Next Wave: Rewriting the venture capital “theory-of-everything”

First published 22 October 2023

In the last 10 years, venture capital has become a global industry, but the latest crisis will test how much the underlying principles of VC investing apply outside of Silicon Valley.

The tragedy of the spiralling identity crisis in the venture capital asset management class is that it is unfolding at the precise moment when Africa and other emerging market countries are building local venture markets. In addition to fighting for funding from a limited pool of Limited Partners (LPs), nascent venture capital markets in emerging economies also need to make the case for more LPs to join the asset class. And they have to process what the ongoing correction in the asset class globally might mean for them. Tough times!

Someone suggested that AI will disrupt venture capital investing. I don’t know if it was a joke or not but given how much VCs are embracing AI, I’ll wager they fear that this possibility is all too real. So why not proactively become an AI bestie? Welcome to this week’s Next Wave and the second installation of our series on the identity crises facing venture capital as an industry globally. If you missed the first one, start here.

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“Rip up the playbook”

Silicon Valley and Europe are already looking back at the last years of venture capital’s excesses and openly discussing the need to reexamine. This week, John Thornhill, founder of Sifted, a Financial Times-backed technology publication focused on European startups, called for the VC industry to “rip up the playbook and start again”. In the last three months, I have probably read close to a dozen or more tweets, articles, comments on articles and LinkedIn posts calling for a rethink of what venture capital means. What Silicon Valley (used broadly to mean all Western VC firms) isn’t saying is what starting the venture capital industry over again would look like.

Other than nauseating subtle and/or open personal jabs on social media, I don’t see much of a conversation about how the global realignment of VC principles affects an industry that has yet to find solid local funding footing. Here’s what the global playbook looked like.

Think of the world of investing as a game where multiple players compete to achieve a set of two objectives. The first objective is to acquire as much capital as possible or feasible from the people who have this capital but cannot be bothered to oversee it every single day. The second objective is to show that they can return even more money than they first acquired to their initial funders after taking fees for standing guard over idle money.

To be able to show a return, the players have to make choices about what businesses can generate the needed returns. They can make these choices on a case-by-case basis in public or private markets, by buying or selling industry at a wholesale level (indexing), or by using complex financial maths to try to extract some form of profit (derivative trading, etc.). This is an oversimplification, but it is more or less the game everyone in the investment and financial world is playing under different names.

This game used to be super exclusive because to play, you needed to know and be trusted by the people who had money sitting idle. Players also needed to be skilled enough to do the hard work of purely using money to make money. But they could become rich and earn a lot of money—and they did. When something pays off, especially financially it tends to attract more attention. As the game became a lot more popular it attracted newer players who stepped in to fill the gaps in how businesses are funded.

Instead of only providing loans, buying shares in mature businesses or borrowing to buy companies and then trying to sell the companies for profit. These newer players were specialists who would do what no one else in the game would dare. Unlike their fellow players, they would absorb plenty of carefully (in theory) curated losses or middling gains, in the hopes that 2 of 10 bets would at least triple the value of the entire fund within 10 years. If they succeeded they could outperform the traditional players, and create bigger and better (in theory) businesses. Success also means being able to repeat the cycle after collecting more capital from rich people/organisations with idle cash who do not mind a 2/10 odds of more than doubling their money without doing any of the hard work over an 8 to 10-year period.

These new players embraced risks of a particular kind (typically new technologies), called themselves venture capitalists and recited whale hunting folklore as the origin story of their tribe. Not unexpectedly the other older players (hedge fund traders, REITs, the old guard Wall Street and lords of high finance across the world) did not appreciate their guts, or the competition for LP capital.

For years (after an initial collapse in the late 1990s) the new players seemingly kept winning short-term bets, until most recently after global hikes in interest rate hikes left many venture bets in short-lived pandemic-era trends naked on the beach. The older players and more established players (though not entirely safe themselves) are taking the time to gloat, and in the now noisy locker room of the new players, the voices and principles that seemed infallible just a few years ago, now inspire little confidence.

In the last few months or so, I’ve seen a lot of takes about venture capital. Everyone from purebred venture capitalists to social impact VCs, hedge fund and traditional fund managers, to public market analysts have an opinion, hand-wringing or unabashed schadenfreude they derive from the collapse of the short-lived roaring 2020s in VC land.

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Needed: New leadership

One of the most criticised parts of venture capital in the last decade was its unhealthy tilt towards herd instinct. Both VC investors and their LP funders are guilty of detrimental herd behaviour, as Dan Gray eloquently shows in this compilation of VCs lamenting the situation.

Ironically, what the industry needs more than ever is clear leadership. But this irony is only in semantics. Leadership in this context does not mean that venture capitalists need to hold a vote to elect a leader. What it does mean is that venture capital as an industry, and especially African venture capitalists need to more rigorously assess and accept the responsibility that comes with managing return outcomes for their investors, and the social or economic impact (positive or negative) that is associated with their decisions. Simply blaming interest rate hikes, bad founders, or even the “herd mentality” of the zero-interest-rates era, is a cop-out.

This leadership does not equal excessive self-confidence. “The cardinal sin in investing is hubris, and markets exist to teach us humility,” Aswath Damodaran, valuation guru and professor of finance at the Stern School of Business at New York University, wrote recently. In fact, the leadership the venture asset class needs right now is the sort that will produce common measurement ratios and support the influence of more data versus subjectiveness (but not too much). If leaning into the data beyond fundraising scores and opaque valuations means a second look at how to optimise the 80/20 power law, then so be it. Let there be no sacred cows.

In the fractious world of venture capital, this is a tall order, but for Africa’s nascent venture space, it is not very negotiable. Sooner than later, the platitudes will lose their magic. getting ahead of that requires this leadership.

Abraham Augustine,

Senior Reporter, TechCabal.

Feel free to email abraham[at]bigcabal.com, with your thoughts about this edition of NextWave. Or just click reply.

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