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Comparing Venture Capitalist Investment Strategy with a Poker Game

Venture capitalist investment strategy

In this blog, we shall discuss on the current Venture Capitalist investment strategy and why success rates of VC owned companies are far lower than a Private equity owned company.
Then we will build a scenario where VC firms can improve their current success rates when they change their investment strategy to that of a poker player.

Venture capitalist investment strategy vs Private equity

  • A Private equity investment strategy is to target companies and invest capital, run the company for a certain time and exit at a higher multiple.During this holding period, the PE firms work with the target management to improve their efficiency and savings which enables them to improve their EBITDA.
  • Private equity firms raise capital through buyout funds.Public and institutional investors invest their money in these funds in order to get a higher returns.These funds hige high returns and none of these funds have been written off or not able to recover their initial investments.
  • Private equity firms also invest in distressed companies and have been able to find a higher success in turning around their performance.Generally a company performs better when they are under a PE ownership.
  • Venture Capitalists on the other hand also follow the similar investment strategy of investing in multiple early stage companies.When we compare the return from VC held funds, they fare far poorly than PE firms.
  • In case of VC firms, majority of the investments in early stage companies do not perform well and these investments are written down.
  • In a VC portfolio, few companies give substantial returns which averages the losses they get from their other investments.
  • On an average a VC fund gives 3% returns as against a PE fund of ~9%.These returns are after paying the fees for the fund managers.
  • The reasons for these abysmal returns by the VC firms is because most of their investments in early stage companies do not have any prior historical data that allow the fund managers to do a detailed due diligence on. Private equity firms on the other end have access to historical data of their portfolio companies and engage consultants to conduct a detailed due diligence.
  • Bessemer funds – One of the leading VC funds recently shared a list of early stage investments which they have given a pass.These companies included Facebook, Ebay and Google.Although the decision not to invest in these firms at that time had a strong rationale – For instance Bessemer had already invested in Friendster and felt that Facebook does not stand a chance to compete with Friendster.
  • This indicates that VC companies have not only invested in companies that did not work but also missed investing in companies that could have given mammoth returns. This decision to invest or pass in a specific portfolio company is taken by wise and educated deal executives.
  • Hence to counter this failure rates and not miss great opportunities, VC funds can emulate a poker player.

Why Venture Capitalists should invest like Poker Players?

  • In a Poker game, a player has a small stake in all the bets.Similarly a VC company can decide to place it’s bets and invest on majority of the early stage companies.This strategy might be complex and daunting for angel investors, but large VC funds can explore this strategy.
  • While this may look like Spray and Pray approach where one is praying that its spray approach might be successful in getting returns from investments, there is more to this strategy.
  • By placing it’s bets and investing small amounts in many startups, VC fund can understand the direction and growth of the company and validate whether the founder strategy is working.This may not have been possible during the time when the owner pitch for raising funds.
  • VC Firms can be a silent board observer in the startup company. When the startup does not do well or meet their targets, then the VC funds can withdraw their investments.This gives an opportunity for VC deal managers to study the company and do a due diligence.If the startups do get success and managed to meet their targets or their business model is finding acceptability from the customers, then the VC firm can expand their investments.
  • This approach allows the VC companies to minimize their losses on underperforming startups and at the same time does not allow them to miss on any great investments.
  • As like a Poker game, the players in its initial moves comes to know if he is going to lose or moving towards a success.In a VC investment, the fund manager can identify the loss making investments early and stop adding more investments.

Conclusion

  • Majority of the Venture Capitalist investment strategy in the startups/early stage companies are failures and yield negative returns.Around 5% of their investments give a majority of the fund overall returns where as 60% of their investments give negative returns.
  • This low returns from the VC funds along with their high risk taking appetite discourages investors to invest in VC owned funds.
  • The VC company can follow a poker strategy to increase their success rates by minimizing losses early on in bad investments and to keep re-investing in those that still have potential based on the additional information gathered.


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