Epistula #5: Betting on Convexity
Resetting expectations for venture capital in a new capital environment
In a world where financial certainty is a rarity, the recent yield achieved by the ten-year U.S. Treasury Bond has caught our attention. The yield has soared to a noteworthy 5%, presenting an investment opportunity that’s hard to ignore. At that level, investors can return 1.6x their capital in 10 years with virtually no transaction or performance expenses by buying and holding one of the world’s safest, most liquid assets. Not too shabby.
The shining performance of the 10-year Treasury Bond casts a shadow on the comparative returns for the venture capital sector. According to Pitchbook data (pg. 23), for the 1999-2013 vintages (i.e., those with at least 10 full years in market), the multiple of dollars distributed to those paid in (DPI) for top quartile venture capital funds only exceeded 1.6x in 5 out of 15 vintages (the median, sadly, only beat 1.6x in 1 out of 15 vintages).
So now that investors have a great way of generating 1.6x without the illiquidity, duration, or costs of venture capital, why should they bother with it?
The Deciens Way
Deciens, and the industry writ large, must strive for much greater performance to justify the challenges associated with being an investor, an LP, in venture capital funds. Otherwise, how can we ask LPs to continue to support our efforts? And how can we satisfy our need to do something useful with our most vital years?
Deciens practices an unorthodox form of venture capital. As we’ve grown and expanded our network, we’ve encountered people who are confused by our iconoclastic approach, especially around portfolio construction. At the same time, many LPs understand and appreciate our approach. Recently, we had the pleasure of seeing one of them, the CIO of a large public pension, who shared with us his belief that Deciens is aligned with 50 Cent’s ethos of “Get Rich or Die Tryin’” – in the spiritual sense.
From our cursory understanding of Mr. Cent’s biography, it seems we have had quite different life experiences. Nevertheless, we do see this LP’s point. VC-backed companies are in the business of getting rich (for their shareholders) or dying in the attempt. Venture capital firms should be on a similar quest to get rich (for their LPs) or die trying, rather than merely existing for the wealth generation of their founders and employees. Thankfully, in venture capital, “death” is generally handled through tidy filings at the Delaware Secretary of State’s office.
The Philosophy of Convexity
In general, venture capitalists invest in opportunities with high convexity – ideally unlimited upside with limited, measurable downside. Each company we invest in could, theoretically, turn into the next Apple, Google, Nvidia, or Microsoft. And because all we can lose is the amount we have invested, we can measure precisely the value at risk and the theoretical downside to which we are exposed.
In this context, we cannot be afraid of backing companies that do not make it. At the same time, this directly contradicts the way that humans are wired. Humans are, for the most part, loss averse; we feel more pain from losing $25 than pleasure from winning $25. This neurological wiring has to be unlearned when thinking in terms of power-law distributed outcomes and securities with convex payoff schedules.
While we are not happy when a company does not achieve our lofty ambitions, we recognize that is a natural outcome of searching for the opportunities with the most potential convexity. We need to be as concerned with upside risk, the risk of not having enough upside in any given portfolio, as we need to be with downside risk, the risk of losing LP capital.
While any given venture investment typically has high convexity, portfolio managers can significantly impact the steepness of their portfolio’s convexity through portfolio construction (i.e., how concentrated or diversified a fund’s capital is). At Deciens, we skew very hard toward concentrating capital. We are in the business of reaching for the potential of extreme outcomes and extraordinary returns. Although constructing diversified portfolios increases “shots on goal,” it also increases the likelihood of mediocrity.
The Art of Engagement and Concentration
A fundamental belief at Deciens is that we derisk our portfolio not by diversification but by engagement – getting hands-on to help build businesses. This risk-management approach reduces the likelihood of downside outcomes without reducing the upside of the portfolio. Our involvement also helps us meter follow-on capital judiciously, allowing us to be smarter in how we concentrate capital. We work tirelessly to find companies, and then, once identified, we lean in to help them achieve their fullest potential.
To borrow from Spinal Tap, we will always turn it to 11. We know this creates increased volatility, but we believe that is a good thing. In navigating volatility, we see the path toward truly differentiated performance. This is especially in light of the need to deliver high multiples of invested capital (on a net basis) to justify the fees, expenses, and illiquidity that an early-stage venture capital strategy asks of its LPs. Increased volatility in markets overall, and in venture capital specifically, suggests that outcomes will be ever more power-law distributed. And to manage in an increasingly volatile world, we increase reserves, especially in an environment where capital is scarce.
We can do this because while we might be extremely concentrated, we see that our LPs are not. The majority of our LPs are highly diversified and do not need more diversification. They need concentration in strategies that have the potential to deliver outstanding returns, ideally in ways that have low correlation to the rest of their portfolios. And because Deciens is designed to let LPs co-invest with us in our breakout portfolio companies at lower fees and carry loads, we can help them add convexity to their portfolios and scale up their capital deployment without creating pernicious incentives that most asset-gathering “venture capitalists” have started to operate with. Doing 3x and 20% IRR over ten years, with illiquidity AND high fee and carry loads, is not good enough in a world where private credit can do 12-15% per year with a 3-5 year lock-up.
The Path Forward
For the better part of a decade, Deciens has been conducting a set of experiments with the goal of creating a VC firm and investment funds that are the most convex in their potential payoffs.
Our convictions are anchored in identifying companies with asymmetric payoffs and pinpointing the necessary characteristics of business models that can achieve this. We structure our investments such that when we find ones that have the desired payoff schedule, we can deploy more capital into them – and we now have a track record of doing so effectively.
We believe that living and not dying are optically the same but, in reality, quite different. Deciens is a grand experiment in living life to the fullest – pushing venture capital to be the best version of itself, pushing us to be the best version of ourselves.
This bold experiment will live on its merits or die trying, the way of so many other experiments. The way of Mr. Cent. This is the only way we can answer the question of “Why bother with venture capital?” to our current and future LPs. And, perhaps more importantly, to ourselves.
