The art and science of venture investing – #3: it’s investing vs divesting and the “relationship”

By ssyc1
March 6, 2020
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Some of the most interesting analyses about investing that has been making the rounds of the institutional investment community in the last few years has been about how fund managers are generally much better buyers than sellers. “Selling fast and buying slow” seems to align with long-held advice (that has almost solidified into doctrine) to cut your losses early and let your winners run.

As opposed to common behavior of fund managers where “selling is simply a cash-raising exercise for the next buying idea”, the strong implication is that the performance of fund managers will increase if they took equal care with selling as with buying.

It is an interesting conclusion and makes us early-stage investors wonder: we don’t always have a lot of chances to “sell” (or I use the word “exit” which is more commonly used in venture and private equity investing).

So, how do we take equal care with exiting as with investing? Is it as important as in listed equities investing?

Perhaps the difficulty in exiting would make us more thoughtful and consider more carefully? I am not sure. Because of the lack of opportunities to get liquidity, we would value each opportunity more? Does it make us want to sell earlier? Put another way, if we had more opportunities to sell or exit, would we VCs exhibit different exit behaviours? For sure, we don’t often have that much choice in pursuing the “cut your losses early” strategy; and then we therefore don’t let our winners run? Subjective evidence from knowing many deals and conversations with venture and private equity investors suggest that the good performers do tend to let the winners run. There is also the difference that because the early-stage journey is by definition more “ups-and-downs” (see #1, 2 and 3 of an earlier post about the “up-and-down journey” in venture investing), it is quite possible that we would have “cut our losses” prematurely (there are plenty of opportunities to worry or “panic” for most venture investors, even the Series A investors in Alibaba). In fact, we end up developing strategies that listed equities fund managers don’t have the opportunity to leverage: we do our best to trust, understand and support the wishes of the founder who has the biggest stake and most informed view. There are a number of these examples that are well known, even if it is very difficult to work out the “counter-factuals”, so to speak (put another way, it is difficult to know the “what ifs”).

We must note a commonality with listed equities investing: the small group of outperforming skilled fund managers, especially the upper quartile performers, tend to have a high win-loss ratio, which essentially means that the profit they make from the average good decisions offset the loss from the average poor decision. As a VC, it is even more important that our “wins” are big wins because of the “power law” nature of returns distribution. Make no mistake though, it is important to spend time with the not-so-obviously-winners too, not only because many highly successful second- and third-time founders come from a first failure, and not only because managing those non-unicorn candidates can make the difference between a fund that returns 3x and one that returns 5x, as a VC peer with a fairly concentrated portfolio puts it eloquently here, and also because of other significant secondary effects too, as one other VC peer puts it, “Your return is driven by your winners, and your reputation is driven by how you handle everything else.”

But speaking with seasoned venture and growth investors, I always hear about: (a) thank God we realised the market was only going to go down and so we found a home for this investment even if it was quite imperfect; and (b) stories of big wins because the investors stayed patient. Knowing what journey to chart out for one’s investee companies and bringing others along is a major part of the continuing dialogue with founders and management teams. That is why we spend time to understand the business before we invest (see also #5 of our earlier post), to develop a dialogue with the key persons during our due diligence, and to test where the gaps are (and where we can add value and find resources to help). This does mean finding entrepreneurs whose commitment to success translates into an ability to take honest feedback and quickly learn and not repeat mistakes (including those who learn to build around themselves some “institutional” mechanism whereby a coach or a mentor or an advisor help them avoid mistakes or catch them early, or to get some sense of what they “don’t know don’t know”; see especially #1 in this earlier post). A key part of the investment equation to us is that there is potential for a relationship that can survive the disagreements, the ups and downs, the mistakes and mishaps, all of the things that come from risking our money and time and credibility on something that involves a complicated journey filled with uncertainties that is expected to last at least several years, and we want to either see the key ingredients there, have confidence they exist, or take steps to put these in place before we invest. Oftentimes, this requires a mutual understanding of each party’s strengths and where they can and cannot bring value. Once those are in place, we continue to invest time and resources post-investment to understand the business and to sustain a productive dialogue.

A note about “information” too: as founder of Oaktree Management, Howard Marks, puts it in a recent note to his clients, “You bet“, “you have to understand the significance of the information you have, as well as that which you don’t have.” And, because of the inherent uncertainty in new and emerging industries, we are often having to “read between the lines”, one of the beautiful things about venture investing. But having an understanding of (the depths of) what we don’t know is one of the first things we should always think and remind ourselves about.