compensated by higher returns, or in other words there is no ‘free lunch’ in an efficient capital market i.e. the only way to earn an extra unit of return is by taking an extra unit of risk, and therefore assets are priced accordingly by the market.
So why are first-time funds riskier?
- Size. To start with, first-time funds are likely to be smaller in size, just like a Seed round is smaller than a Series A round. Preqin data shows how first-time fund size targets have ranged between $100-170m for the past 10 years, compared to a range of $200-370m for non-first-time funds. Smaller funds tend to play more earlier stage where the attrition rate is higher, as is the dilution risk from not having enough funds to follow on in the winners, but also where the potential return from hitting the outliers is much higher (this is also referred to as convexity of returns, in that the downside is capped at 0x but the upside is, theoretically, limitless);
- Focus. As a first corollary to the smaller size, first-time funds tend to focus on a single region or on a single sector, thus not benefiting from a more diversified portfolio that would reduce the volatility of returns;
- Incentives. A second corollary to fund size is GP incentives: raising larger subsequent funds allows GPs to earn larger, and cumulative, fixed cash compensation regardless of fund performance. Management fees on first-time funds tend not to be substantial in absolute terms, particularly when netted off of GP commitments. So one could argue the attitude towards risk taking is higher in managers of first-time funds;
- Impatience. As sub-corollary to incentives, first-time funds main goal is to demonstrate enough proof points to allow them to raise a second fund; in doing so, they may be more tempted to accept quick early exits as validation, which might generate higher IRR (though lower multiple and less cash creation) compared to more patient non-first time fund managers;
- First-time funds can be managed by first-time managers who don’t benefit from previous investment experience or come with a completely different background from existing funds. That can either make them more susceptible to making mistakes, but equally more receptive to ground breaking, yet dismissed, ideas in the absence of preconceived notions or powered by unique perspectives;
- First-time funds can also be managed by experienced GPs who may have spun-off from more established funds; they may come with proprietary experience and networks, taking them away from non-first time funds, which coupled with a clean sheet may yield very different returns;
- Innovation. First-time funds are more likely to be exploring innovative strategies and funds models, which are yet unproved and could yield very different (read more dispersed) outcomes from those on non-first-time funds; such strategies can also be developed in response to markets, conditions and opportunities that non-first-time funds cannot adapt to (quickly enough), thus missing out on them;
- Brand. Lastly, a first-time fund, by its very nature, has no institutional heritage nor brand to leverage (though as mentioned above “spinoff GPs” in first-time funds do), which could potentially lead to a different quality of dealflow from non-first-time funds.
It would indeed be very interesting to have the same top chart, but showing returns adjusted for risk, to see if first-time funds do indeed generate true alpha (i.e. that portion of excess return that isn’t explained by extra risk) compared to the industry as a whole. It would equally be very interesting to split performance for first-time funds into first-time GPs vs first-time vehicles managed by spinoff GPs, and also first time fund performance by fund size or strategy.
While I don’t have that data at hand, and the preconceived notion in the industry is that success breeds even more success, I like to believe that first time funds have an increasingly good chance at capturing alpha in the industry. A recent Cambridge Associate report demonstrates how venture capital itself is undergoing disruption: returns are getting more democratised and are no longer exclusive property of the top 10 firms on Sand Hill road.
As innovation and company creation happen literally everywhere, the next unicorn can be hiding where non-first-time funds aren’t closing looking. There is also a softer argument made by an investor who commented to my tweet, that first time fund managers work harder to to prove themselves. There may be some truth in there too!
While entirely anecdotal, the delta between performance of first-time and non-first-time funds in Fig. 1 of the Preqin report appears to be increasing over the period under consideration: is that because first-time funds are getting riskier or could there be some alpha in there?
The good news is that LPs are taking notes. According to Preqin, half of the c. 4,200 investors tracked by the platform and confirmed as actively investing in venture capital have either committed to first-time funds or are open to the idea. Also, according to Shai Goldman‘s spreadsheet that tracks <$200m venture funds closed since 2011, first-time funds continue to attract strong LP interest, with average fund size having increased from $54m in ’13 to $81m so far in ’16, showing more conviction. And notably 2016 is already higher than 2015 in both number and amount raised for first-time funds (though likely to end up down from the 2014 peak by 30-40% in numbers and 20-25% in dollars).
Last night I was invited as a guest to a networking event, hosted by Tablecrowd and attended by about 20 people. The format is more intimate than other networking dues I get to attend, consisting of drinks, followed by a proper dinner, closing off with a quick speech by the guest and Q&A. Given most of the audience was made of entrepreneurs, I talked about what I look for in entrepreneurs.
— Caroline Sherrington (@sherringtoncj) November 30, 2015
Here is a quick summary of what I talked about.
When investing at the early stages of a company there are two factors that matter more than anything else in my view: people and market. So in evaluating investment opportunities, I end up spending the large majority of my time thinking about them.
The reason I am obsessed with people and market is that if you get one of them wrong, or worst you get both wrong, you have limited scope for manoeuvring. While a team may be able to fix a product, or improve unit economics, it’s incredibly disruptive to replace founders when an early stage business has 12–18 months of runway, and it’s obviously inconceivable to change a market. Of course a company can pivot to address a different audience, or to a new business model or pricing strategy, we often expect them to do so. It’s rare that a company successfully pivots to a different market. It can happen, but as an investor I’d rather not take that risk.
So, what do I look for in founders? The answer is very subjective, a different investor will have a very different answer to that question. I found the answers to the following three questions to be highly correlated to ultimate outcomes:
- Would I work for this founder(s)? I find that it’s almost always a great sign when I am tempted to drop everything and join them in their journey, regardless of what they are working on. It’s a way to set the bar very high. Founders I would have worked for all had similar traits:
- ability to inspire smart people to join by selling them a dream, a vision, and making it look achievable
- ability to lead employees towards realising that vision, with all that leadership entails (e.g. long term strategic thinking coupled with attention to details, delegation skills, hustle, relentlessness, honesty, trustworthiness, ethics etc )
- ability to raise capital, a necessary ingredient until the business is cashflow positive
- Does the founder posses proprietary knowledge? Does the founder know something that others don’t or does she understand something better than anyone else?
- The answer to this question often revolves around the founder’s personal history and what brought her to start that business in the first place. What I am looking for is an obsessive passion for solving a specific problem. Passion often derives from a deep, visceral understanding of the problem, the market, the customers. The stronger the passion, the more proprietary the knowledge.
- Passion is critical because when the going gets tough entrepreneurs only keep hustling through it if they are deeply passionate about what they are working on. That’s why I am typically less keen on what I would call a management-consultant approach to startup: a numerical exercise to picking an opportunity. Again, this is just a personal framework, there are plenty of successful founders who used that very approach.
- Are the founders working on a problem I understand? I need believe I can play a role in helping the founders achieve their vision, beyond just providing the capital. Have I got other investments in the space? Do I know people in my network who can help? Do I know potential customers?
What do I look for in a market? I have narrowed it down to three tests:
- Is the addressable market large enough to sustain at least a £50m revenue business in a capital efficient way and in a sensible time frame, without having to make absurd assumptions on long term market share? By absurd market share I generally mean > 10% and by sensible timeframe I mean 5-10 years. Again this is completely subjective and highly dependent on the size of the fund under management and stage of investing.
- Is the market addressable right now? Is the timing right? One can be too early, and with limited runway the market can “remain irrational longer than you can remain solvent” (J. M. Keynes); or too late, in which case it will take much more capital to catch up with the market leaders.
- Has the company got a good shot at becoming the market leader? The rationale behind this is that value tends to accrue disproportionately to the #1 in a market, so as a VC you really want to back the leader, rather than #2 or#3.
Last week I was kindly invited by Ross Bailey to participate in a panel at the Appear Here offices, featuring Mark Evans of Balderton, Russell Buckley of Ballpark Ventures and myself. Despite feeling outsmarted by two of the best in the business, the common denominator between us three was that we had all invested in Ross and Appear Here at different times and stages.
The idea of the session was to expose the entire Appear Here team to some of the strategic thinking that goes on between management and investors, which rarely makes it through all the ranks of a company, and at best gets ‘massaged’ down. It was also an opportunity for the team to ask us investors some difficult questions.
Interestingly, and unexpectedly for me, we ended up talking mostly about company culture. Ross has always been religious about it since the very early days of Appear Here, I know that because I got involved with Appear Here when it was just him and a few slides, so I have had the privilege to see the baby grow from its very early days: from his obsession with style, design, look & feel, to messaging, choice of words and, later on as growth kicked in, hiring, office layout, parties etc. Today the Appear Here culture transpires consistently across every single touch point with every stakeholder, from the website to the office to the employees.
It’s very hard to define what culture actually means for a company, it’s often not immediately tangible, it’s the result of multiple different things all contributing to it over time, and it’s often very hard, if not impossible, to quantify the monetary impact of having (or not having) one. There also is no widely accepted way of going about building one. What’s clear though is that some of the most successful companies out there happen to have a great company culture, unique and native to them, which has followed them consistently throughout the years. People tend to think these companies have a great culture because they have been successful, but it’s in fact often the very opposite: they have been successful because they have over-invested in building a culture from the early days, which helped them attract and retain the very best people.
It’s very clear from talking to people the other night, that everyone at Appear Here is absolutely delighted to work there, and they all seem to be working incredibly hard and passionately for that reason.
We also talked about a high profile startup, with scale and hundreds of employees by now, who is having a very hard time with culture at the moment. Its founder never really thought culture was a critical factor to its success, and as a result it was never treated as a priority over hard work, growth, processes and KPIs. Now that they have reached scale, they realised they have a problem and that its employees are complaining about the company culture (or the absence of it), and some (many) are leaving. They tried to react by injecting culture, almost artificially, but it does not seem to be working. Culture is not something you can turn on on tap, it’s something that matures with time. There are no shortcuts to it.
Appear Here never had a significant amount of funding until they raised their Series A from Balderton in November 2014, and yet they managed to create a strong culture from the early days, being scrappy, creative and resourceful.
As investor I often get dragged into over-analysing unit economics of a business, addressable market sizes, competitive landscape etc when culture, or the founders’ ability to create a culture that attracts and retains talent, is often the most determining success factor, certainly in the long term. The skill of spotting entrepreneurs that have that innate ability before it’s obvious cannot be learnt at school or from books, it only comes with years and years of experience. I’m still learning…
- An underlying trend supporting the rise of digital fabrication
- The downward spiral in entry costs for small-scale digital fabrication (i.e. 3D printing, CNC milling, laser cutting), coupled with the improved output quality and the widespread adoption of digital design softwares, have revolutionized the economics of batch manufacturing. As these machines become widely available at local small-scale workshops, it is now possible to leverage a network of makers that can manufacture high quality products, on demand and in small batches, while being close to the end customers and without having to rely on economies of scale to drive their economics.
- We are still only at the dawn of this trend, and OD is well positioned to ride along it.
- A compelling user proposition for all 3 sides of the marketplace
- For designers: OD aims to be a remunerative route-to-market for both up and coming and established product designers who normally struggle to bring commercially viable product designs to market via the traditional routes. Stuck in a vicious cycle of needing strong retail appetite in order to secure financing for the manufacturing, while not being able to test retailers’ appetite for their product designs unless they have resources to manufacture them, they can only hope that a brand discovers them and gives them access to their infrastructure. On OD furniture designers can upload their digital creations and connect directly with end customers: OD will act as the curator/moderator who ensures the designs are commercially viable and uploaded in the right format, ready to be manufactured by the local manufacturers that are plugged into OD. Designers will ultimately earn royalties, as well as gain visibility in a community of like-minded professionals.
- For makers: OD aims to be a source of highly qualified, validated and paying customers for furniture workshops, who welcome a no-risk way to fill up surplus capacity (similarly to what Just-Eat does for takeaway restaurants) by accessing both quality designs and end customers on OD.
- For customers:
- Quality at affordable prices: on OD they can find real wood, customisable design furniture at only 2-3x the price of equivalent mass produced furniture (which, by the way, is often made of pulp rather than actual wood) and well below the more expensive alternatives of buying wooden designer branded furniture (generally 10-20x more expensive than anything on OD), or commissioning custom made furniture.
- Short lead times: since OD furniture is manufactured locally by leveraging a network of furniture workshops, lead times from purchase to delivery tend to be significantly shorter than the alternatives offered by traditional design furniture distribution companies that often rely on sea shipping from the Far-East and are generally are not able to cope efficiently and economically with small order quantities.
- Emotional appeal: I believe there is an increasingly evident demand among consumers and companies for unique products and experiences, handmade goods, craft and artisan-ship, locally made and sourced a products and a wider movement away from the mass-produced, the commodity shopping establishment, the Ikeas and Tescos of the world. Consumers ascribe an emotional premium to the experience of having a direct connection with the makers (think Esty), the hosts (think airbnb), the drivers (think Uber/Lyft) or whoever is crafting the experience for the end user. OD, by connecting the customers with the makers and the designers, provides a much more engaging, transparent and responsible way to buy furniture that the alternatives out there.
- An elegant “asset-light” business model
- The OD marketplace is built on top of the pre-existing digital fabrication supply chain, and as such it does not require investment in the hard assets that a traditional retailer or brand would need in order to operate, such as warehouses, inventory, working capital, manufacturing equipment, raw materials, logistics network etc. OD simply enables the existing supply chain to function more efficiently by removing the frictions and the intermediaries that exist in the traditional retail or manufacturing value chains, and in doing that is able to capture (and defend in the long term) a large share of the incremental value it unlocks along the way.
- A big and compelling vision executed by a team with deep domain knowledge
- Office furniture is clearly only the first step for OD, although it in itself represents a large opportunity to build a valuable business. Once the machine is well oiled though, there is nothing stopping OD from moving into home furniture and home decor more broadly and, eventually, into any product category that can be digitally fabricated. The idea of of ultimately taking on Ikea, a €30B revenue business, is not that far fetched.
- I am confident that a team with deep domain knowledge in industrial design and crowd-sourcing, such as the one that Tim is leading up, is best placed to execute on this compelling vision.
I am excited to see the business grow and validate my investment thesis over the next few years!
I have been keeping a close eye on the recent IPO activity of online retail businesses in the UK.
AO World is the most recent example, an online retail business selling a range of white good brands which listed on March 3rd 2014 and achieved a market capitalisation in excess of £1.5B (close to 6x historic revenues), joining ASOS and Ocado in what seems to be an uncontrollable euforia amongst retail investors for anything that involves selling and online.
Having looked at ecommerce businesses in the private market as an investor over the past four years, what caught my interest is that such valuations are nowhere to be seen in private equity land. Some of the most recent deals in the private markets (interestingly one has to go back to December 2011 to find the first relevant one), such as Wiggle, Moonpig or MyProtein, were done at 2-3x revenue and 10-13x EBITDA. This is a world apart from what the listed markets are valuing online retails businesses at the moment: Ocado (70x EBITDA), ASOS (80x EBITDA), AO (147x EBITDA).
So why are private equity investors not paying such high multiples for online retail businesses, while listed market investors pile in?
A few charts should help shed some light. Red dots represent listed online retail companies (including the ones rumoured to be listing in the next few months e.g. Boohoo, Photobox), blue dots represent privately owned online retail companies. Three things appear quite evident:
1) Listed market investors are happy to pay a premium for revenue growth, unlike private equity investors;
2) Private equity investors value margins, while the listed market investors don’t seem to care that much;
3) There is a slight premium for scale in the listed markets, not in the private markets;
Three things could be explaining this data:
1 – The level of sophistication amongst private equity investors is higher than that of listed market investors (listed equity fund managers, pension funds, retail investors). This would explain private equity’s obsession with margin (a rough proxy for the quality of the business model) rather than topline growth (which could come at the expense of margins). In a nutshell this is Amazon’s equity story of how they won the heart of Wall Street: a business carefully run at zero margin to keep topline growing at >20% pa to win market share of all retail. More equity analysts covering UK ecommerce stocks could be a good thing as the market capitalisation of online retail businesses in the UK now tops £10B.
2- There is a scarcity of growth stocks for UK fund managers to take exposure to and the offline to online shift is still one of the few attractive growth stories remaining out there. So anything that simply smells ecommerce, regardless of the actual underlying business model, will attract a premium valuation. This is actually causing severe headaches amongst some of the best IPO candidates (and their bankers) that, despite operating at 30-40% margins, will inevitably be thrown in the “online retail” bucket by the listed markets and possibly get an Ocado (5% margin) or an AO.com (3% margin) multiple on their revenue (c. 4x). I am sure they won’t be un-happy about those multiples, but in theory they should trade at a premium to less attractive business models.
3 – Listed markets seem to believe that with size come economies of scale in ecommerce, and therefore they are happy to ascribe a premium for larger businesses. But is that actually the case? The same data set suggests the opposite, the larger the business the lower the margins (a proxy for its efficiency) i.e. it’s either growth/scale or margin in ecommerce. This brings us back to point 1: how sophisticated are the listed market investors?
Every year, 40 million people walk in and out of Piccadilly Circus underground station in London. That’s 770 thousand a week, 110 thousand a day, every day. That’s a lot of footfall, but also potential eyeballs.
You can actually rent a retail shop in Piccadilly Circus station for £1,500 / week. To keep it simple, you could just hang a large billboard in front of the shop unit, so you don’t have to bother about fitting it, staffing it, stocking it etc.
Now, assuming that all 770 thousand people walking in and out of the station on a weekly basis look at your billboard, that’s costing you just shy of £2.0 CPM (£2 for every 1,000 impressions).
Let’s say you wanted to buy 770 thousand impressions online from an audience that is similar to the people that pass through Piccadilly Circus every day (i.e. 50/50 men/women, ABC1, shoppers, tourists, 18-40, professionals). That’s likely to cost you a lot more than £2.0 CPM. For example, the Mail Online, world’s largest online news site (with close to 200 million monthly UVs and an audience somewhat comparable to the Piccadilly crowd) charges anywhere between £20-50 CPM for ad space on its web property.
I’ve made the assumption that all people walking through the station would look at the billboard, which is obviously optimistic. However to achieve a CPM comparable to the online CPM only 4-10% of the people would have to look at the billboard, which feels quite conservative given people have to walk by it to get in an out (I for example always look at ads in the tube and at stations, I suspect I am not the only one).
I have also assumed for simplicity that one would just hang a billboard in front of the shop, which would not attract higher than average attention from the crowd. In reality, with a little investment, the unit can become an interactive billboard where potential customers can walk, touch and feel the products, talk to staff and buy.
Overall it feels like there is an opportunity for online businesses to leverage flexible offline retail presence to drive impressions at attractive CPM rates, with the upside of the human interaction.