“For a given alpha, a shorter time to exit requires a larger growth rate. If it takes 20 years to exit a patent (alpha = 1.5) it implies a year over year growth rate in value of about 10%. If you wanted to exit in five years you would need a year over year growth rate of closer to 50%. To get to an alpha close to 2, as in venture capital, with an average time to exit of 5 years, the year over year growth rate of the portfolio companies needs to be 22%. For a time to exit of 3.5 years, the growth rate needs to be 33%.”
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Power Laws in Venture | Reaction Wheel
Gerry Neumann is writing the most interesting material on VC right now, and I suggest anyone who’s interested in the industry to read his blog.
This post is a super interesting look at how power laws actually work – beyond “amazing outcomes are extremely rare but big”. Since the whole idea of Venture Capital is based on this (and it’s totally counterintuitive to everything we encounter in normal life), it’s importatn. Go read it and dig into the sources, and come back.
Some of the conclusions:
- Low Alpha (less losses/small returns, and more outlier winners) is mostly a function of time and growth rate
- Patents and smaller/earlier funds have low alpha: The very long timeframe for patents, and unproportional outcomes of large wins for small funds are probably the main reasons.
- The market of VC is crowding around an alpha of 2, probably designed by market forces: usually very similar time horizons for funds, and the very low likelihood of extreme growth startups. If those are found (FB, Uber, Instagram, Whatsapp), the incredible growth rates determine the outlying returns in a short time (since the normal fund cycles don’t get changed).
What do I think that means?
- A fund with a really long term horizon can achieve lower alpha if they invest in things that match this trajectory
- A fund focusing on later stage deals could innovate by taking outlier risks, but since the amount of high growth companies in late stages are so few (and well known), there is upward drive on the price, which brings the alpha back down
- Short term investing is almost impossible, since high growth opportunities are so rare and easily spotted, that prices go up super fast
- Extreme valuations are explainable by their high growth rates above all else. However, it remains to be seen how patient this capital needs to be (they usually have a different time horizon from VC, so it might work for them).
- Category killers like Uber that look like long term winners have both sides of this equation to their benefit.
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