Why are VC returns correlated over time but mutual fund manager returns not??

by on September 5, 2017 at 12:47 am in Economics, Uncategorized, Web/Tech | Permalink

Try on these propositions for size:

1. Intangible-rich businesses are harder to fund with debt, because the lenders cannot take home much in the way of physical assets.

2. Intangible assets, because of their potentially scalable nature, can produce the kind of “home run” successes that VC investors look for.

3. Given that intangible investments are relatively uncertain, the idea of successive funding “rounds,” with successive evaluations at each stage, makes more sense in those cases, and that too matches the VC model.

4. Companies with lots of intangible assets try to take over markets that are “contested,” but note that leading VC firms behind these investments are heavily invested in the entire ecosystem.

5. If a good VC company is plugged into the right social networks, and investing in a highly productive ecosytem, it can reap high returns year after year, and from a relatively “within-sector” diversified position.  The VC companies can outperform the broader market, even if the VC leaders themselves would not be superior “stock pickers” in a mutual fund context.  That said, the VC leaders may not be well diversified across sectors, and so a systemic tech bust can hurt them.

6. Not everyone can build those social networks with equal facility, so VC advantages can endure for considerable periods of time for the leading firms.  It is the ability to “position socially and manage contestedness and spillovers and maintain the flow of good deals” that is so hard to scale up.

That is all from the forthcoming Capitalism Without Capital: The Rise of the Intangible Economy, by Jonathan Haskel and Stian Westlake.  Their discussion of venture capital offers further points of interest, including a discussion of why it is so hard to replicate VC environments in other settings.  Here is my previous post on the book.

1 Harun September 5, 2017 at 1:06 am

I should have put this in the story below. mea culpa.

2 Ian Fellows September 5, 2017 at 2:02 am

Haven’t read the book. Looks interesting.

7. Being plugged into the right social networks, a good VC can provide significant value add in terms of both strategy and intervention in critical deals. This can create a success where one wouldn’t have existed otherwise and is especially true of earlier stage investments.

3 Ray Lopez September 5, 2017 at 8:17 am

You can also say that VC firms that are famous and successful are only in the handful, on Sand Hill road in Silicon Valley, and due to their name recognition–a common law trademark btw–they attract fledgling startups more so than say a place in Birmingham, Alabama; therefore VC’s ‘persistence’ is just a historical accident of being in hot Silicon Valley (really HOT these days, temperature wise, due to an Indian Summer heat wave).

4 Brian Smith September 5, 2017 at 9:01 am

Yes, and the fact that VC forms are likely to be more involved in running the company seems relevant.

5 prior_test3 September 5, 2017 at 2:03 am

But how do privately owned companies with a major focus on real world commodities do in comparison? You know, the sort of company that creates life’s basic essentials.

6 Steve Sailer September 5, 2017 at 2:22 am

The Wojcicki Sisters are a good example of how the Internet, which was supposed to let you work from anywhere, has instead increased the returns from Who You Know because you lived In the Right Place At the Right Time:

http://takimag.com/article/a_tale_of_two_sisters_steve_sailer/print#axzz4rmarMxK2

7 Ray Lopez September 5, 2017 at 8:14 am

Same as it ever was. Juan Trippe–founder of Pan Am–got his break to found his airline from his connections via a fraternity brother and getting a contract with the US Postal Service since his friend’s US congressman was on the postal service federal commission awarding contracts to fledgling airlines, and, he was a good networker and managed to buttonhole Charles Lindbergh at the height of his popularity and put him on the board (no mean feat). You’ll be pleased to know SS that “Juan” was a name christened in honor of his aunt, but Trippe was not Hispanic though he did fly to South America with Pan Am a lot.

8 msgkings September 5, 2017 at 12:32 pm

Yeah there’s no evidence that Who You Know is more important now than before. Not everything one notices is correct.

9 rayward September 5, 2017 at 7:40 am

A small problem: most of these intangible-rich companies produce no profits, many produce no revenues. Indeed, the principal advantage of being an intangible-rich business is that nobody knows the value of the intangibles, unlike fixed assets, for which there are many appraisers who could provide an accurate assessment of value. Aren’t many of these intangible-rich businesses selling nothing more than “blue sky”; and aren’t many of the VCs just funding a con?

10 Ray Lopez September 5, 2017 at 8:07 am

You’ve got it all wrong counselor, but it’s hard to explain here. You must read this finance textbook: Applied Investment Theory – Coleman (2016), it will rock your world. In a nutshell, almost nothing you think you know about finance it right. Sample: almost no news that most people think will move a stock actually ends up moving a stock (and no, this is not just the Efficient Market Hypothesis, though that’s part of it, it’s also herd mentality: when people think stocks should go up–animal spirits if you will–they go up, regardless of fundamentals, and the opposite is also true). Coleman btw has real world experience (he made money in Africa, and worked for Exxon) as well as being a fine academic in Australia.

Bonus trivia: I used to think that maybe the Swiss central bank devaluation of the Swiss franc in January 2015 was the cause of the short drop in GDP at the start of that year for Switzerland, being export-driven, and perhaps this was evidence of money non-neutrality, but, if you look at a chart of the Swiss franc vs the dollar/euro, it rebounded almost right away after Jan 2015, so that was not really it. I was fooled by coincidence / randomness it seems.

11 rayward September 5, 2017 at 8:22 am

Actually, I do understand: it’s all about human behavior. Behavioral economics will soon dwarf the rest of the field. For those who haven’t noticed, Cowen is giving behavior an increasing level of attention on this blog. The blog post after this one suggests people pay more attention to religion. And they should, since religion has such a profound influence on peoples’ behavior. Of course, the problem is that human behavior can be highly unpredictable. And irrational. And self-destructive. Cowen may believe that’s a good thing, since unpredictability will thwart complacency. Maybe. But unpredictability also means disorder. I suppose that at heart I am a conservative, since I place a high value on order. I look at stock prices and housing prices and I think people have lost their senses. What they believe (I will repeat, what they believe) is that prices will continue to go up, and up, and that there will always be someone who believes (I will repeat, someone who believes) prices will go up even after they know (I repeat, they know) they won’t. Investing has taken on all the characteristics of religion, decision-making based on belief rather than knowledge. Maybe investors do need to spend more time reading the Bible and less time reading financial statements.

12 msgkings September 5, 2017 at 12:35 pm

Stock prices have always gone up, since the dawn of capitalism. Plenty of reversals along the way of course, but they are always temporary. Relax. http://www.rationaloptimist.com

13 static September 5, 2017 at 11:00 am

Rather than blue sky, they are seeking blue ocean, in the sense of new markets without competition. As there is no proof that these markets exist, it is a given that some of these blue oceans will turn out to be blue ponds. So, while the business as a whole is not a con, it is a bet on a market existing, a product doing a job that needs to be done for that market, the market choosing the product, and the economics actually working to support scaling the business.

14 Vivian Darkbloom September 5, 2017 at 8:29 am

“Why are VC returns correlated over time but mutual fund manager returns not??”

Any proof for the statement that VC returns are correlated over time but mutual fund manager returns are not? Before one delves into the “reasons”, I’d be interested to hear more about what this headline purports to mean.

15 Chappy September 5, 2017 at 1:49 pm

Agreed. What are they correlated to? I assume most people usually mean correlation to the S&P 500. I find it hard to believe that mutual funds don’t have some level of correlation to that index since many funds are benchmarking to it.

16 byomtov September 6, 2017 at 8:25 am

Yes. How do we know the VC returns are correlated over time? Note that there may be a strong survivorship bias in any data, so be careful.

As to why this might happen, the capital markets are a tough place for small companies. Despite some of what you read getting VC funding is hard, and it is likely that many VC deals are at prices that are quite favorable to the investors, even considering the risks involved. This might well apply to later rounds as well. If you can consistently buy equity at a large discount you can do quite well. Mutual funds can’t do that.

And of course VC investors will generally be much better informed about the business they invest in than fund managers. The firms themselves are smaller, and the VC will be on the board and exercise a fair amount of control.

Some things are easy to overthink.

17 Anon. September 5, 2017 at 8:46 am

What about PE funds?

18 Dick the Butcher September 5, 2017 at 9:00 am

What are the purposes of capital, tangible or intangible? Note there are wide differences between accounting capital, bank regulations, finance capital, economics capital, and the real world.

It’s seems skewed by the ETF revolution, the zero-rate environment and the massive amounts of money chasing gains/yield.

19 Floccina September 5, 2017 at 9:49 am

How about the more successful the VC firm has been in the past the more needed publicity it will get for a start up just by investing it.

20 MikeP September 5, 2017 at 10:43 am

Very true. When Sequioa funds, other VCs want in.

21 mavery September 5, 2017 at 10:42 am

The simple answer is that VC companies are playing with their own money while mutual fund managers are playing with other people’s money. VC directly reap rewards from the value of the companies they invest in. Fund managers are rewarded via management fees which are only indirectly tied to performance.

22 msgkings September 5, 2017 at 12:37 pm

Not really the case. Most mutual fund managers invest in their own funds (many are required to), and most vc managers are investing other’s capital alongside their own.

23 mavery September 5, 2017 at 1:10 pm

Fair enough, but AFAIK, VC managers don’t get a percent of the money they manage, which is how many fund managers are paid.

24 msgkings September 5, 2017 at 2:19 pm

The VCs that run funds of public money (endowments, institutions, etc) definitely get a % fee.

25 static September 5, 2017 at 11:05 am

It may have something to do with access differences and greater asymmetrical information differences in private markets versus public markets. While anyone can copy the portfolio of a successful public company fund, less connected private investors cannot get into the best deals.

26 Douglas Scheinberg September 5, 2017 at 11:28 am

The answer to this is simple: reputation creates self-fulfilling prophecies.

https://thezvi.wordpress.com/2015/05/15/in-a-world-of-venture-capital/

27 William Gadea September 5, 2017 at 1:24 pm

I think it’s simpler than that. The Mutual Fund managers are trying to fulfill a far more diverse set of investment objectives: growth, income, blend, industry-exposure, geographic-exposure, etc. The VCs are pretty much just about aggressive growth with a tech emphasis.

28 Sandia September 5, 2017 at 1:36 pm

Well many if not most mutual fund managers have nothing but publicly availlable information avialable to them, plus gossip from the banks. So even if they have social networks, information transfer within those networs is highly proscribed (illegal). If insider trading laws were eliminated you might see more auto-correlation in mutual fund returns.

29 Chris September 5, 2017 at 1:39 pm

I think you’re overstating the efficiency in non-public markets. Mutual fund managers have it difficult because public equity are highly efficient and liquid, and therefore have some weird behavior. Chief among these is the price discovery issue — a business with a good outlook is bid up until the price matches normalizes the expected value of the cashflows, which quickly minimized any alpha available for capture by active managers. This process is now so well known and reliable that the standard advice to most investors is to ‘buy the index’ because they can’t beat the market.

In VC, and more generally, private equity as a whole, the price discovery process is greatly weakened. There is no public data available to an early stage startup, so there is much less alpha being eaten up by the price discovery mechanism. You invest in the company, or you don’t, and you help operate the company, or you don’t. There’s no army of algorithms pricing and repricing the startup based on a stream of public data. This lack of efficiency is what gives operators in the space the chance to capture the so-called alpha.

So basically, the less liquid, visible and efficient a market is, the more likely there is alpha available for capture by skilled business people. If you ran the numbers, I’m sure you’d find serial correlation of returns across nearly all small businesses, with the notable exception of publicly traded and liquid assets. So the question is not, ‘what’s so odd about VC?’, it’s ‘what’s so weird about public markets?’

30 Kevin September 5, 2017 at 2:13 pm

This is way more convoluted than Berk and Green (2004). Funds can flow to good mutual funds until value-added per dollar is negligible. It is much more difficult to scale up VC investments (pt 6), so good VCs do not raise monster funds.

31 James Anderson September 6, 2017 at 7:11 am

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32 Marc September 6, 2017 at 3:42 pm

Mutual funds (generally) trade public, liquid markets where efficiency dominates, prices move quickly, etc. –> generally efficient markets.

Venture capital funds do not price efficiently at all. Huge incentives to managers, in fact, to manipulate prices to enhance predictability. Simplified pricing policy for VC Fund:

1. Is the investment 60% deployed? Gotta raise a new fund!! Find positions doing well, rationalize marking them up, because this is a marketing exercise after all.
5. Do I have follow-on transactions in any of my companies? Yes, my auditor makes me mark them up. No? See #4…maybe do a couple of small ones myself…gotta show some gains for new fund…and my auditor will make me mark them up.
6. Exits…yes, my investors actually make some money.

33 Marc September 6, 2017 at 3:47 pm

Clearly some VC is interfering with my post because I’ve tried twice and cannot get this to work right!

Mutual funds (generally) trade public, liquid markets where efficiency dominates, prices move quickly, etc. –> generally efficient markets.

Venture capital funds do not price efficiently at all. Huge incentives to managers, in fact, to manipulate prices to enhance predictability. Simplified pricing policy for VC Fund:

1. Is the investment 60% deployed? Gotta raise a new fund!!
Find positions doing well, rationalize marking them up, because this is a marketing exercise after all.

5. Do I have follow-on transactions in any of my companies? Yes, my auditor makes me mark them up.
No? See #4…maybe do a couple of small ones myself…gotta show some gains for new fund…and my auditor will make me mark them up.

6. Exits…yes, my investors actually make some money.

34 Marc September 6, 2017 at 3:44 pm

(Don’t know why lost most of this in previous attempt to post??)

Mutual funds (generally) trade public, liquid markets where efficiency dominates, prices move quickly, etc. –> generally efficient markets.

Venture capital funds do not price efficiently at all. Huge incentives to managers, in fact, to manipulate prices to enhance predictability. Simplified pricing policy for VC Fund:

1. Is the investment 60% deployed? Gotta raise a new fund!! Find positions doing well, rationalize marking them up, because this is a marketing exercise after all.

5. Do I have follow-on transactions in any of my companies? Yes, my auditor makes me mark them up. No? See #4…maybe do a couple of small ones myself…gotta show some gains for new fund…and my auditor will make me mark them up.

6. Exits…yes, my investors actually make some money.

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