August 22, 2014

Understanding the Changing Face of the Venture Industry – Part 1

In the parlance of engineers, the opportunity migrated “up the stack”, from communications infrastructure to the things that could be built on top of that infrastructure @TimBliamptis @WeathergageTeam

A discussion about the multiple facets of brand power and innovation waves on US venture investments.

We frequently are asked what is going on in venture capital and how did it get the way that it is? When people ask these questions, what they usually want to know is what happened to the old Top 20 List of VC brands, and why has the distribution of  VC fund sizes become barbell shaped? Our goal with this piece is to answer these questions and demystify some of these changes in the VC industry.

To that end, let’s start with admitting that conventional wisdom failed to predict both the turnover in the old Top 20 list and the “barbelling” of the VC industry. Explaining these developments isn’t complicated, but it does require introducing a few simple concepts which, when put together, provide a pretty satisfying explanation.

Why is there so much disappointment among investors who followed the Top 20 List strategy?

Venture Brands Have Multiple Dimensions. Venture capital brands have at least two dimensions: one limited-partner facing and one entrepreneur-facing.  Brands are built on investment performance. Great performance is built on great companies, which are built by great entrepreneurs. More on how the limited-partner-facing and entrepreneur-facing brands can diverge later.

Innovation Waves Drive Venture Returns. Venture capital opportunities come from waves of innovation. At any point there are multiple waves of various sizes in action, sometimes unrelated and sometimes reinforcing each other. Over time the shape and nature of those waves shapes the venture capital industry itself.

Brand Power Follows Innovation. Top VC firms stay that way by being potent with the entrepreneurs who matter.  But innovation waves are dynamic and the entrepreneurs who create one wave may or may not be well positioned to create the next.  To stay on top, a VC firm’s partners must groom their networks and add resources in anticipation of subsequent waves.  In the 1990s, the largest and most lucrative wave was the build-out of the data communications (datacom) infrastructure around the globe. Many great venture brands were built or enhanced by the strength of performance derived from lucrative investments in this industry. Venture capitalists benefited from the virtuous circle derived from their existing networks and strong brands with the best datacom entrepreneurs. Persistence of superior returns across subsequent funds resulted, establishing or enhancing those brands with their investors. The datacom boom lasted a decade or so, long enough for VC brands to be built and the idea of a static Top 20 List to become conventional wisdom.

When the bubble burst many bad things happened. But for the masters of the datacom universe, the worst was that the datacom industry matured, meaning fewer opportunities for building the next great datacom company (or even the next great Cisco acquisition). In the parlance of engineers, the opportunity migrated “up the stack”, from communications infrastructure to the things that could be built on top of that infrastructure.

Fast forward to 2014. Billions of mobile and desktop devices around the globe are interconnected at very high data speeds. The devices know where they are, how fast they are moving, who their friends are and have access to the accumulated knowledge of the human race. A new generation of entrepreneurs is building new applications and indeed new industries on top of these capabilities. There is an extremely powerful virtuous circle for the venture capitalists who have strong brands with these entrepreneurs, but having been in the right circles in 1990s has very little correlation with the entrepreneurs of today.

Back to the Top 20 venture firms of 1999. Not all of them crossed this chasm. While many limited partners continued to view them as elite brands on the strength of their 1990s performance, what ultimately mattered was their standing with a different generation of entrepreneurs who had different skillsets and networks. Some of the Top 20 made brilliant hires and transitioned them successfully into the new reality. Others did not, or did so too tentatively. The transition also created the opportunity for new entrants to establish themselves in the ranks of the elite, and a few have.

In my next blog, I’ll continue the conversation by answering: why have venture fund sizes become barbelled?

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A nautical term that indicates a favorable position relative to the wind. A ship that "has the weathergage" has the initiative and hence a significant advantage over its rivals.