Can Active Managers Outperform?

How to invest can sometimes be more important than where to invest. That is why looking at the rationale to invest in active or passive strategies  is highly relevant

The ability of managers to over-perform the market is the source of much debate in the Financial Economics discipline because of the underlying debate on the validity of the Efficient Market Hypothesis. The consensus is that the degree of over-performance a manager can achieve is related to the level of inefficiencies in the market it operates in. Illiquid assets are usually associated with higher inefficiencies, as shown by the higher dispersion of returns on Venture Capital, LBOs and Real Estate (basically Private Equity), because of the higher valuation uncertainty. 

Furthermore, in Private Equity there is a big set of  evidence showing that fund managers that outperform the market consistently do so over successive funds: it is not only the volatility of returns that drives the differences, it is the difference in skills among managers.

Therefore, good fund managers can greatly outperform the market in these asset classes, making a solid case for active investments through funds.

Publicly traded asset classes such as stocks and bonds show more concentrated returns across asset managers with lower after-fees persistence in returns. The main driver in these markets is the return of the benchmark. Consequently, good asset managers perform similarly to bad ones and they usually barely justify the fees spent on them. 

Private Equity assets are also the ones where it is harder to diversify a portfolio of direct investments passively since minimum tickets are usually sizeable, there are no direct investment diversified vehicles and the costs of analyzing and selecting deals is very high. 

Publicly traded markets provide easier ways to have a diversified exposure to a whole array of individual assets across an asset class through ETFs or directly investing in the individual assets. Consequently, investing in active funds does not provide diversification advantages over passive funds. 

I avoided talking about Hedge Funds on purpose because their case is more difficult. On average, Hedge Funds exploit the inefficiencies of liquid markets, but they amplify these differences by deviating from benchmarks, using leverage, beta neutral strategies and many other non-conventional tools. There is no passive way to do a Hedge Fund, so there is no way to avoid them and get exposure to their strategies.  Risk-adjusted returns analysis for HF is very hard to perform since they use non-linear trading strategies; but most evidence is consistent with pointing out that they do not outperform the market on a risk-adjusted basis. So, the decision here is not whether one should get active or passive exposure to HFs strategies, but whether one should invest in HF strategies at all. A debate for a different entry. However, I do believe that HFs are a more sensible way to search for alpha in public markets than regular mutual funds since they have enough discretion to do so.

Conclusion

To sum up,on average, it is better to invest with active managers in illiiquid, inefficient and volatile markets (Private Equity, Frontier Markets Equities, Frontier Markets Debt, Emerging Markets High Yield. etc) and to invest passively  in liquid, efficient and stable markets (Large Cap, US Treasuries). 

Has Buenos Aires become an IT hub?

The positive Network Effects of Clusters are a cornerstone of modern geographic and development economics. The concept is pretty intuitive: having a lot of companies in the same industry creates a pool of talent, buyers and suppliers that simplifies the establishment of new similar companies in the same place. Therefore, acquiring a critical mass of companies is crucial for the future development of the industry.

In IT, the main advantage of these clusters is the reduction of the acquisition costs of talent. Someone has already done 95% of what an IT company is doing; acquiring people with the right capabilities and experience lets you jump ahead of the competition. The most famous cluster in IT and innovation is, obviously, the Silicon Valley. It is not only for ideological reasons that the Valley has been pushing so hard for changes in the immigration policies and the JOBS Act.

It is very hard to know what is the minimum size required to call a place a hub: you know one when you see one. But the most important characteristic of an IT hub is the access to talent when building a new company in the sector.

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Buenos Aires has been an important software and IT services center for a long time. Almost 90% of all the Latin American start-ups of the 90s where originally from Argentina. The country still has one of the most literate populations in the continent.

Furthermore, it has picked up significantly duriing the 2000s, with sales growing a fivefold since 2003 and standing today at a staggering USD 4 Billion. Buenos Aires and its suburbs concentrate ~70% of the more than 1400 companies in the sector. A lot of them provide IT Services , but 52% of them are pure software development companies.

ICT Sales, Exports and Employment in Argentina

Source: OPSSI - Semi-annual report on the Software and IT Services Industry in Argentina. Seprtember 2013

Even if  significant for a country with a USD 470 Biillion GDP like Argentina, the ~50.000 employees in the sector in Buenos Aires are very small when compared to the Silicon Valley where ~300.000 people are dedicated to the industry and 150.000 people are dedicated to innovation. Moreover, most of the firms in the SV are dedicated to software development (vs 50% in Buenos Aires) and their employees have a better education and perform more sophisticated non-standarized tasks. So, no, Buenos Aires is not the Tango Valley.

However, the city does have enough resources to be a hub in some sectors. Buenos Aires is the home town of the two biggest IT companies of Latin America and they are both in Consumer Internet: Mercado Libre is quoted at a USD 6 Billlion Market Cap on NASDAQ.and Despegar was valued at ~USD 1 Billion in recent private transactions. These companies are creating a huge pool of knowledge in the sector and it is empowering new ventures like OLX, the Craiglist of Emerging Markets with presence in over 100 countries that was founded by the owners of De Remate, a competitor bought by Mercado Libre.

The city also has some sectors that are gaining significant traction like video-games with more than 70 companies and 1000 employees, where 72% create their own IP. Another relevant sector is Business Process Outsourcing, where Globant alone has USD 120 Million in revenue.

The high level of development in some sectors and the nascent status in some others makes public policy all the more important to capture the full value of the network externalities. The most obvious thing Buenos Aires needs for this industry to develop is a stable macroeconomic environment in which to operate. Even if, as we have written in previous blogs, the VC industry can circumvent most of the red tape, most of the IT industry is not VC material and is highly sensitive to the business environment. The other main driver of the industry is education since, as we have discussed earlier, talent is the most important asset. Finally, the state could help industries export their services and connect with each other.

In conclusion, the software sector in Buenos Aires is far from the biggest international IT hubs. However, it is a world-class hub in Consumer Internet and it has the potential to be a hub in the whole industry if public policy gives a helping hand.


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Thank you to Gabriel Wallach and Marcos Amadeo from the Government of the City of Buenos Aires for their assistance with the data

Venture Capital in Latin America over the next decade

Latin American Venture Capital will remain attractive for investment in the middle of a deceleration of the Emerging Markets in general and of the BRICs in particular. The appeal of its Copycat Ventures continues in place due to its still high growth and large market size; while the appeal of its Innovative Ventures grows because of a maturing ecosystem, backbreaking growth on R&D and Education Investment and active Public Policy to promote Innovation, Entrepreneurship and Venture Capital.

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As we discussed in a previous posts, Venture Capital in Latin America has mostly focused on Copycats that replicate and adapt US business models in their local markets (i.e. Mercado Libre/ Ebay, Despegar/ Expedia). Over the past ten years there has been a surge in the interest for these investments with key GPs (i.e. Redpoint, Burril, Sequoia) and LPs (i.e. Horlsey Bridge, Silicon Valley Bank, Cisco) entering the Region with a focus in Brazil.

VC Investmet Distribution in Latam

Source: Axia Ventures Proprietary Analysis

This growing interest was the consequence of Latin America´s high growth, Brazil´s new role in the world as a key market and a member of the BRICs and the successful Copycat Ventures of the 90s.

Today, the main driver of the growth of the last 10 years in the region is not there anymore: the rise in in commodity prices is slowing down as China rebalances and reduces its growth. Furthermore, the increase in asset prices via reduced risk spreads caused by institutional improvements has evaporated since spreads have compressed to almost zero.

Therefore, the growth of Latin America over the next few years will not come from the rise in commodities; it will come from productivity gains. Productivity gains in Latin America could be achieved by raising the capital and technological intensity of production, specializing through more trade or innovating.

In this context, the decision by the Pacific Alliance (Chile, Colombia, Peru, Mexico) to create a regional free-trade market for their already open economies has been appreciated by the markets that believe such strategy is a cornerstone of future growth and a sign of a willingness to eliminate red-tape that will allow for higher capital efficiency and intensity. Although we agree with this view, we believe that the region as a whole will continue to grow at a higher pace than developing nations because it is still far from the capital and technological frontier and it has stable institutions in a converging world. This is the fundamental secular reason to invest in the region since the rest of the issues will prove cyclical (i.e. politics). Most International Economic Organizations are forecasting Latin America to grow at a 6% CAGR over the next five years, 50% higher growth than the Advanced Ecomies.

Source: IMF World Economics Outlook

Furthermore, the valuations in the region have already adjusted to the slow-down of the past 2 years, paving the way for further gains by riding the growth in multiples and diminishing the downside risk. Low entry multiples have been one of the most important conditions for high PE and VC returns over the decades. Jim O'Neil, the former Goldman Sachs guru that coined the BRIC term in 2001 and predicted the emerging markets rally, says the selloff has made the Emerging Markets "very attractive".

Consequently, we believe that investing in Copycat Ventures in Latin America continues to be a sound investment due to Latam´s big and growing market and its discounted valuations and costs.

Source: Yahoo FInance

But above all, we believe there is a great story to invest in Innovative Ventures in Latin America. The Region has doubled its R&D and Education Investment over the past 6 years, on the back of growing GDP and the increasing relevance of Innovation Policies. However, there is very little capital pursuing these opportunities since there are no key innovation hubs in Latin America when looking at it on a single city or country basis. 

Source: OECD

Innovation Policies in South America

Sources 1) 14/03/2013 – FINEP- Launch of Plan Inova 2) http://www.finep.gov.br/inovaempresa/ 3) Financial Statements 1H 2013 4) Colciencias 5) MINCyT 6) “Fronteras en Biociencia" 7) Cumbre Latinoamericana de Innovación 8) Josh Lerner and Ann Leamon – Harvard Business Review

This is starting to change because R&D and Education are cumulative long-term investments that are starting to show the results of a decade of hard work and Rio de Janeiro, Medellin, Santiago de Chile and Buenos Aires are aggressively trying to position themselves as Innovation Hubs with a global competitive mindset. The Region is already producing some top-notch innovative companies like IndexTank, CVDentus, Amyris, Ciencias para la Vida, Keclon or Bioceres.

These opportunities are coming at very competitive valuations today because of the lack of capital for such investments, the recent steep decline in foreign exchange rates and the competitive pricing of technology experts and scientists. Those investors prescient enough to invest in this embryonic part of the Latin American VC ecosystem will get rewarded in kind. 

To exploit these opportunities consistently as a Venture Capitalist, a Latin American geographic and a generalist industry approach are necessary since only then will the Deal Flow have enough depth to make an Innovative Fund viable. Also, Innovative Ventures need to have Validation from Key Innovation Hubs and Business Development in the Advanced Economies. In the past, this would have been a great difficulty; but in an integrated digital world it is actually an opportunity since it creates a global company from day one.

To sum up, Latin American Copycat Ventures are still a sound investment since the Region has a big market that will continue to grow. But we also believe that there will be a growing success story in the Innovative Ventures of the Region.

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Thank you to Lisandro Bril -Managing Partner of Axia Ventures- for his collaboration on this piece

Globant. A new Latin American IPO. Another Argentinian

Yesterday, Globant filed for an F-1 with the SEC to raise USD 86 million in an IPO in the NYSE, the second Latin Tech Company to have that privilege along with Mercado Libre, another Argentinian company. Paradoxically, this happens the same week that a New York court ruled against the Argentinian Government for the restructuring of its defaulted debt.

http://www.sec.gov/Archives/edgar/data/1557860/000114420413048053/v350224_f1.htm

Globant is a symbol of Argentina´s renaissance after its 2001 crisis. Founded in 2003 as an outsourcing IT services firm, it took advantage of the abundance of talented and trained people in Argentina that were available at the cheap after the crisis and the threefold devaluation.

Since then, Globant has evolved its offering by providing more sophisticated services to its clients and refining its financial structure compensating for the loss in competitiveness of the increasing USD costs that the recovery brought with it and the complexities of the highly volatile Argentinian labor market.

Its current revenues stand at a staggering USD 120M with 82% coming from US clients like Google, Electronic Arts, Linkedin, Cisco or Coca Cola. Their revenues have grown at a 50% CAGR over the past 3 years.

The company´s bredath of services and geographies and their strategic stand in the IT sector have prompted WPP -the world´s biggest advertising company by revenues- to invest in the company and it now owns 21% of the company.

The only stain on their balance sheet is the USD 1.3 million recorded loss in 2012 which they attribute to USD 11.7 million share-based compensation charge; but it was probably also due to the high real exchange-rate fluctuations in Argentina. In 2013, they established a different compensation mechanism for exchange rates via bond purchases and they have already recorded USD 8 million earnings in the first 6 months.

The company is not alone in the world of successful technology companies of the 2000s from Argentina: Despegar is headed for an IPO, Restorando raised a 12MM Series B, Technisys is growing very fast and headed for a Series B itself, Onapsis is growing at amazing speeds in the US...

All in all, Globant´s success is a living proof that there is a lot of competitively priced talent in Argentina and that, with a management team capable of navigating the country´s financial instability, there are big opportunities to invest in its world-class technology sector. Those who decide their investment allocation based on political headlines alone are bound to miss out on a lot of opportunities. 

Disrupted Venture Capital - Part III: Seed Financing

This is the third and final article of this series. So far, the title seems more than a little misleading as the Venture Capital Industry does not seem to be facing any sort of disruption in its relationship with LPs nor with its portfolio and prospective portfolio companies. 

But there is a sector that has undergone substantial change and continues to do so: Seed Funding.

Traditional Venture Capital has been moving out of the earliest financing stages in investments for digital businesses and has been replaced by a combination of Accelerators, Company Builders, Angels/ Super Angels and Crowd-Funding.

There are many reasons for this shift in stages. The main one is that it has become much cheaper to start Internet and Software companies; making the tickets too small for a hands-on Venture Capital. If the VC funds made their usual 10-20 investments in the early stage with the amounts currently being raised, they would have a very small fund, with very little management fees and, consequently, not enough resources to consistently add value.  

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The most common starting point for most VC-style digital companies today is being accepted into an Accelerator. These programs provide financing (USD 10-50k) and coaching for start-ups for a short 3-6 months period as well as access to key players in the industry (Angels, VCs, Lawyers, Digital Marketing). The key difference with VC Funds is that they invest less capital and add value more intensively during a much shorter period. Since the investment is smaller and the time-frame for adding value is shortened, Accelerators invest in a lot of companies taking a new "class" every year or semester. 

This approach is superior to Early Seed VC Funds because the resources offered to the entrepreneurs are standardized and optimized across classes, the size of the investment and the time-frame are the appropriate ones to test the business models and the extra-diversification is consistent with the much more skewed distribution of returns at this stage.

There are three main problems with Accelerators: the valley of death, the returns and the exit. 

After finishing their program the start-ups have accomplished their MVP (Minimum Viable Product) and are ready to expand; but since most digital companies do not grow organically, they need financing. The need for extra capital is the biggest difficulty companies face after their acceleration because there operations are financed for a very short period of time and they struggle to survive this valley of death. Accelerators work hard on demo-days and luring investor to solve this shortfall. The rise of Angels and Super Angels is helping a lot at this stage. 

The second issue is that the economics of Accelerators remain uncertain for its investors. Although they are rather new enterprises, as of today, very few ones have reported good returns. As we discussed in a previous entry, average VC returns are not very good. By investing in so many companies, it is hard for accelerators to outperform this average. Obviously, this issue could eventually be addressed by changing the terms of investment or having a side-car fund. So, returns are in no way a limit to the existence of Accelerators but a reflection of its current market dynamics.

The latter problem is more structural since Accelerators do not seem to have a proven exit path. Investors do not know how or when are they getting their money back. The most conventional view is that they could pay dividends after a series of successful exits of their portfolio companies or pay back all the capital and investment and raise money again after a few years. However, none of this is contemplated at the moment of investment, putting  investors in a difficult situation. Nowadays, most investors consider their investments as a way to gain strategic access to portfolio opportunities and not as a financial play. This has to change for Accelerators to survive.

To sum up, Accelerators are a superior approach for early stage investing that still needs to refine its financial model.

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A new force that has emerged with strength coupled with Accelerators is that of the Angels and the Super Angels. This are individual investors that commit 10k - 100k (Angels) or 100k - 250k (Super Angels) per venture.

These investors have emerged from a very successful generation of entrepreneurs that remained involved in the ecosystem once they had cashed-out of their companies at a very young age. This phenomena coupled with a general distrust in the financial system after the 2008 financial crisis has spurred this form of direct investments.

Angel Money covers the capital gap between accelerators and fully fledged Series A VC Funds. They usually do not come with as many demands as VCs and help with some introductions and general counseling, but they do not offer the same degree of hands-on approach VCs usually do. At this stage, start-ups face the challenges Accelerators trained them for: product development, traction, etc.

Angels do not have the same screening capacity a Seed VC Fund has, so they rely on recommendations and, yes, accelerators to get a level of deal flow they can handle individually. That is why, even if accelerators might not be great investments per se, they provide the deal flow Angels need to invest correctly and get good returns.

Accelerators+Angels have created a Lean Symbiotic Ecosystem for early investments that is more appropriate than the standard Seed VC Fund approach.

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Crowd-Funding is a practice where many people invest/ donate very small amounts into a project, most likely via a webpage. According to Massolution, more than 1.7 billion dollars were raised in 2012 using this mechanism. However, most of those funds were donations, geolocated projects or loans. The Equity Investment Crowdfunding niche is still under development because the SEC has not yet regulated the JOBS Act that opened the door for the mechanism that was prohibited before in the US.

Crowdfunding gives small investors the opportunity to invest in projects they would otherwise not be able to; increasing the overall availability of funds for early stage ventures. That´s great!

However, there are a number of concerns. The first and most significant one is that there is a high probability of fraud. To avoid this, crowdfunding sites have to make a lot of due diligence that makes the investment process more expensive than it would otherwise be and they have to use standardized equity contracts to avoid malpractice that diminish the flexibility. Also, equity investments into startups cannot be algorithmically studied the way loans are with your credit score. Consequently, it is really hard to help uneducated investors to invest in endeavors with fair valuations and the returns could be dismal. Finally, early stage investment is a high-risk / high-return game. If investors are not properly advised, they could end up losing more money than they were willing to.

In conclusion, Crowdfunding is a great idea, but only people with some understanding of the industry should get involved in it. A lot of money coming in through crowdfunding could have negative effects on the long term for the VC Industry as returns fall and the industry gets a bad rep.

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Company Builders are a new trend that has emerged over the past few years. They are companies that create start ups from scratch by recruiting the founders team to address a problem or copy a business model in other part of the world. Usually, the Managing Partners are former entrepreneurs with a lot of operational experience. The aim of this company builders is to take their companies all the way through their seed stage and then get a Series A round.

I am very bullish about the success of this business models to create copycats in Emerging Markets. The Managing Partners have the skills to correctly identify the business models and they can recruit the best teams to execute them. Finally, their structure finances its companies all the way through the Seed Stage allowing them to execute faster then Accelerators+Angels, a key in these copycat business models.

Their ability to create truly innovative companies is a bit more questionable since the innovation process seems a lot like the failed Corporate Innovation Process.

To sum up, company builders have Team+Opportunity+Execution for Copycat Ventures, a winning combo. However, they might not be the most innovative ones.

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In conclusion, the Early Stage Investment world is mutating very fast with a lot of new business models. Only time will tell which ones survive. 

Latin American Private Equity and Venture Capital: A Decade in Review

Latin America has had a decade (2002-2012) of solid growth and social improvements.  We believe there were two main factors behind this success: the steep rise in commodity prices and the significant improvements and stability in the politic and economic institutions after 20 years of democracy.

Source: World Bank and IMF

The result was a boom focused in the industries connected to commodities (energy, agriculture, metals) and the industries with high leverage and low risk that benefit from falling bond rates (infrastructure, real estate, transportation, utilities); with spillovers to domestic-demand industries via income growth.

Source:  IMF (2005 base=100)

Source: Multiple sources via http://www.quandl.com/economics/spread-over-us-treasuries-all-countries

The Private Equity Industry had a very good decade as it rode the growth in revenues and multiples of their companies:

• It went from USD 0.5B raised in 2003 to USD 10B in 2011 according to private sources
• It had Return Multiples of 2.4x Market Returns (Bovespa)

Ernst & Young assumes these extra returns come from PE Strategic and Operational Improvements, but that is a rushed conclusion since PE Investments are usually highly leveraged and have a higher beta. However, 2.4 times market returns are great returns and probably well in excess of its risk premiums. PE in Latam was a great investment. 

It is interesting to understand the main drivers of EBITDA growth. PE is usually associated with cost reductions and hard social outcomes as it lays off workers. However, as we can appreciate from the data, PE benefited mainly from Organic Revenue Growth, specially when investing in companies under USD 100MM. Geographic expansion and demand growth, both deeply connected to macroeconomic growth, were the key growth sources. Upon exit, high multiples via lower risk-premia and high growth rounded up the great returns.

This decade also saw the rise of Brazil as a new economic power and a part of the BRICS. Brazil is half of the South American Economy, but it received way more attention from the investment world than the other half. According to private data, Brazil represented 80% of the total Fund Raising of 2011 and 60% of the Investments.

The Venture Capital Industry took part in this wave by investing mainly in Copy Cat Ventures that expanded and replicated companies across the Latin American Market. The focus was mainly in Internet where replication is more often not protected by patents, the technical threshold is low and the market is regional. The main strategic focus when investing in a Region for such ventures is the Size of the Market and its growth. Therefore, its incentives and timing are closely aligned to those in standard PE.

VC Investmet Distribution in Latam

Source: Axia Ventures´ Proprtietary Analysis

Since most investments in VC were made over the past 2-3 years, the jury is still out on its performance. However, early signs suggest good returns for the bigger funds in the Region.


This decade things are starting to change. Growth has slowed down a bit, the investors are paying more attention to the Pacific Alliance countries, R&D Investment is growing quickly, Exchange Rates are changing directions, Bonds have almost no default-risk upside, the Political Map is mutating...

How will the next 5-10 years look like? Should one invest in Latin America? How? Where?

 A new article soon to come.

Disrupted Venture Capital - Part II: Money Ball and Spread and Pray

Part II: Money Ball and Spread and Pray

In an underperforming industry, innovation and disruption are the norm. In Venture Capital, however, we have not seen many transformations over the past 30 years... but that seems to be changing

Recently a set of new tactics has emerged: Spread and Pray and Money Ball. In a nutshell, both strategies are using portfolio theory and econometrics to generate what they believe are better investment decisions.

Spread and pray is a strategy where one invests in a big portfolio of companies without investing too much in nor adding too much value to any of them.The investment thesis is that since VC returns are driven by home runs and predicting them is impossible, investing across a big portfolio increases the probability of getting  one and delivering good returns. 

This strategy is often compared to investing in indexes of the stock market where one gets diversification and  low costs. When the investment is diversified, the expected return is the same; but the volatility is lower because the idiosyncratic risk is greatly reduced. If costs are reduced, then, expected returns are also higher because of the savings. This strategy is sound because financial markets are first-degree and possibly second degree efficient; meaning that stock prices fully reflect all public information. Consequently, investing blindly in the stock market yields the same return as "studying" stocks.

Venture Capital investments are slightly different. First of all, there are thousands of people investing in stocks and at least a dozen analysts covering each company from investment banks and major investment funds. Venture Capital deals are analyzed by only a few funds and valued, at most, by a couple. Consequently, to invest in a VC-style company you cannot just invest by assuming market valuations correctly reflect underlying fundamentals, because such information does not exist. You have to pay analysts to make an educated valuation and perform due diligence, so you cannot save money on costs. 

A second difference is that VC investments cannot be fully atomized the way stocks are. Even if funds spread their money across many investments they will still have at most 20 investments of a universe of thousands of companies. Early stage and Angel investment allows for smaller investments and, in that case, it might be possible to spread your investments a bit more. Accelerators are good examples of this trends with 500 startups and Y Combinator investing in hundreds of new companies.

A final difference is that a regular asset allocation is mainly invested in stocks, so investing in an index is a way to diversify the whole portfolio. A VC Fund represents at most 5% of a portfolio and, therefore, the volatility it adds to the portfolio does not only depend on its own volatility but on the covariance with the rest of the assets. This cross-effect is constant, no matter how big the portfolio.

To sum up, spread and pray does not give better expected returns because the fixed costs are the same as more concentrated Venture Capital; but they give a little lower volatility to the portfolio. In exchange, Fund Managers cannot add value consistently to their portfolio, reducing the potential upside of each company. If Limited Partners want more diversification, they could simply make smaller commitments into many non-spread and pray Funds and get the same lower expected volatility with more GP value added. Spread and Pray is a good strategy for an Angel Investor, but a poor one for a Fund.

The Money Ball strategy is a little more vague on its meaning; so I will take the definition by Matt Oguz -Palo Alto Venture Science- of what Money Ball VC does:

• Establish a data-driven selection model
• Optimize investment sizes per company
• Optimize investment portfolio of companies

Creating a data-driven automated algorithm for investment is an idea taken from Wall Street´s Quant or Algorithmic trading strategies, a long standing practice in the financial markets. These strategies rely on sophisticated Financial Econometrics to predict prices or relative prices.  They have been very successful in the past, but statistical arbitrages have become harder over time because of stern competition and unstable market conditions.

To generate a robust predictive model one needs a lot of data and good and stable relationships. Venture Capital lacks all of this.

First of all, there is very little data on Venture Backed Firms. VC information is private, so getting access to it is really hard. Also, a lot of the ex-ante important info on start-ups is subjective (i.e. the quality of the team). Finally, financial markets have operations every second; VC has only 500 exits a year.

Also, I have not crunched the numbers nor seen the databases, but  it is hard to believe there is a strong correlation between risk / success rates and measurable variables (years of experience, team size, industry, etc), even if complemented with internet data-crawling (visits, growth, mentions, links).

Finally, even if those relations exist, they should be very unstable since successful VCs have invested in companies with very different profiles across time. This is a recipe for harder econometrics (building completely time varying correlation matrixes is hell) and diminished robustness.

This does not mean that you cannot extract value from data, but that you cannot rely on it solely. Data-crawling can help you understand the real depth of penetration of a brand or product and understand trends. Data analysis can give you hints, add information and insight.  But they cannot give you yes or no answers to investment.

The Start Up Genome Project has put together a database of 16.000 start ups. Their conclusions are a good guide to what you can do by using statistics. They have established that: Pivots, Team Size and Team Experience are valuable inputs into the Investment Decision Process; while Mentorship, Experience and Super High Growth are not. They did not say how valuable Team Size is, but they found bigger is better. So, you should value big teams, you just do not know how much.

The most relevant Fund that uses Big Data and Statistics is Correlation Partners. However, they are never the lead investors on their ventures. This means that they believe that the data helps them predict within the firms that get funded which ones will do better; a much more subtle claim than being able to choose from the whole investment universe. In lots of ways, they are free-riding other VCs!

Most firms that talk about Money Ball only claim that they complement their decision process with data: Google Ventures, General Catalyst, OpenView, Greylock.

Data-driven selection models do not seem like a sensible claim as of today. Data-supported decision processes on the other hand are here to stay.


Then there is the "portfolio theory" part of the Money Ball: optimize investment size and optimize investment portfolio of companies. A pretty similar claim to Spread and Pray: lower volatility and lower risk  by optimizing correlation (Markowitz, etc) instead of increasing portfolio size.

In a regular VC fund only 10-20% of the companies survive, mainly because of idiosyncratic risk. So, it is not clear how can an industry correlation analysis significantly diminish the volatility of returns, since you have no idea which companies will survive.

There might be a claim that survival depends on industry performance and, therefore, portfolio theory also reduces volatility by stabilizing survival ratios. This is a fair point, but only valid for "generalist" funds since industry-specific funds cannot diversify across counter-cyclical and cyclical businesses. Once again, LPs could invest among many industry-specific funds and get similar risk/ return profiles.

Maybe, this technique is used to reduce the covariance of the VC investments with stocks and reduce the Beta of the portfolio. However, a good valuation already takes Beta into account, so this would hardly be an improvement.

In conclusion, portfolio theory seems to add very little value by increasing the number of portfolio companies or their distribution across industries. And there is no reason why this shouldn´t be done at an LP-portfolio level instead of a VC-portfolio one.



All in all, Spread and Pray and Money Ball can help individual VC funds perform a little better by reducing volatility and increasing returns. But, only some of the techniques are really useful. I am particularly keen on data-supported decision processes.



Other opinions:

http://venturebeat.com/2012/11/09/startup-algorithm/
http://venturebeat.com/2013/01/10/vc-moneyball-rebuttal/
http://venturebeat.com/2012/12/23/venture-moneyball/
http://online.wsj.com/article/SB10001424127887323384604578326221992355916.html+
http://www.slideshare.net/paulsingh/moneyball-a-quantitative-approach-to-angel-investing-austin-tx-aug-2012