What Venture Capital Can Learn from Private Equity

The venture capital game has changed, yet many VCs are still using an old, outdated playbook

By Peter Rip

Baseball and venture capital always seem to make an effective pairing for analogies. As in baseball, much of the cachet of venture capital is inspired by the romance of the metaphoric grand slam. The recipe has been the same since venture capital began: Find a team, give it money, sit back, and wait for the bloom. Most investments fail. But a few could be big winners and make it all turn out just fine. It used to be said in this business: "You can only lose one times your money." The implication is that winners will pay back the risk many times over.

The reality is that this approach works for an ever-winnowing number of companies, and shockingly few since 2000. The median venture capital fund has seriously underperformed the Russell 2000 Index since 2000. This is a stunning reversal over the prior two decades. What happened? There was a structural change in the game, yet most of the incumbents kept executing the same playbook.

Traditionally that has meant funding disruptive change and managing execution risk. For example, the decision by Kleiner Perkins Caufield & Byers to recruit Eric Schmidt was a masterful way to take the risk out of business execution at Google (GOOG) early on. Closer to my home, my partner, Jim Feuille, led change in our business model when we invested in Pandora Media, changing from a subscription service to free personalized Internet radio. Today, Pandora is the largest radio site on the Web. Managing execution risk at Pandora meant adding measured risk to capture the return of a bigger opportunity.

The classic VC play has always been to take enough risks and you'll be rewarded with the Great Exit, such as a big IPO or acquisition. VCs learned to excel at team selection and the mitigation of execution risk, often considering other risks inherently uncontrollable. Venture capitalists tended to place less emphasis on issues such as valuation, the timing of exits, and future capital availability precisely because you could only lose one times your money.

The Bull Benefit

Great Exits happened from 1982 to 2000 with a regular cadence. The strategy of going for the grand slam in every deal in every portfolio worked often enough during that bull market. The bull market gave public companies more currency to buy startups and often instilled public investors with confidence in the future of small growth companies. There were some spectacular successes among many long-forgotten failures.

The bull market in technology ended with a bang in 2000. Nevertheless, most of the venture capital industry still executes the same playbook, ignoring the public market, which is why the industry has performed so poorly since 2000.

Author Michael Lewis chronicled the success of baseball teams such as the 2002 Oakland Athletics in his book Moneyball. The A's didn't have the funds to buy top athletes, but instead assembled a winning team through a more analytical approach. Statistical analyses included in the book found that ballclubs that simply tried to get a man on base as many times as possible won more games than teams that focused on hitting home runs.

Most investors in venture capital understand that you cannot generate an acceptable rate of return by hitting singles and doubles. What they don't appreciate is that a strikeout is far more destructive when grand slams are fewer and further between. And with fewer grand slams, time also matters. In a secular bear market, that Great Exit may take so long to occur that the drought destroys your internal rate of return.