Taking advantage of venture dispersion

There is increasing optimism in the early-stage venture market that the worst of the slowdown caused by the 2022 and 2023 rate hikes is behind us. Entrepreneurs are stepping forward to launch companies that utilize new artificial intelligence (AI) capabilities to modernize established industries with “broken” processes, such as healthcare, logistics, security, and enterprise solutions.

Allocators may (and probably should) be looking to get their clients exposure to this latest innovation wave, but they may understandably be apprehensive, given the level of risk in venture capital (VC) and the level of return dispersion among VC funds. Dispersion is often used negatively to describe the significant difference in returns among venture funds but, of course, dispersion is not bad if you end up on the right end of the spectrum. Then it’s called upside.

Why do returns vary so greatly in VC, and - more importantly - how can investors take advantage of it?

At its core, dispersion among early-stage venture capital fund managers (or General Partners [GPs]) primarily stems from two related factors: who they know and who they choose to back. 

In the early stages of VC, the most successful funds (small in number) are those that attract top-tier founders (even smaller in number). Each innovation wave, from chips to networking to consumer internet to mobile to enterprise and now AI, generally produces only a handful of breakthrough companies that drive the majority of venture returns for limited partners (LPs). This is the power law of venture returns.

You can turn power law into your friend by being highly selective, finding managers with both the connections to generate visibility on and access to high-quality opportunities, and a track record of working with/identifying transformative founders.

The GP-founder relationship

Many of our discussions in the first half of this year across our network of early-stage managers end up focusing on the importance of finding the right fit and developing productive working relationships between GP and founder. 

This is especially true among emerging managers - who are refining their ability to find and attract top-tier founders. These emerging managers repeatedly emphasize the importance of building trust with founders, which manifests in two key ways:

1. Purposeful fund sizing to signal their focus on partnership: Successful GPs tend to understand the importance of fund size and the signal it sends. Several emerging managers with whom we chatted (and many of those that have graduated out of the “emerging” category) told us they are prioritizing a disciplined fund size, as this signals to founders their commitment to genuine partnership. By avoiding an overly diversified approach, these managers can better access funding rounds for breakout companies, because founders know the GP will have the bandwidth to offer real support when called upon.

2. Leveraging their previous operator experience: Emerging managers that have firsthand experience in building successful companies have real advantages in fostering empathy and trust among founders, who are increasingly focused on finding GPs with real entrepreneurial experience after the trials of the last couple of years. The shared experience of operating with grit and having the guts to start something new can really build trust with founders and help create a good working relationship.

As the next wave of innovation unfolds, the power law and dispersion will persist, with only a select few funds providing access to the next generation of successful companies. If history is a guide, allocators should carefully consider how the fund managers they invest with attract and support talent.

Emerging managers can form part of that success, provided they have the right personal experience, connections, skillset, and mindset to identify and work with talented founders.

How this manifests: the Pear VC story

Consider the story of Pear VC, founded by Pejman Nozad in 2013. Nozad, an Iranian immigrant who cut his business teeth working at a yogurt shop, then a car wash, and ultimately a Persian rug store in Palo Alto, gained recognition in Silicon Valley for his ability to attract top talent through his community-building efforts - including meet-ups at his rug store.

Though he was brand new to venture, by establishing trust with its founders through his entrepreneurial grit, Pejman was able to invest in DoorDash’s seed round, resulting in significant returns for Pear’s LPs.

Pejman's story exemplifies the value proposition of emerging managers in capturing new innovation waves: a deeply personal connection to founders via tenacity and partnership, with the discipline to remain focused on providing support to a few high-conviction companies. 

And, of course, the first fund is always the most important. Without smart investment (and a lot of hard work) in fund one, there is very unlikely to be a fund two.

The right end of VC dispersion

By finding managers adept at navigating a complex and technical, but also deeply personal, asset class, investors can potentially end up at the right end of the power law distribution - where returns can be potentially transformative for investors.