Last week, Youngrok and I finally launched our episode together on Superclusters. In the midst of it all, we wrestle with the balance between the complexity and simplicity of questions to get our desired answer. Of course, we made many an allusion to the DGQ series. One of which, you’ll find below.
In many ways, I started the DGQ series as a promise to myself to uncover the questions that yield the most fascinating answers. Questions that unearth answers “hidden in plain sight”. Those that help us read between the lines.
Superclusters, in many ways, is my conduit to not only interview some of my favorite people in the LP landscape, but also the opportunity to ask the perfect question to each guest. Which you’ll see in some of the below examples.
Asking Abe Finkelstein about being a Pitfall Explorer and how it relates to patience (1:04:56 in S2E1)
What Ben Choi’s childhood was like (2:44 in S1E6) and how proposing to his wife affects how he thinks about pitching (1:05:47 in S1E6)
How selling baseball cards as a kid helped Samir Kaji get better at sales (45:05 in S1E8)
In doing so, I sometimes lose myself in the nuance. And in those times, which happen more often than I’d like to admit, the questions that yield the best answers are the simplest ones. No added flare. No research-flexing moments. Where I don’t lead the witness. And I just ask the question. In its simplest form.
For the purpose of this essay, to make this more concrete, let’s focus on a question LPs often ask GPs.
“Tell me about this investment you made.“
In my mind, ridiculously simple question. Younger me would call that a lazy question. In all fairness, it would be if one was not intentionally aware about the kind of answer they were looking to hear OR not hear.
The laziness comes from regressing to the template, the model, the ‘what.’ But not the ‘why’ the question is being asked, and ‘how’ it should be interpreted. For those who struggle to understand the first principles of actions and questions, I’d highly recommend reading Simon Sinek’s Start with Why, but I digress.
Circling back, every GP talks about their portfolio founders differently. If two independent thinkers have both invested Company A, they might have different answers. Won’t always be true, but if you look at two portfolios that are relatively correlated in their underlying assets AND they arrive at those answers in the same way, one does wonder if it’s worth diversifying to other managers with different theses and/or approaches.
But that’s exactly what makes this simple question (but if you want to debate semantics, statement) special. When all else is equal, VCs are left to their own devices unbounded from artificial parameters.
Then take that answer and compare and contrast it to how other GPs you know well or have invested in already. How do they answer the same question for the exact same investment? How much are those answers correlated?
It matters less that the facts are the same. Albeit, useful to know how each investor does their own homework pre- and post-investment. But more so, it’s a question on thoughtfulness. How well does each investor really know their investments? How does it compare to the answer of a GP I admire for their thoughtfulness and intentionality?
(Part of the big reason I don’t like investing in syndicates because most outsource their decision-making to larger logos in VCs. On top of that, most syndicate memos are rather paltry when it comes to information.)
The question itself is also a test of observation and self-awareness. How well do you really know the founder? Were you intentional with how you built that relationship with the founder? How does it compare to the founder’s own self-reflection? It’s also the same reason I love Doug Leone’s question, which highlights how aware one is of the people around them. What three adjectives would you use to describe your sibling?
Warren Buffett once described Charlie Munger as “the best thirty-second mind in the world. He goes from A to Z in one go. He sees the essence of everything even before you finish the sentence.” Moreover in his 2023 Berkshire annual letter, he wrote one of the most thoughtful homages ever written.
As early-stage investors, as belief checks, as people who bet on the nonobvious before it becomes obvious, we invest in extraordinary companies. I really like the way Chris Paikdescribes what we do. “Invest in companies that can’t be described in a single sentence.”
Invest in companies that can’t be described in a single sentence
And just like there are certain companies that can’t be described in a single sentence — not the Uber for X, or the Google for Y — their founders who are even more complex than a business idea cannot be described by a single sentence either. Many GPs I come across often reduce a founder’s brilliance to the logos on their resume or the diplomas hanging on their walls. But if we bet right, the founders are a lot more than just that.
Of course, the same applies to LPs who describe the GPs they invest in.
In hopes this would be helpful to you, personally some areas I find fascinating in founders and emerging GPs and, hell just in, people in general include:
Their selfish motivations (the less glamorous ones) — Why do this when they can be literally doing anything else? Many of which can help them get rich faster.
What part of their past are they running towards and what are they running away from?
All the product pivots (thesis pivots) to date and why. I love inflection points.
If they were to do a TED talk on a subject that’s not what they’re currently building, what would it be?
Who do they admire? Who are their mentor figures?
What kind of content do they consume? How do they think about their information diet?
What promises have they made to themselves? No matter how small or big. Which have they kept? Which have they not?
How do they think about mentoring/training/upskilling the next generation of talent at their company/firm?
The DGQ series is a series dedicated to my process of question discovery and execution. When curiosity is the why, DGQ is the how. It’s an inside scoop of what goes on in my noggin’. My hope is that it offers some illumination to you, my readers, so you can tackle the world and build relationships with my best tools at your disposal. It also happens to stand for damn good questions, or dumb and garbled questions. I’ll let you decide which it falls under.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.
Earlier this week, I was listening to a fascinatingly thoughtful conversation between Tim Ferriss and Kindred’s Steve Jang, where Tim said one line that stood out in particular: “I’ve been paying a lot of attention, but I’ll be honest, I don’t know how to pay proper attention.”
And well, it got me thinking. About the difference between knowing what to look at and knowing how to look at it.
One of my favorite TED talks is by Will Guidara (quite honestly I think it deserves more views on YouTube than it has). Will is probably best known for co-founding one of New York’s hottest fine dining restaurants, Eleven Madison Park, and for writing the book, Unreasonable Hospitality. And in it, he talks about how just listening to the conversations that are happening at the tables and delivering these small, unexpected pockets of joy can create experiences that transcend money and time.
In the afore-mentioned talk, he talks about how there are four diners at Eleven Madison Park. That they went to all the top restaurants in NYC. Le Bernardin. Per se. And so on. And Eleven Madison Park was the last on their to-do list. But the only regret they had was that they never got to try a New York hot dog. Of course, upon hearing that, Will storms out the door to buy a $2 dog, brings it back to the kitchen and convinces the chef to serve it over the aged duck that took years to perfect. And when he finally delivered the next course on the menu as the hot dog he just bought, the four guests went bonkers. That despite on the multiple courses and the brilliant food, that their favorite dish was the NYC hot dog.
That it was because Will paid proper attention to his guests that he was able to deliver a truly unforgettable experience.
The truth is how to pay proper attention to anything that deserves our attention is the million-dollar question.
Paying proper attention
There’s the famous selective attention test, where viewers are asked to count the number of times the ball is being passed between the players, only to fail to realize that there is gorilla that walks across the screen. We’re told to pay attention to the ball passes, but only by paying proper attention to the purpose of why the test is being administered, do we catch what is hiding in plain sight.
Similarly, Raymond Joseph Teller (or better known for being half of the dynamic magic duo Penn & Teller) did a fascinating talk a decade and a half ago about the illusion of expectation. That magic in all of its novel facets feeds off of the expectations of its onlookers. When one tries to pay attention to the coins that are “magically” jumping from one hand to the next, you might fail to catch the sleight of hand in between. But only after he reveals his secrets is the simple magic act all the more impressive. In other words, in the second half, he teaches you how to pay proper attention.
If you have eight minutes in your day, would highly recommend watching the below video.
I can’t speak for every topic, industry, relationship, and so on out there, but at least for the cottage industry of venture capital, why I choose to write an angel or an LP check is similar. I don’t really look for what will change. ‘Cause damn, it’s so hard to predict what will change and how things will change. If I knew, and if one day, I know, please invest in my public markets fund, which will be the best performing fund of all time. But I don’t. We, as pundits sitting around the table, might draw predictions. But even the smartest of us (not sure why I say us, ’cause not sure if I can put myself in that category yet) would be lying if we knew what would happen in foresight.
Instead, I look at what doesn’t change.
What doesn’t change?
The great Charlie Munger passed away last week at the age of 99. And without question, a great loss to the world we live in today. Just half a year prior, he and Warren Buffett were hosting their 2023 annual meeting. And just two weeks prior, he was still doing CNBC interviews. And one of my favorite lines from that May annual meeting was:
“Well, it’s so simple to spend less than you earn, and invest shrewdly, and avoid toxic people and toxic activities, and try and keep learning all your life, et cetera, et cetera, and do a lot of deferred gratification because you prefer life that way. And if you do all those things, you are almost certain to succeed. If you don’t, you’re going to need a lot of luck. And you don’t want to need a lot of luck. You want to go into a game where you’re very likely to win without having any unusual luck.”
In reducing the requirement to need luck, one of the most effective ways to find what is constant in life. That despite changing times and technologies, these stay true. Or as Morgan Housel and Naval Ravikantput it, If you lived your life 1000 times, what would be true in 999 of them? In investing jargon, pattern recognition. Across my investments and more, where have I seen outperformance? What characteristics do they all share? What about human nature won’t change?
In fairness, pattern recognition gets a bad rap. And for a lot of investors, that’s because they choose to only invest in their comfort zone, and what they know best. Their former colleagues. Their Stanford GSB classmates. People who look like them, think like them, act like them. But recognizing thematic threads stretch across all facets of our life. We learn that not brushing our teeth well can lead to cavities. We learn that after stubbing our toe on the kitchen counter numerous times, we take a wider turn before turning into the kitchen. And we learn that eating piping hot foods kills your tastebuds for the next few days.
The venture corollary
In venture, we’re always taught to look at the team, product, and market. And that all are important. But if you tell a new grad or an ex-founder or an emerging angel to do just that. To them, that means nothing. They wouldn’t know how to judge. They have no benchmarks, nor do they know what’s right versus wrong. Now I don’t want to sound like a broken record, but I do believe previous blogposts like this and this are quite comprehensive for how I pay proper attention as an investor.
Emerging LPs are not immune to the lack of perspective as well. My hope and my goal is for how to be just as important if not more than the what. And for the why to be just as or more important than the how. It’s because of that, I write essays like this and this. And of course, it’s why I started Superclusters because I, too, am looking for how to pay proper attention to the next generation of venture investors. (Stay tuned for the coming Monday for episode four where we unpack the bull and bear case of early distributions in a fund!)
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.
Some of you reading here are busy, so we’ll keep this top part brief, as an abstract sharing our top three observations of leading fund managers.
Generally speaking, don’t sell your fast growing winners early.
Except when…
Selling on your way up may not be a crazy idea.
You might sell when you want to lock in DPI. Don’t sell more than 20% of your fund’s positions unless you are locking in meaningful DPI for your fund. For instance, at each point in time, something that’s greater than 0.5X, 1X, 2X, or 3X of your fund size.
You might consider selling when you’ve lost conviction. Consider selling a position when you feel the market has over-priced the actual value, or even up to 100% if you’ve lost conviction.
You might consider selling when one is growing slower than your target IRR. If companies are growing slower and even only as fast as your target IRR, consider selling if not at too much of a discount (Note: there may be some political and/or signaling issues to consider here as well. But will save the topic of signaling for another blog post).
Do note that the above are not hard and fast rules. Every decision should be made in context to other moving variables. And that the numbers below are tailored to early-stage funds.
Net TVPI Benchmarks from Years 5-15Net DPI Benchmarks from Years 5-15
Let’s go deeper…
On a cloudless Friday morning, basking in the morning glory of Los Altos, between lattes and croissants, between two nerds (or one of whom might identify as a geek more than a nerd), we pondered one question:
Everyone seems to have a financial model for when and how to invest, but part of being a fiduciary of capital is also knowing when to distribute – when to sell. When RVPI turns into DPI. And we haven’t seen many models for selling yet. At least none have surfaced publicly or privately for us. The best thought piece we’ve seen in the space has been Fred Wilson’s Taking Money “Off the Table”. At USV, they “typically seek to liquidate somewhere between 10% and 30% of our position in these pre-IPO liquidity transactions. Doing so allows us to hold onto the balance while de-risking the entire investment.”
As such, it gave birth to a thought… What if selling was more of a science?
What would that look like?
Between two Daves, it was not the Dave with sneakers and a baseball cap and with the profound disregard to healthy diets, given the fat slab of bacon in his croissan’wich, who had the answer there.
“To start off, in a concentrated portfolio of 30 investments, a fund returner is a 30x investment. For a 50-investment fund, it’s 50x. And while hitting the 0.5x DPI milestone by years 5-8, and a 2x DPI milestone by years 8-12, is the sign of a great fund, you shouldn’t think about selling much of your TVPI for DPI unless or until your TVPI is starting to exceed 2-3x.” Which seems to corroborate quite well with Chamath Palihapitiya’s findings that funds between 2010 and 2020 convert have, on average, converted about 25% of their TVPI to DPI.
“Moreover, usually you shouldn’t be selling more than 20% of the portfolio at one time (unless you’re locking in / have already locked in 3X or more DPI). You should be dollar-cost averaging – ensuring time diversity – on the way out as well. AND usually only if a company that’s UNDER-growing or OVER-valued compared to the rest of your portfolio. Say your portfolio is growing at 30% year-over-year, but an individual asset is growing slower at only 10-20% OR you believe it is overvalued, that’s when you think about taking cash off the table. Sell part (or even all) of your stake, if selling returns a meaningful DPI for the fund, and if you’re not capping too upside in exchange for locking in a floor.”
Meaningful DPI, admittedly, does mean different benchmarks for different kinds of LPs. For some, that may mean 0.25X. For others that may mean north of 0.5X or 1X.
“On the other hand, if a company is outperforming / outgrowing the rest of the portfolio, generally hold on to it and don’t sell more than 10-20% (again, unless you’re locking in meaningful DPI, or perhaps if it’s so large that it has become a concentration risk).”
I will caveat that there is great merit in its counterpart as well. Selling early is by definition capping your upside. If you believe an asset is reaching its terminal value, that’s fine, but do be aware of signaling risk as well. The latter may end up being an unintended, but self-fulfilling prophecy.
So, it begged the question: Under the assumption that funds are 15-year funds, what is meaningful DPI? TVPI? At the 5-year mark? 7.5 years in? 10 years? And 12.5 years?
The truth is the only opportunities to sell come from the best companies in your portfolio. And probably the companies, if anything, you should be holding on to. By selling early, you are capping your downside, but at the same time capping your upside on the entire portfolio. When the opportunity arises to lock in some DPI, it’s worth considering the top 3-5 positions in your fund. For instance, if your #2 company is growing quickly, you may not be capping the upside as much.
Do keep in mind that sometimes it’s hard to fully conceptualize the value of compounding. As one of my favorite LPs reminded me, if an asset is growing 35% year-over-year, the last 20% of the time produces 56% of the return. Or if an asset is growing 25% YoY, if you sell 20% earlier (assuming 12 year time horizons), you’re missing out on 45% of the upside.
As a GP, you need to figure out if you’re IRR or multiple focused. Locking in early DPI means your IRR will look great, but your overall fund multiple may suffer.
As an LP, that also means if the gains are taxable (meaning they don’t qualify for QSBS or are sold before QSBS kick in), you need to pay taxes AND find another asset that’s compounding at a similar or better rate. As Howard Marks puts it, you need to find another investment with “superior risk-adjusted prospective returns.”
And so began the search for not just moolah in da coolah, but how much moolah in da coolah is good moolah in da coolah? And how much is great?
Net TVPI Benchmarks from Years 5-15Net DPI Benchmarks from Years 5-15
Some caveats
Of course, if you’ve been around the block for a minute, you know that no numbers can be held in isolation to others. No facts, no data points alienated from the rest.
Some reasons why early DPI may not hold as much weight:
Early acqui-hires. Usually not a meaningful DPI and a small, small fraction of the fund.
There’s a possibility this may be the case for some 2020-2021 vintages, as a meaningful proportion of their portfolio companies exit small but early.
In other words, DPI is constructed of small, but many exits, rather than a meaningful few exits.
TVPI is less than 2-3x of DPI, only a few years into the fund. In other words, their overall portfolio may not be doing too hot. Obviously, the later the fund is to its term, the more TVPI and DPI are alike.
As a believer in the power law, if on average it takes an outlier 8 years to emerge AND the small percentage of winners in the portfolio drive your return, your DPI will look dramatically different in year 5 versus 10. For pre-seed and seed funds, it’s fair to assume half (or more) companies go to zero within the first 3-5 years. And in 10 years, more than 80% of your portfolio value comes from less than 20% of your companies. Hell, it might even be 90% of your portfolio value comes from 10% of your companies. In other words, the power law.
GPs invested in good quality businesses. Some businesses may not receive markups, but may be profitable already, or growing consistently year-over-year that they don’t need to raise another round any time soon.
Additionally, if you haven’t been in the investing game for long, persistence of track record, duration, and TVPI may matter more in your pitch. If you’ve been around the block, IRR and DPI will matter more.
As the great Charlie Munger once said, “selling for market-timing purposes actually gives an investor two ways to be wrong: the decline may or may not occur, and if it does, you’ll have to figure out when the time is right to go back in.” For private market investors, unless you can buy secondaries, you’ll never have a time to go back in until the public offering. As such, it is a one-way door decision.
Some LPs are going to boast better portfolios, and we do admit there will be a few with portfolios better than the above “benchmarks.” And if so, that’s a reason to be proud. In terms of weighting, as a proponent of the power law, there is a high likelihood that we’ve underestimated the percent of crap and meh investments, and overestimated the percent of great investments in an LP’s portfolio. That said, that does leave room for epic fund investments that are outliers by definition.
We do admit that, really, any attempt to create a reference point for fund data before results speak for themselves is going to be met with disagreement. But we also understand that it is in the discourse, will we find ourselves inching closer to something that will help us sleep better at night.
One more caveat for angels… The truth is as an angel, none of the above really matter all that much. You’re not a fiduciary of anyone else’s capital. And your time horizons most likely look different than a fund’s. It’s all yours. So it’s not about capping your downside, but more so about capping your regret. In other words, a regret minimization framework (aka, “spouse regret/yelling minimization insurance”).
That will be so unique to you that there is no amount of cajoling that we could do here to tell you otherwise. And that your liquidity timelines are only really constrained by your own liquidity demands.. For instance, buying a new home, sending kids to college, or taking care of your parents (or YOU!) in their old age.
But I do think the above is a useful exercise to think through selling if you had a fund. You would probably break it down more from a bottoms up perspective. What is your average check size? Do you plan to have a concentrated portfolio of sub-30 investments? Or more? Do you plan to follow on? How much if so? And that is your fund size.
In closing
Returning above a 3x DPI is tough. Don’t take our words for it. Even looking at the data, only 12.5% of funds return over a 3x DPI. And only 2.5% return three times their capital back on more than 2 separate funds.
In the power law game we play, as Michael Mauboussin once said, “A lesson inherent in any probabilistic exercise: the frequency of correctness does not matter; it is the magnitude of correctness that matters.” Most will return zero, or as Jake Kupperman points out: More than 50%.
But it’s in the outliers that return meaningful DPI, not the rest. Not the acqui-hire nor really that liquidation preference on that small acquisition.
At the end of the day, the goal isn’t for any of the above to be anyone’s Bible, but that it’d start a conversation about how people look at early returns. If there is any new data points that are brought up as a result of this blogpost, I’ll do my best to update this thread post-publication.
Big thank you to Dave McClure for inspiring and collaborating on this piece, and to Eric Woo and all our LP friends who’ve helped with the many revisions, sharing data, edits, language and more. Note: Many of our LP friends chose to stay anonymous but have been super helpful in putting this together.
Footnotes
For the purpose of this piece, we know that “good” and “great”, in fact all of the superlative adjectives, are amorphous goalposts. And those words may mean different things to different people. This blogpost isn’t meant to establish a universal truth, but rather serve as a useful reference point for both LPs, looking for “benchmarking” data, and GPs to know where they stand. For the latter, if your metrics do fall in the “good” to “great” range, they’re definitely worth bragging about.
And so with that long preamble, in the piece above, we defined “good” as top quartile, and “great” as top decile. “Good” as a number on its own, enough for an LP to engage in a conversation with you. And “great” as a number that’ll make LPs running to your doorstep. Or at least to the best of our portfolios, leveraging both publicly reported and polled numbers as well as our own.
Our numbers above are also our best attempt in predicting steady state returns, divorcing ourselves from the bull rush of the last 3-5 vintage years. As such, we understand there are some LPs that prefer to do vintage benchmarking, as opposed to steady state benchmarking. And this blogpost, while it has touched on it, did not focus on the former’s numbers.
EDIT (Aug 18, 2023): Have gotten a few questions about where’s the data coming from. The above numbers in the Net DPI and Net TVPI charts are benchmarks the LPs and I agreed on after looking into our own anecdotal portfolios (some spanning 20+ years of data), as well as referencing Cambridge data. These numbers are not the end-all-be-all, and your mileage as an LP may very much vary depending on your portfolio construction. But rather than be the Bible of DPI/TVPI metrics, the purpose of the above is give rough reference points (in reference to our own portfolios + public data) for those who don’t have any reference points.
Stay up to date with the weekly cup of cognitive adventures inside venture capital and startups, as well as cataloging the history of tomorrow through the bookmarks of yesterday!
The views expressed on this blogpost are for informational purposes only. None of the views expressed herein constitute legal, investment, business, or tax advice. Any allusions or references to funds or companies are for illustrative purposes only, and should not be relied upon as investment recommendations. Consult a professional investment advisor prior to making any investment decisions.
