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The math of “quality” is a dubious “math”

The laws of math can’t be defied, and the math of venture capital is straightforward. You can’t invest nearly $600 million of venture capital out of one fund and generate a VC-like return for limited partners. Fred Wilson demonstrated this in his now famous VC math articles last spring. You can’t invest nearly $600 million out of one fund and still call it venture capital.
Reading this news item, it’s hard to feel good about the direction of private investing in 2009. Capital markets are at last emerging (allegedly) from a cataclysm fueled in important ways by market inefficiency – which is to say, herd mentality, both on the upswing and the down – attributed in large part to inordinate concentration of capital and capital flows within an increasing circle of influence… and it seems as though we’re back where we started, making the same mistakes.
In an interview announcing the completion of a $585 million “venture capital” fund, the quote which sticks out is this: “We’re seeing a flight to quality at all levels — for LPs, VCs, and entrepreneurs.” Before we ponder the significance of that statement, and what “flight to quality” may actually mean in the context of high-risk early-stage investing, let’s consider the following consequences upon the three constituencies mentioned:
  • In the new technology environment it can cost less than $1 million to build a successful web business, what with hosting and bandwidth fees coming down, with cloud computing and software as a service on the rise, and not to mention the cost of labor going the way of commercial real estate. Now, it seems unlikely that a $585 million fund will buy into hundreds of deals, and so deal sizes are likely to be materially greater than $1 million. Let’s guess that $10-30 million will be more like it, with that same amount held on reserve for future doubling-down. Is this “flight to quality” a good thing for entrepreneurs who only need $1 million?
  • Without getting into the math of liquidity events necessary to produce VC-like returns for LPs at these levels – I defer again to Fred’s spring 2009 articles on this subject – I would suggest that the so-called “flight to quality” means either that the VC model is abandoned, or that LPs will earn sub-standard returns. Possibly both.
If ever there was an investment approach and a target investment profile that calls for high diversification and small investment amounts, it would have to be the early stage venture category. And this is not only the case for individual investments, but for funds themselves: the risk and return standard associated with early stage investments should also apply in the same way to early stage investors. Which is to say, small investment amounts and broad diversification among many funds should be desirable for LPs just as it is good practice for venture funds.
A “flight to quality”, as described, is only a flight to bigness and reduced diversification, and we’ve seen how this all tends to turn out.

Disclosure: No positions.