Theories on Why Venture Capital Doesn't Scale

We continue to drift in the middle of a chaotic venture capital market that many say is "broken." I have been thinking about this and I am trying to understand the factors that add up to this "broken" state. To me, "broken" means that as an asset class venture capital is not performing well relative to the risks taken and the performance of other asset classes given their risk profile. (By asset class I mean the venture industry taken as a whole.) This industry's turmoil reveals itself in many ways but its root cause started as too much cash and now seems to be too little cash. Cash comes from several places including raising new funds or decreasing investment rates and operating expenses.

Raising new funds is not all that easy because the industry's recent track record is not exactly stellar. Decreasing our investment rates has been easy to manage and we cut operating expenses where we can. At the end of the day...the only true source of oxygen is "the next fund."

There are different reasons new funds are not so easy to raise for so many firms. One principal reason is that funds in the late 1990s and early 2000's were ambitiously large. By this I mean that firms used these funds to substantially expand their operations and investing scope. We saw many funds triple in size over the predecessor funds. Now if a new fund was three times as large as any predecessor fund...it had to likely have thrice as many "hits" as its predecessors in order to perform at least as well. In order to generate three times as many hits, venture funds recruited additional players en masse. This is really where the problem starts.

In my opinion, venture capital is much more artful than it is scientific. The best venture capitalist can not simply codify his instincts and experiences in such a way that they are highly transferable to other humans. The best venture capitalists are simply instructors who provide tools to a school of students some of which prosper many of which do not. There are good schools and there are not-so-good schools. Good schools take time to develop. As a result, it is very difficult to scale this business. No matter how many students Roger Federer enrolls in his tennis academy it is unlikely to produce the next Roger Federer. The odds against it are great.

A good venture capital firm probably has at any one time three or four natural athletes. Each firm can talk about this process and that process and proprietary secret investment formulas but I don't consider those plausible ingredients for achieving scale. It is marketing lingo for "it's ok to give us right now 3x more money than we can handle." The core team can put to work only so much capital and watch it effectively in a way to achieve results consistent with the risks undertaken. The school takes time to develop. Nonetheless...our current tendency is to continue trying to raise gargantuan amounts of capital well beyond any plausible management scale. This is, in effect, investors making the bet that a successful venture capitalist can transfer his skills with an efficacy that results in two Roger Federer's by the end of next year.

The other issue is this: there are only going to be so many big winners per period. By winner I mean investments that generate a lot of return. Since late 2001, the number of winners seems to have dwindled but the number of venture capitalists has sky rocketed. This means that a large body of professionals has really not had close contact with winners in such a way that they can understand what happened, why it happened and imbibe enough experience of success to plausibly create another success. This is not one of those life experiences where the only learning comes from failure..

There are many exceptions to this perspective..but there are many more points of proof than there are exceptions.