Venture Unlocked Shorts: Why VC has gone mainstream and the parallels to private equity and hedge funds

0:00Welcome back to another episode of Venture Unlocked, the podcast that takes you behind the scenes of the business of venture capital. As we continue to grow Venture Unlocked after three years, we're now going to release short conversations highlighting a specific point of view of a guest. These points of view may have come through a tweet, an article they wrote, or a conversation, and our goal is to unpack these interesting views in short form. Our first guest in this format is Ed Sutt, founder and managing partner of Alpine Ventures. Prior to starting Alpine, Ed was at Goodwater Capital. Recently, Ed tweeted something that I thought was particularly interesting, and it was around how venture capital is going mainstream, and it drew some of the parallels to VC, to other asset classes such as private equity and hedge.

0:42I wanted to go deeper into his tweet, which we did during our short conversation. I really hope you enjoy it. Samir Kaji is the CEO and co-founder of Allocate. Allocate and Venture Unlocked are independent of each other. Any statements or references made by Samir or his guests regarding third parties, investments, or securities are solely their views and opinions and are not intended as investment advice or an endorsement of such parties or securities by Samir, his guests, or Allocate. Allocate or its clients may maintain relationships with or investment positions in guests, third parties, or securities mentioned in this podcast.

1:16This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Ed, thanks for doing this. Thanks, Samir. Glad to be on. And this is part of a new format related to something topical. And you had a tweet, I want to say a couple of weeks ago, and it was this concept that venture is now mainstream. And you made some parallels related to private equity and hedge and those markets and the maturation, the evolution of those type of asset classes. And there was a lot of comments and it was actually a really interesting tweet. So I want to maybe go back to what was the inspiration and what parallels do you see with venture relative to some of those other asset categories?

2:00So I've been a longtime student of investing, not just venture, but the whole alternative asset industry, including private equity, buyouts, hedge fund, et cetera. And it's been striking to see how much venture has grown scaled as an asset class over the last 10, 15, 20 years. And I think it's, you know, post 2021, it's really come into its own as a more mainstream asset class. There's a lot more awareness of it as an industry outside of tech circles, and much more willingness and propensity for different types of investors, including non-institutional investors to be much more interested in it.

2:40And so it came from a lot of thoughts around that. And one of the things that was striking to me was just how eerie there were in terms of similarities between how venture firms were scaling and evolving and diversifying in very similar ways to the way that private equity and hedge funds have done as well. So there are a few things I'll note. One is just how much those industries have scaled over time. Once upon a time, the private equity buyout industry was relatively small, just a cottage industry of a handful of players like KKR, Blackstone, et cetera, that were all generalist and fairly small funds.

3:19Same thing with hedge funds. But now you've seen a maturation of those sectors where there are a number of players that are public, that are very diversified, global, managing trillions of dollars of assets. And I think venture is going to undergo somewhat of a similar trend where over time you'll see, I imagine players that become global, that become diversified, that become maybe even public over time. And the industry as a whole will grow. Now, what does that mean as a whole? One of the ramifications of that is that it's going to be harder and harder to differentiate and drive alpha. So once upon a time, it was relatively easy to drive returns in venture given all the funds were fairly small.

4:04There wasn't much competition for deals. And so everyone could afford to be a generalist and afford to take their time and not really specialize. And candidly, it wasn't that difficult to drive returns relatively. Now it's become a lot harder where a lot of the things that used to differentiate firms, things like portfolio services, building brand and marketing, being founder friendly, et cetera, those are all table stakes today. And pretty much every venture firm does some combination of all those. And so it's become increasingly harder to specialize and to become differentiated. Let's maybe distill down a little bit more into that.

4:45So going back to this parallel in private equity, I think it's a great example because you did have a smaller group of firms that fundamentally were generalists and more or less looked the same. But there was just so many opportunities that even if there were competitive competition for deals, there was enough deals to go around where you can drive alpha. You look at venture 80s and 90s in particular, very little capital up until kind of the tail end of the dot-com bubble. And then over the last decade in particular, we've seen an explosion both in the number of firms, but also the amount of capital that's been deployed by LPs into firms and also firms deploying into technology startups post, let's call it Amazon Web Services, cloud and mobile.

5:34And one of the things that has happened in private equity is that you've had clear fragmentation, right? You have middle market, you have large funds, you have lower middle market, and you've had this mass segmentation. It does appear that venture has also gone through this fragmentation, the big mega cap players, the niche players, the seed funds. And you had, I think, indicated in the tweet that there was this quote by Doug Leonor of Sequoia where he was looking back maybe 20, 30 years ago and saying venture used to be, as you mentioned, a artisanal business with fewer firms, smaller funds. And there was really high margin.

6:16And now we're kind of into a low margin, which speaks or at least implies that there's less alpha and there's more beta. As an investor in venture, knowing that private equity is still heavily funded both by institutional and non-institutional investors, if venture continues down this arc of growing to where private equity and hedge have done, where is alpha? And then what is this comment about low margin businesses? Because obviously, low margin is not what you're looking to get in venture, typically. That's right. So to clarify, I don't think that there's no alpha in venture, much like on the buyout side, there are still pockets of types of firms, whether they're in specific sectors of specialization, or they're in the lower middle market area where there is continued alpha as a whole.

7:05And that industry, you know, has, it still exists and it still thrives very well. There's still a place for venture in an institutional allocator's portfolio, but the nature of that has changed a lot. So like you mentioned, I think the industry has, and will continue to further bifurcate over time. On one end of the spectrum, you'll have, let's call them beta parts of the market. So very, very large funds that are well diversified, that have very stable and sticky pools of LP bases that are global, that invest across stages, that invest across sectors. For those funds, the nature of what LPs expect from those firms is quite different than what they expect from call it emerging manager venture firms.

7:50For those funds, they're trying to provide more stability and returns and more stable exposure to tech and tech innovation. So it's kind of a different game than what the traditional venture industry was all about. And so you have a handful of players, I think, that will continue to be these asset aggregation machines that will provide very stable sources of exposure to early stage innovation and late stage innovation in tech. On the other end of the spectrum, you have the emerging manager pocket within venture. And that's also undergone a big explosion in the last few years, and I think we'll continue to do so.

8:33It's a more volatile segment, but that's where you can still get true alpha and true differentiated returns and very, very high impact and high upside. And it comes from a few things. One is structural. Those funds tend to be smaller. So mathematically, it's easier to return smaller funds and larger funds and achieve higher returns there. Those firms also tend to be more specialized. Many of them are sector specialists or geo specialists or some combination of those. And so by specializing and developing expertise in one area, they have an above average probability of backing the winners in that particular segment.

9:13So that also drives returns. And then finally, culturally, a lot of these newer firms just frankly work harder and drive faster than the old incumbents. Oftentimes they're solo GPs. They make decisions very quickly. They work incredibly hard. They hustle really hard. And that also goes a long way and I think is sometimes overlooked as a factor in driving returns too. So I want to run something by you because I do think when we, and of course, Twitter and LinkedIn are not necessarily a great sort of indicator of what reality is sometimes. But it does seem that we've seen the demonization in some ways of larger funds, an emerging manager, Twitter saying, well, why would you ever invest in a bigger firm?

9:59And you hit on something that we talk about a lot internally, which is venture capital is no longer a monolith, and there are almost sub-asset categories or sub-products within the spectrum of venture capital. And if you think about a traditional barbell, so on the right end of the barbell, some of these larger firms, well, the characteristics of those are probably lower volatility, but it comes with lower return potential because it's hard to return a 5x on a$3 billion fund because mathematically, unless you're in a Stripe or one of those companies with high ownership, it's really just hard to get that.

10:38But at the same time, your band of returns is probably a little bit narrow in terms of both on the downside and the upside. And on the other corner of the market, you know, the let's call it the sub$100 million funds, which there are a lot by number, right? So if you think about just raw numbers, that's where it's the fat tail of the market. In that situation, the way we view it is, yes, you can get that height and upside when it comes to cash on cash returns. But by very definition, you're going to have much more volatility and a higher standard deviation of returns, both on a firm basis, but also across the firms.

11:13And I've gotten some pushback on that where people are saying, well, no, look, these are more risky. And I just don't think that's true. They are more risky because the bigger funds to me tend to be more like indexes. A lot of those funds are in the series B and later because they're reserving much more. and here you have companies that you're backing from a seed standpoint or seed fund standpoint where it's inception phase, there's more variables that can happen throughout the course of the company's life cycle that could impact returns in a meaningful way as we're seeing right now. Does that map to what you also believe?

11:51Yeah, that's totally right. And you're right that at least in the Twitterverse, there's been a little bit of a demonization of larger venture firms, or it's become popular to make fun of them. But like you said, the reality is they're incredibly sophisticated firms. Many of them drive very, very strong returns, even for their size. You know, I think we need to pay our respects to the firms that have built those big platforms. And you're also right in that venture is no longer a monolith. And I think it's perhaps inaccurate to bucket all of these different firms into one asset class because the fundamental nature of the styles of investing, the return profiles, the risks are very, very different.

12:34A$10 million pre-seed fund one is fundamentally a totally different, almost a different asset class than a multi-billion dollar multi-stage manager that's on a fund 10 or above. And so the returns and risk profile also reflect that. And you're totally right in that. What's often lost when evaluating the emerging manager bucket is how important manager selection is or building a portfolio that's diversified enough to capture that upside, but also mitigate some of the downside risk. In much the same way that on the venture side, we fundamentally think of pre-seed or seed stage investing as very different than growth investing that are analogs on the LP side and how they should evaluate different venture firms.

13:22I agree with that. And ultimately, the way we think about it from an LP perspective is on the emerging manager, let's call it sub$200 million funds that have the alpha high-end potential where you have more volatility and standard deviation, it's a discovery and diligence exercise. Whereas at the top end, it's more of an access exercise. Can you actually get into those funds? Now, going back a little bit to where we started this conversation, probably a good place to end the conversation is this parallel with other asset categories. And we've seen those evolutions. Those other industries are much bigger.

14:01If you look at the size of the hedge fund market, you look at the size of the private equity market when it comes to buyout. It's much, much larger than what the venture market is, despite the growth that we saw in 2021. Where are we in that evolution relative to where private equity was maybe 10 years ago? And what do you think are the main themes that we'll see over the next few years in the continued evolution of venture going mainstream and mapping back to the parallels to PE and hedge? Yeah, so I think we're still pretty early overall in terms of where venture is in that life cycle. I think 21 was somewhat of a local maximum, but much like if you track it to parallels on the private equity side, that's also had boom and bust cycles.

14:46In the 80s, there was a big boom cycle with the junk bond market evolving and it had a bit of a bust. The GFC was a big bust for a lot of buyout firms, but over time it's monotonically increased in terms of size and scale. So I think venture will do the same. I don't know if it'll ever get as big just because it's very concentrated in the singular industry within technology. But I think we'll continue to see growth as a whole. I don't think that we're at a global maxima or even close to that in terms of how large the venture asset class can be, as well as the largest players. In terms of some of the themes, I won't speculate on specific verticals so much, but more just maybe structurally where I see the industry going.

15:32On one hand, I think you'll see the bigger players continuing to compound, continuing to be really aggressive, particularly in expanding outside of traditional minority equity investing. So, you know, one of the things that was in the news recently was General Catalyst, a very prominent multi-stage firm, buying a hospital as part of their healthcare practice and expanding their expertise in healthcare as a vertical. I think we'll see plays like that, that maybe on the surface look a little off in terms of what you'd expect from a traditional venture firm and diversification, but they will align with an overall strategy in driving and scaling innovation powered by technology.

16:16And I think we'll continue to see things like that over time. It's a really interesting point. And I agree with you. I mean, this actually happened with a lot of the PE firms that started to establish new types of products that were non-core to, let's call it a traditional buyout, whether it was GP staking, whether it was credit funds that people were launching. Of course, the Aries and the Apollos of the world. GC is a great example because this was in the news, where on the surface, that doesn't look like a VC deal. It's not a minority stake. It's hospital. It's not traditional. But then you read into it and there is actually a really interesting reason for them to go down that route.

16:54And it speaks to the continued maturation of firms like that that are multi-product. I mean, GC also had a credit fund that was doing credit type of facilities that were a little bit nuanced and interesting, but providing capital to companies in a way that wasn't primary equity. And so I really appreciate you coming on. You know, it was a really interesting tweet. And as somebody that spends a lot of time thinking about venture and the parallels in venture to what we've seen historically with other asset classes, I totally agree with it. For those that, you know, are listening here, Ed, where can they find you?

17:31Yeah, so my email is ed at alpine.vc. I also tweet fairly regularly. So I'm just edsaw on Twitter. I'm open to always meeting with interesting founders, prospective LPs, and other folks in the ecosystem. I love learning and I love meeting interesting people. So always down to meet folks. All right. Well, sounds good, Ed. Thanks again for being on. Yeah, thanks, Samir, for having me. Thanks so much for listening to another episode of Venture Unlocked. We really hope you enjoyed our conversation with Ed. To learn more about him, be sure to go to the Venture Unlocked Substack at ventureunlocked.substack.com, where you'll find detail notes of the show and a listing of past episodes.

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18:41Thank you.