Firehose #156: 📈 Bullish on VC? 📈

Could venture still be undercapitalized? Plus: Amazon reads your palm, Spotify's second act, a tribute to Clay Christensen, and more.

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One Big Thought

Cambridge Associates released a report this week with some compelling data about the venture capital (VC) market.

For those unfamiliar with Cambridge Associates, the firm advises large pension funds, endowments, and family offices on their allocations to various money managers. Founded in the early 1970’s, Cambridge Associates was the first firm to focus heavily on VC. At the time, commitments to VC funds were puny — only a few hundred million in aggregate each year.

The firm’s timing was impeccable with respect to two regulatory developments, as chronicled by Paul Gompers in his 1994 essay “The Rise and Fall of Venture Capital”:

The first was the 1978 Revenue Act, which decreased the capital gains tax from 49.5% to 28%. The second was the change in ERISA’s “prudent man” rule in 1979, which explicitly allowed pension funds to invest in venture capital….Prior to that date, the Employee Retirement Security Act of 1974 prohibited pension funds from investing substantial amounts of money in venture capital or other high-risk asset classes.

Annual commitments to VC funds subsequently rose by 30x to over $6 billion by 1983, with pension funds accounting for nearly half of inflows. Moreover, returns went up with all this additional capital. Median fund returns exceeded 30% at the decade’s peak in 1982, driven by a number of IPOs never-before-seen in technology:

The conventional wisdom on a 30x inflow of capital to an asset class is that it drives returns down due to simple laws of supply and demand. Clearly, the opposite occurred. What naysayers neglected to realize in the 1980’s was how much additional tech could be productized with the raw materials left over from the semiconductor boom of the 1960’s and 1970’s. Pension funds essentially created a market by funding VCs, who in turn funded a generation of remarkable founders.

This historical context is relevant for the aforementioned report. It argues that institutional investors should allocate an even greater portion of their portfolio to venture capital. I’ve summarized a few of the report’s observations below.

First, top decile institutional investors in 2019 have an average allocation to VC of 15%, nearly double their allocation in 2009.

The dispersion in returns is likely driven by superior access for top institutional investors into top VC firms. In other words, long-term devotion to the asset class tends to reward those who stick with it disproportionately.

Second, while the industry’s top VC firms tend to persist, new and emerging VCs also drive significant returns for each vintage. From 2009-2016, an average of 7 of the top 10 performing US VC funds have been new (Fund I, II) or developing (III, IV). An important caveat is that the TVPI metric tends to favor smaller funds, where higher multiples are more common, and new funds tend to be smaller. Yet, those small funds often get bigger and become new franchises over time. Hence, limited partners have myriad opportunities to get into the next great fund, if they’re willing to take risk on a new manager.

Third, venture capital is far less risky than it used to be. Loss ratios after the dot-com bubble were “only” 20% on average, while impairment ratios were 41% over the same period. These metrics exceeded 52% and 66%, respectively, from 1991-2001. Cambridge Associates posits that VC funds present lower risk due to greater portfolio diversification, as well as shorter times and capital exposed between company development milestones.

Lastly, the private equity markets, including VC, are “eating” public equity. The number of publicly listed companies in the U.S. has fallen by half over the past two decades to 4,336. Over this period, a late stage VC market has risen dramatically. 8,352 unrealized and partially realized companies were funded cumulatively by 2019. In aggregate, the market cap of the latter now more than 10% of the former. Globally, Cambridge Associates counts $340 billion of Net Asset Value (NAV) of VC-backed companies — a paltry 0.5% of the $85 trillion of global public equities.

After 40+ years of broad access to institutional capital, this data suggests that VC as an asset class could grow even larger in the future. Moreover, if we use the period of the 1980’s as a comparison, that growth does not necessarily imply lower returns. Just as companies in the 1980’s built their products on top of a mature semiconductor industry, companies in the 2020’s will benefit from prior innovations in the web, cloud computing, mobile, machine learning, wireless broadband, and open source software.

As the surface area of technology broadens and builds upon the work of those who came before, don’t be surprised to see VC grow even larger as an asset class in the coming decade.


Tweet of the Week

Links I Enjoy


Talk to the hand. →

Amazon is entering the point-of-sale (POS) business, according to the WSJ. It plans to deploy palm-recognition technology as an authentication mechanism for payments.

While “scan your face” has become an acceptable method of payment in China, Americans are not likely to get on board with that technology in the checkout line due to privacy concerns. Alternatively, tracking palms seems relatively benign since palms can’t easily be tracked passively.

I would expect Amazon to first roll out this technology at Whole Foods, which it owns, providing a unique test bed at scale.

Veg out. →

Rachel Drori, CEO/founder of Daily Harvest*, was interviewed by Forbes regarding the company’s release of its first “Veg Report.” It goes into detail on how frozen produce is actually better for you than what you find in the grocery store:

Not all frozen is the same. In fact, the majority of frozen options out there are hyper-processed, hyper-refined, and chock full of additives and preservatives. At Daily Harvest, we take frozen back to what it was before the dawn of TV dinners… when it was a method of preserving food in its unadulterated form without adding preservatives. Daily Harvest has created what food can be in the future. When done right, frozen offers the perfect solution for those with busy lives - more convenience, superior nutrients and flavor, and less waste. 


Ambient hours. →

Brett Bivens wrote a post on Substack (newsletter inception!) about the fight for a consumer’s ambient hours. My partner Jeremy Liew used a similar term to describe the opportunity for our investment in Cheddar back in 2017. The only way to grow media hours in a 24 hour day is to go after “mixed attention” time.

In this post, Brett nails the core danger for Spotify.* Its core feature, streaming music, is a complement for all its competitors — Apple, Amazon, YouTube, Tencent, and (increasingly) ByteDance. Whether they sell high margin hardware or earn non-music advertising revenue, these competitors will seek to commoditize music streaming to drive revenue to their other, more profitable business lines. Spotify must diversify quickly if it wishes to survive.

Brett argues that this strategic weakness will drive the company to continue to verticalize (e.g. Gimlet acquisition in podcasts) and extend formats (kids, corporate, etc). The final push should be into social products, but those are notoriously hard to build natively in a music app. Alternatively, Spotify could acquire a social network, but few exist independently other than Snap* and Discord, and the former is worth almost as much as Spotify itself.


RIP Clay. →

The business world lost an icon in Clayton Christensen.

At HBS, I took the class that Clay originated, but with a different instructor. He substituted for a single class, which I remember to this day. The core lessons of his classic text The Innovator’s Dilemma have influenced countless practitioners and investors in the technology field, myself included. Most business books can be summed up in a few pages. Clay’s insights were deep enough to underpin a career.


Massive gravity. →

A professor at Imperial College London has a novel idea that could provide an explanation for the accelerating pace of universal expansion. Professor Claudia de Rham posits that gravitons — the particles that mediate the gravitational force — may themselves have mass. It’s a beautifully recursive idea, that if proven, could solve one of the most troubling questions in all of physics.


Is this real life? →

The release of Playstation 5 will bring video game realism to another level. This YouTube video shows off some upcoming titles with mind-blowing graphics.

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Disclaimer: * indicates a Lightspeed portfolio company, or other company in which I have economic interest. I also own stock directly in AAPL, ADBE, AMZN, CRM, FB, FTCH, GOOG/GOOGL, NFLX, SHOP, SNAP, SPOT, SQ, and TWLO.

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