This blog post was written in collaboration with one of my partners at Spur Capital, Paul Gompers. It is a delight to work with Paul as he is widely respected in the venture capital community and his professional and personal accomplishments seem endless. Paul’s research on the topic of performance persistence in entrepreneurship was used throughout this blog post. We hope you enjoy it.
Performance persistence in entrepreneurship plays a significant role in the success of start-ups. Academic research has demonstrated that successfully exiting a venture-backed start-up is a strong predictor of the likelihood that the entrepreneur’s next start-up will also generate attractive returns. Consequently, top venture capitalists often have a strategy of actively attracting previously successful entrepreneurs for potential investments, positively impacting their investment performance. And, in a virtuous cycle, successful venture capital firms are more likely to have better deal flow in subsequent investments (1).
As recent research surveying top venture capitalists has shown, perhaps the most important ingredient for success as a venture capitalist is consistent and robust deal flow (2). In the long run, venture capitalists with strong access to high-quality entrepreneurs are more likely to outperform VC firms with “less access” to the best start-ups. While “venture capitalists do add value to startups through the provision of mentoring and monitoring, the persistent differences in performance across VC firms appear to stem more from firms that have become known for their past success having better access to future sought-after deals than from the better ability of VC firms to select and nurture startups to success (3).”
When thinking about performance persistence amongst entrepreneurs, Paul Gompers (Harvard Business School Professor and Managing Director at Spur Capital Partners), states that a successful venture capital-backed entrepreneur has a 30% chance of succeeding in her next company. This is due to two important skills that successful entrepreneurs tend to exhibit: general management ability and market-timing skills. Entrepreneurs who are skilled at market-timing know which sectors are likely to be attractive in the future and are adept at starting and exiting firms at opportune times. Alternatively, some entrepreneurs are talented managers who can set strategy and assemble talented teams. Others have argued that past success creates a “halo” effect. This halo effect allows previously successful entrepreneurs to attract resources and people that believe in their ability to succeed. This belief that successful entrepreneurs are more skilled at managing others can induce real performance persistence (3).
Academic research has also shown that previously successful entrepreneurs have a 32.2% chance of succeeding in their next venture when funded by more experienced venture capital firms, and a 31.6% chance of succeeding when funded by less experienced venture capital firms. While the impact that venture capital firms make on previously successful entrepreneurs is nearly the same, the experience of the venture capital firm for first-time and serial entrepreneurs with histories of failure, is meaningfully different. See chart below:
Fig. 1: Probability of Success for First Time and Serial Entrepreneurs w/History of Failure
Persistence of Returns at the Fund Level
Additional research has focused on persistence of returns at the fund level. This research has attempted to identify which “asset classes” have the strongest pattern of persistence from one fund to the next and has shown that venture capital firms have exhibited the highest levels of persistence within private equity and across all asset classes (4). Venture capitalists spend time cultivating their reputation, building their networks, and proactively reaching out to the best entrepreneurs. These efforts create high quality deal flow and the ability to generate value through sourcing and selecting. Top performing venture capital investors highlight the critical importance of having access to the best deals as one of the key reasons that performance persistence exists in venture capital, but not among publicly traded funds. Why? Investment firms who are investing in public equities need not compete for access to deals.
A unique characteristic of venture capital investment performance is the high dispersion of returns. According to Blackrock Investment Institute, the net IRR interquartile spread was 30% for venture capital. Between 2004 and 2016 upper quartile venture capital funds earned approximately 27% while the lower quartile threshold was -3%. For publicly traded equity managers the spread was roughly 18%, upper quartile of 15% vs. lower quartile of 3%. High dispersion in fund returns implies that investors are rewarded for picking the right managers within venture capital much more than they are for manager selection in public equities or other asset classes (5).
Achieving top quartile performance is not random, but rather correlated with a firm’s level of access to investment opportunities, strength of relationships with entrepreneurs and management teams, ability to capture the best business plans and tap strategic investors, and first-hand operating experience in building and strengthening businesses, to name a few factors (6). Many of these attributes are hard to quantify and identifying which managers possess these skills takes deep industry knowledge and connections.
Performance persistence in entrepreneurship and venture capital is well documented and creates an important tiered structure in the industry. Access to these groups of entrepreneurs and identifying those that are likely to succeed in the future is critical to building a successful investment platform in the industry.
In the same way that selecting entrepreneurs is important for venture capital firms, selecting the right venture capital firms is important for fund-of-funds managers. At Spur, our success in selecting funds that consistently outperform has been driven by our deep understanding of the value creation process, a broad view of the investment universe, the diversity of our experience, our long-standing relationships with fund managers, and reputation as thought leaders within early-stage venture investing.
Contributors: Kevin Moore and Paul Gompers, Spur Capital Partners
- The Persistent Effect of Initial Success: Evidence from Venture Capital
- How Do Venture Capitalists Make Decisions
- Performance Persistence in Entrepreneurship
- Private Equity Performance: Returns, Persistence, and Capital Flows
- Blackrock Investment Institute
- Private equity: Characteristics and implementation considerations