Micro-Private equity is a new asset class that takes advantage of a systemic dislocation in the venture capital market. The excessive concentration of returns across a small subset of a typical venture portfolio creates this opportunity. Micro-Private equity investments are typically up to $20 million in size with majority ownership positions.
In 2016, venture capitalists invested $69.1 billion into 7,751 companies. Historical data demonstrates that on average 8% of spent venture capital dollars generate 92% of the returns in the asset class. Following this trend, we would expect that only $5.6B of invested capital will drive a vast majority of the returns.
What these statistics are describing is the Venture Capital Power Law. Venture capital is a “Home-run” return model. Across the entire venture market, only a handful of companies drive all the value.
Babe Ruth Effect
Most people recognize Babe Ruth as of the greatest home-run hitters and baseball players of all time. But fewer know that he was also known as the King of Strikeouts. Known for his “all-or-nothing” batting style, Ruth also held one the largest strikeout records in baseball. To “swing” for the fences with every pitch, Ruth overlooked opportunities for doubles and triples.
Every investor in Silicon Valley is an aspiring Babe Ruth wearing a Patagonia vest and blue jeans. Successful venture capitalists appropriately swing hard and focus all their attention on the one or two companies in their portfolio that are likely to outperform. The remaining suffer from neglect or worse, the desire of venture investors to over-invest.
The venture capital is a minority ownership model requiring significant exits to have return impact. Example: assume a $200 million early-stage venture firm owns 15% of a startup by investing $5 million. If the company sells for $200 million, this would be considered a failed outcome from the VC perspective. The return of $25 million only represents a 12.5% impact on the fund. Successful VC firms need billion dollar outcomes to have a chance of returning capital.
So where did $64 billion go?
If only $5.6B of the $70 Billion invested in 2016 drives all the value, then what happens to the rest? These dollars went into trying to prematurely turbo charge startups, scaling them beyond readiness. Swinging hard means pushing investments beyond their capabilities to achieve hyper-growth.
Over-investing can significantly impair a healthy startup. As soon as a promising startup turns to venture capital, they inherit the “go-big or go-home” business model of their investor. Too much money raises the stakes and the pressure on growth.
Common Sins of the “Babe-Ruth Effect” include:
- Prioritizing rapid growth over cash flow
- Funding unsustainable burn-rates
- Financing rounds to get to the next financing
- Prematurely using venture debt
- Over-investing in technology + sales staff
- Inability to raise follow-on capital at higher valuations
- Dysfunctional boardrooms where founders and investors are not aligned
The collateral damage can be staggering. Thousands of founders and entrepreneurs look back only to realize they wasted a good portion of their lives building companies on the VC’s business model, not theirs.
Dislocation in Market
Wheelhouse sees an opportunity in the market where companies are left neglected by their investors’ business model. These companies have differentiated technology, significant revenues, and products that customers love. With proper management, these companies can quickly return to cash-flow profitability and rational capitalization tables.
Within the $64 billion invested annually are hundreds of great product companies waiting to be run and exited profitability.
Most of these organizations are perceived as too early for traditional Private Equity and not eligible for home-run financing by venture investors. With a sturdy base of customers and revenue, these companies can reach steady cash flow, but the fundamentals are masked under significant employee headcount, high expense rates, and challenged capitalization tables.
Wheelhouse is leading a new Private Equity model by gaining majority interest, deploying expert management teams, best-in-class business operations, and advanced digital sales and marketing processes to this underserved market. We believe EBITDA growth is the key to unlocking value. While this is a foreign concept to the Babe Ruth investors, profitable growth is what is needed for these companies to blossom.
2017 Yearbook by the National Venture Capital Association.
Silicon Valley Venture Survey by Fenwick & West LLP