Alexa Binns 00:03
Hi, welcome to swimming with alligators, the VC podcast from the LP perspective, with your host, Alexa bins and Ernest. You ready? Let’s dive in on

Earnest Sweat 00:13
Today’s episode. We have David Clark. He’s a CIO at vencap, one of the long standing and most respected fund to funds in our global venture capital ecosystem, with 30 plus years of analyzing venture cycles, technology shifts and manager durability, he’s well known for really breaking things down from the data and not just vibes. Today we’re going to chat about why venture is returning to a power law world, asking the question, is there a middle class in venture? Can there be one, and then a whole host of other things? So with that, we welcome David,

David Clark 00:58
great, and it’s a pleasure to be here. Alexa, great to see you for the first time as well, looking forward to the conversation.

Earnest Sweat 01:04
Thanks so much as am I. I wanted to start out, you know, so some people from you know, our audience of allocators and venture capitalists might know you from your very informative tweet threads that are very data driven. I wanted to ask, kind of like, what experiences, kind of getting some insight of how you got to this world kind of led you to always, kind of looking at things from a data perspective. Was there a certain role, or, I don’t know, childhood experience,

David Clark 01:43
nothing that really jumps out. I think, I think part of the reason we do it at vencap is, you know, we started off as venture investors with an approach that was fairly similar to what a lot of LPs are, which is, you know, you meet with a load of managers, and you try and figure out which ones actually are going to be successful and which ones aren’t. And we found that we were not really much better than the market. I mean, slightly better, but not materially better. And so we just thought about their way of doing this, and that’s where we really, then sort of turned to the data side of things and tried to sort of understand a little bit about, you know, what is it that actually drives venture returns? What does the market look like, you know, not from anecdotal perspective, but from, you know, a real underlying data perspective. And I think it just kind of snowballed from there.

Alexa Binns 02:37
I was just curious about making that shift. Were there underlying assumptions you had that the data corrected you on, and I understand you’ve been in the seat for 33 some years, so this is probably ancient history. When did you start sort of looking at things more quantitatively?

David Clark 03:01
Yeah, I think, I think, again, like a lot of LPs, we were surprised at what the average performance of LP funds ultimately looks like. And I think there was definitely a sense that that, you know, we could kind of book that trend through having a rigorous diligence process and spending a lot of time with the managers, understanding their strategy, understanding their process, and really, we found that those were not accurate predictors of how a fund was ultimately going to perform. So, yeah, I think that’s, that’s really what was, what was driving it from, from our perspective,

Earnest Sweat 03:38
There’s a lot of data in public markets, not as much in the private market. So how do you like when you’re even, let’s say, you know, there’s a new fund to fund, or a new allocator looking to go into venture. How do you even aggregate the right data and match that to a lot of things that are being said in pitches and that are more anecdotal? How do you, you know, make things apples instead of apples to xylophones?

David Clark 04:25
I think it’s really hard for new entrants because, you know, as you said, you know, a lot of the publicly available data isn’t great. You know, even, even you know, something like a pitch book only has returns data on a very small percentage of the funds that have actually raised capital over a particular period, and they’re missing chunks of the market as well. So I think it’s very difficult to draw really strong conclusions from the publicly available returns data. And the other feature of venture is that the feedback loop is just so long, you know, at least on when you. An equity analyst, you could kind of every, every quarter you had a scorecard that you could kind of go back to exactly, whereas in venture it takes 10 plus years before you kind of get any sense as to you know whether the assumptions that that that you had in place when you made an investment actually are going to prove to be true. And one of the things actually we found is in some instances, we invested in funds that were very successful, but they were very successful for reasons that were completely different, for the reasons that we actually made the investment in the first place. So it just feels that within venture there are so many unknowns when you go into a fund that I think it just takes time for any allocator to experience those to kind of look back and figure out, you know, why has something worked? Why hasn’t something worked, and then hopefully draw their own conclusions from that experience.

Alexa Binns 05:55
Can you give us any examples of what you thought? What was the convincing data point? But then what actually ended up in? Ended up making the difference.

David Clark 06:04
I think one of the things that that that was really interesting, I look back, and there were a couple of managers we backed, where I did the diligence early in my career, and spent a lot of time meeting with the manager, you know, going through their process, understanding the team, understanding, you know, what they were looking for, and really feeling I knew their firm inside out. And what I realized is sometimes, the more time you spend looking at something, the more you end up with confirmation bias. And so one of the things you know we try and do now is, do a lot of our work on a firm before we meet them for the first time, so that we actually have a view as to, is this something that kind of fits our bar, you know? Is it something that, you know, has the characteristics that we look for? And I remember reading something that Warren Buffett wrote a while ago, where he said that most of his work is reading the quarterly reports and the annual reports of companies. It’s not meeting with the CEOs and the executives of those companies, because they bring a narrative that is actually quite a distraction. And I think that’s true in ventures as well. You know, I’ve said before that I still come out of just about every meeting with a VC, wanting to invest because the narrative is, the narrative is just so powerful, and these are super impressive people, and it’s, it’s only when you kind of take that step backwards and kind of really appreciate the context. And you know how hard venture is, and the fact that most funds don’t produce returns that are worth it from a risk return perspective. And similarly, you know, most venture backed companies end up losing money for their investors. It’s only when you have that perspective that that I think you then start to to ground what you’re seeing and what you’re hearing in some sort of reality,

Alexa Binns 07:58
what you’re describing makes me think this actually could, could be healthier could it could bring healthier outcomes? Yeah, a little bit, yeah.

David Clark 08:29
I think that the role of a GP is very different to the role of an LP. And if I had to put you know, how much of it is, you know, how much of a success of a company is kind of based on the quality of that sort of founding team and the entrepreneurs it feels, it feels like that, you know, that’s relatively high. And so I think, you know, if you’re able to develop that filter where you can recognize what a world class founder looks like, you know, I think there’s no substitution for that. And you know, one of the things we’ve seen when we’re talking to the GPS back is that the fact that they have been working closely with, you know, multiple highly successful founders, gives them a pattern recognition that I think over time is really helpful. And that’s not to say you can’t get someone coming from left field that, you know, looks and sounds very different to, you know, the bulk of founders who can’t be successful, but I think they’re able to kind of cut through quite quickly to understand, you know, does this person have the characteristics that we’ve seen from, you know, from our successful founders previously. And I think that’s one of the things that really differentiates the very best managers, is they’ve seen what world class looks like from the inside. And having that past experience, I think is incredibly important.

Earnest Sweat 09:55
David, real quick, for our other allocators, what are some kind of. Tips and Tricks on this kind of like doing the homework before you meet these founders. That has worked really well for you all.

David Clark 10:08
Well, I think if you know, for us, it comes back to understanding what really drives returns within the venture industry. And what we’ve found is that, you know, we’ve talked a lot about venture being a power law asset class and how a relatively small percent of companies ultimately drive the bulk of returns for the entire industry. So I think you know our main filter really is, you know what? How many times has this particular manager been able to back one of those top 1% companies, and then the second level down is and have they been able to really move the needle from that single investment? So for an early stage fund, we want a single investment to return the entire fund, and hopefully multiples of the entire fund. For a growth fund, we still see the best companies being able to return 100% of the growth funds. But I think more realistically, we’re looking for a single company to maybe return a third to half the fund. And so it’s, it’s those two kinds of filters that we would really look at first, and that ends up, you know, coming out with a relatively small number of names within the industry that that kind of passed those two filters.

Alexa Binns 11:20
How do you gauge repeatability versus, well, that they happen to invest in their college roommate?

David Clark 11:29
Yeah, I think it’s, you know, that’s, that’s the challenge. You know? What we’d like to see is multiple partners at a particular firm being able to do that on more than one occasion. We’ve, we’ve struggled backing solo GPS, because I think it’s, you know, the sort of risks that we’re willing to take within venture are probably, I think they’re misaligned with a solo GP. Again, not to say that there are some unbelievably successful solo GPS out there. And, you know, in hindsight, you know, we would have loved to have been investors in those but I think we feel that where we’re wanting to the sort of risk that we’re willing to take is, you know, can this manager back a top 1% company, and can they return the fund from doing it? I think what we don’t want to take is kind of the same level of risk around the firm, around operations around, you know, is this single partner going to stay in the venture for the next 20 years? Because, you know, realistically, it can take that long for a seed stage fund to go from first investment to fully liquidated.

Earnest Sweat 12:38
. One of those that has come up is this idea of even, like power law. I know, as we’ve had more entrance in the market, some people are like, No, I don’t have to have, maybe I can get a lot of two x’s, or a lot of, you know, a lot of triples and doubles, and have an outperforming fund. You all came out with a paper that said power law is not getting smaller, but it’s intensifying. And so I just wanted to give the opportunity, like, can you kind of share some of the findings and why you all feel that way? Yeah.

David Clark 13:54
I mean, again, you know, we go back to the first principle when we look at funds that have returned 3x net, back to us. 92% of early stage funds have at least one company that returns the entire fund. And I’ve seen a number of our peers come out with similar statistics as well. So I think, you know, I think it’s, it’s very clear that that, you know, the power load does exist in venture and you know, we’ve yet to see that model where, you know, singles and doubles can generate strong outcomes at the fund level. Again, not to say that it’s impossible, but if I’m willing to take a bet, I’d be wanting to maximize the probabilities of being successful. And for me, at the minute, that means, you know, adopting that power law framework as we’re looking at managers. And then, really, the paper we put out was kind of suggesting that, you know, the power law was going to intensify. And this was really something we did on the back of having had, you know, four or five years, you know, between 2018 and let’s call it 2022 where the market. It was going up, where everybody was able to show strong performance, where, you know, companies were able to raise capital relatively easily, easily and at higher valuations. And it felt as if that was a part of the cycle that was coming to an end. And for perhaps 18 months, that was the case. And then we had the AI wave, which, which kind of jumped back, jumped back. And it feels like we’ve kind of gone back to that a little bit over the last kind of 12 to 24 months. But I think at the time we wrote the paper, we just felt that we were going to see fewer companies being able to have the underlying metrics that then justified investors giving them additional rounds of capital at higher valuations. And when we saw what was happening, particularly at the IPO on the IPO market, it was clear that you need to get to a certain scale in order to get the attention of the IPO market. And there are going to be fewer companies that we’re probably going to be able to reach that scale. And I think if you look over the last 12 months or so, it’s interesting. When you look at the exits that have happened, you know, they’ve been a relatively small number of IPOs and MQ days, but, but the valuations have been, have been pretty high. You know, I look at, I look at stuff that we’ve had out of our portfolio. And there’s probably been, you know, three or four companies that have been able to exit at kind of north of $20 billion over just the last 12 months. And I think that’s indicative of that kind of power law intensifying. The flip side of the power law is more companies will fail as well, which I think is important to understand and and, you know, we definitely, we definitely felt that kind of post the correction we saw in 2223 we were going to see a lot of companies that had been able to raise money at high values ultimately fall away. And we saw that to some extent, it still feels like there’s a bit of that story still to play out, because those companies have done a great job at preserving capital, in extending runway,

Alexa Binns 17:12
you’ve been posting about how private markets are the new high growth public markets. So how do you sort of square those two things that we can’t ignore the venture landscape at the risk of missing the most important parts of the growth curve. But it’s really hard. Statistically, most people lose at this sport.

David Clark 18:12
Yeah, yeah, I do feel nervous about the for 1k investors kind of coming into the market without really understanding the dynamics of what the dispersion of returns within the VC industry looks like. And I think, I think there is a risk that a lot of those investors will ultimately end up being pretty disappointed in the returns that they’re able to generate at the same time, if you do and then this is the, I think, going back to what you were saying there, Alexa, at the same time, if you’re able to do venture well, and if you’re able to access that, that small group of companies that does generate, you know, the bulk of the performance, and There’s a small group of managers that are consistently able to back those companies. If you can get access to that, then venture is definitely capable of generating very strong performance and being additive to your portfolio. But I think the reality is that there’s only a relatively small group of investors historically that have been able to capture that excess return, and it certainly hasn’t been retail that’s been able to do it. So it does make me nervous about this. We see something similar in the UK, where the government is very keen for pension funds to put more capital into private markets and into VC, and particularly into UK VC. And I do think there’s a risk there of swamping a market with capital that it’s not able to allocate efficiently, and ultimately, that’s going to depress returns for the entire market. You. There will still be a small group of managers, a small group of LPs, hopefully, in a small group of companies that do well even in those challenging times. But it does feel as if the spread of performance within the industry is probably going to get wider, not narrower, because of these sorts of things.

Earnest Sweat 20:21
on this podcast, we’ve had a number of individuals talk about the only pathway now to get returns is through emerging managers and smaller funds. And so it’s this whole adage of like David or Goliath, which is the way to return. And you’ve been very vocal like, this is not right. The data does not support this. What do you do? What does that argument or absolute have wrong from your viewpoint, and how you guys see that, you know, the opportunity to like to invest well in venture managers,

David Clark 21:16
I think they just don’t see the returns from the very best funds, you know, from the very best firms. Rather, let’s call it that. You know the ones that have been established, you know, the ones that have consistently been able to back those top 1% companies. You know, the performance of those firms isn’t generally publicly available and so, and it’s certainly not in a lot of the databases that are out there that contain VC performance numbers. So I think you’re just not seeing, you know, what the best managers are able to generate on a returns basis, and how consistent their performance is. Now I know, if you said, you know, what are the chances of those managers generating a 10x fund? It’s, it’s, it’s going to be relatively low, but the chances of anyone are relatively low. You know, we, I put something out on X recently, around what the returns are, how the returns break down for venture based on, based on the pitch book data, and its 2% of funds generate 10x plus returns. You know, when we look at the managers that those large managers that we back across the same vintage spread, which was 2000 to 2019, 5% of their funds generated 10x so it’s not impossible for them to do it. And actually they do it more frequently than the market generally. So I think you have to really see that sort of data and filter that into your understanding of the VC industry. And what I’d you know we’ve one of the things we have been quite explicit about, is publicly sharing that data. Yeah, what I don’t see from emerging managers and emerging manager LPS is their willingness to share their data in the same way. And I’m, you know, I’d love to, I’d love to be able to see it. If they’re not willing to share it publicly, then please share it privately. Because I think one of the things we’re always trying to do is to make sure that we’re not blindsided. You know, the best, I think the best proxy I’ve seen for emerging manager data is the Carter returns, and when we compare our performance to the Carter numbers, we’re consistently top quartile. And so again, you know, it’s, I think a lot of the time, it’s, it’s people not really appreciating how consistently well the best managers are able to perform despite the increase in their fund sizes?

Earnest Sweat 31:54
It seems like, and a lot of people have talked about this, the market is really bifurcating, where there’s more and more pre seed, see smaller funds, maybe specialized in certain verticals, or the rise of solo GPS, and then firms getting bigger and bigger and bigger and bigger and having multiple, multiple strategies. A lot of those firms that have become bigger were kind of like your kind of pure play, standard size and strategy of a venture. Do you think there’s a place for this kind of, like middle class anymore, or has it as this, this asset class matured so much we just have these two different buckets.

David Clark 32:42
I think it’s getting harder for that, for those VCs in the middle again, you know, there’s no absolutes here, there’ll be, there may well be some of those firms that are able to do very well. But I think generally, you know, if you’re seeing things, you know, let’s look at it from a founder perspective, because ultimately, this is, you know, ventures, about can I partner with the best founders? And so why would a founder choose to take, you know, firm as money, as opposed to Firm B’s money? And so I think you have to look at the product that firms are selling to founders. And so if you’re I don’t know, let’s call it a $200 million late seed, early type firm, and that’s it. Yeah, it’s very difficult for your product to compete with somebody that has, you know, maybe a platform services team where they can help that founder with recruiting, where they can, you know, they’ve got people on the business development side so they can help, you know, bring in customers. You know, the advantage that the smaller firms have is that you know all of your time is partner time. And you know that that can be an advantage against some of the bigger firms, where, you know you might be seeing multiple people depending on, you know, ultimately, what you want to do. The other part, I think, of the journey is, is that, you know, if these companies are successful, they’re going to need lots of capital, and they’re going to take time, and there’s going to be, you know, multiple additional financing rounds. And I think knowing that, that you have a partner at your coming in to lead your series, a that if things go well, has the capacity, just like Andreessen has done with Databricks, to invest in your B and your C and your D and your E and your f and so on, and support you all the way to IPO and even perhaps beyond. I think that’s also a valuable proposition when you’re pitching the best founders, because the best founders clearly see themselves on that journey.

Earnest Sweat 34:46
I will push back on that, knowing that firms like that are great partners, especially with all of the Capital One side, just quick aside that also puts them in a. Position of, like, they have to continue investing, or they could, like, any it’s not a great signal if there’s, you know, some flat growth and they’re not as involved. So that’s one thing the brand can be taken, given and taken away as well. And so where I’m kind of getting that is like, I think these firms, especially with the intensity, the power law intensifying, companies staying private longer, they have a place in the market. But are they the best at every stage? Is this really my question, and that’s why I think that there’s probably a place for the exceptions in that kind of middle class, right? Being there to have more voices that are valuable on your cap table and board?

David Clark 35:48
Yeah, I think, you know, I kind of look at the, you know, look at the leading AI companies that have emerged over the last, you know, two to three years, and then, you know, maybe actually even going a little bit, a little bit earlier than that as well. You know what, what we’ve seen is, is that, by and large, it’s the established names that are the early investors in the vast majority of these and you might find, you know, the odd emerging manager or the odd firm that’s in that kind of middle you know that that middle ground, that that that does, you know the ordeal here and there, but I think consistently, if you’re looking at the cap table of the of the leading AI companies over the last few years, it’s the established managers that dominate that cap table and and you know, regardless of like, how we might want to rationalize, you know, what A founder think so what they’re looking for, like their their behavior is very clear. They want the money from these firms,

Can you, without giving away the names, tell me that example? Share that example you shared with me about why discounts shouldn’t be relevant based on how you’re underwriting these assets?

David Clark 44:35
Yeah, so the best secondary we’ve done in the last 20 years, we bought it at a premium, and it delivered a 7x multiple and I think it just comes back to why venture is almost a unique asset class. And I think a lot of people that are looking at venture secondaries are doing it from the perspective of private equity secondaries, where you have a more normal distribution of returns in the. The line portfolios and where you have really no extreme outliers on either side of the normal distribution curve in venture, we know that that’s very different, and we also know in venture, the valuation methodology used is far more of an art than a science. And I think in private Yeah, in private equity, it feels there is more quantitative data there to base your valuation decisions on. And so as a result, I think when you’re looking at private equity secondaries, most of the value, most of the gain comes from the discount you’re able to negotiate, rather than necessarily the growth of the portfolio with venture secondaries. The opposite is the case. You know, the worst thing I think you can do in venture is to buy mediocre portfolios at deep discounts. It looks great for the first couple of years, but long term, that discount just dissipates, and you end up struggling to generate performance for us secondaries, it just follows the principle that we apply on the primary side, which is we want to try and maximize our exposure to those top 1% companies, and do it at a way that we think is pricing those appropriately, given where we think they will ultimately end up. So, you know, the price relative to a bit of an arbitrary nav that the manager might be reporting. That relationship is far less important to us in venture as we think about it, we probably spend more time thinking about what does the you know, what’s the discount relative to the last round value that these companies have raised at. When did that last round happen? You know, if they were raising in the market today, would they be raising at a higher valuation, or a lower valuation, or the same valuation? And then ultimately we look at, you know, what do we think the terminal outcome of these companies is likely to be? And kind of work back from there, it just feels like anchoring around the discount to prevailing nav is the wrong way to do this.

Alexa Binns 47:07
You hinted at this idea that the difference in return profile of your classic Manager Fund versus what you’re sort of developing on the secondary side is attractive to different types of LPs, and you are an expert at these massive institutions working with these massive institutions, the sovereign wealth funds, the pension funds. Can you give us any color? A lot of you, a lot of our listeners, are so early in their careers, in working with lps on, on, who’s buying what now? Oh, what categories of some of these institutions are truly looking for the more kind of classic venture alpha versus who’s not worth really knocking on the door right now, like, Is Europe closed and Asia is open?

David Clark 47:54
Yeah, I don’t think I’ve got, you know, any sort of real insight there, because each, you know, the LPs are not a kind of uniform class. I think each LP is different, and it very much depends on where they are in their kind of journey. We know within the venture space or within the private equity space, I would say that, like just fundraising is hard right now, full stop, and really that’s being driven by just a lack of liquidity, that’s been coming back from private markets generally over the last couple of years. One of the things we do here is that perhaps ventures in a better space from the liquidity side of things than private equity and buyouts. Yeah, because, you know, we have had stuff go public. We have had stuff bought there that was, you know, we’ve actually had a pretty strong year in terms of distributions. Back to us, you know, part of that is funded by the new things that have happened, but part of it is also, you know, there was a chunk of companies that went public in 2021 that our managers were still holding part of their position. And that’s being sold down over time. So I think, generally, you know, we, everybody is telling us that outside of a handful of, you know, really high profile brands like fundraising, is a slog, and I think you just have to put the reps in. You just have to do the meetings, you have to have the conversations. You know, there’s, there’s no kind of shortcut, and I don’t get the sense that there’s any kind of part of the market that is, you know, particularly active, you know, more so than any others. So I think it’s, yeah, it’s, it’s, it’s just tough.

Earnest Sweat 49:35
David, so since you’re, my last question is, so, since you established and knowing kind of like these established branded firms, and being able to, like diligence them really well, you know, something that’s kind of a disconnect for me is all I hear as a GP and from other GP friends is like people warning and. In Scope Creep. But if we look at the evolution of a lot of these larger firms, one could say they’ve, they’ve scope creeped in there. How they’re, you know, what’s their structure, what strategies they’re applying? Why are they allowed to scope creep and and are they doing it in a great way, or like, like, is there a thoughtful way that, I’m sure that some firms get big and don’t do it a great way, and others do it in a way that there’s some congruence just kind of work that out for me. I’m gonna lay down like it’s a therapy session.

David Clark 50:37
We talked previously, Ernest about, about this kind of purity test that, yes, you know, some people have on the bigger managers and and I, yeah, I just don’t think it makes sense for me. You know, when I started doing venture in the early 90s, the market was so different from where it is today, and we would be worried if our managers didn’t evolve, because, you know, the opportunity set is evolving. The founders are evolving. They’re looking for different things. You know, we want, we want our managers to keep innovating and keep, you know, skating to where the puck is going, not to where the pub has come from. And so I think as long as they’re doing that in a way that is sensible, and as long as they’re doing it in a way where they’ve clearly thought out the implications of this, then I think we’re supportive of it. You know, it’s the same for Team transition. The worst thing in venture is having the same team for 20 years because, you know, people go stale, they go out of date. You need to continually refresh the partner base at a firm. And I think it’s the same with strategy, with focus areas and with structures as well. But, but ultimately, you know, with all of that evolution that’s happening, it still comes down to the two principles I outlined earlier, which is, are you consistently partnering with the world’s best founders, and are you doing that in a way that moves the needle at the fund level? And if the answer to either of those is no, then that’s where, you know, we disengage.