Behavioral economics has seen its mindshare grow significantly in the investing world over the last decade as more and more people have used it as a primary lens for how to think about decision making.
In 2000, well after people like Daniel Kahneman and Amos Tversky began making their contributions but before the concepts wrapped inside the field made their way into every corner of the business world, investor Richard Fuller published a paper titled “Behavioral Finance and the Sources of Alpha” that framed the way competitive advantage is gained in investing and identified 3 primary sources of potential market outperformance:
- Informational — Proprietary access to superior information
- Analytical — The ability to process information more effectively
- Behavioral — The ability to take advantage of behavioral biases and mental mistakes by other market participants
Since that time, highly regarded investors, analysts, and operators across the spectrum (like Howard Marks, Michael Mauboussin, and Tim Ferriss) have latched on to the framework and implemented it into their own process.
While the three sources of alpha laid out by Fuller are quite comprehensive in the world of S-1s and 10-ks, they fail to fully encompass the way that alpha is created in the much more opaque and jagged early stage venture market.
Public Markets vs. Venture Capital
For a multitude of reasons, early stage venture capital remains a completely different beast than public market investing.
Despite a playing field that is leveling over time (thanks to Angellist and the like), informational edges are still major drivers of long term success as strength of networks play a key role in which investors see which deals. Additionally, the lack of well understood first party operational performance data for startups and industry-wide benchmarks has provided an opportunity for firms like Social Capital (via its Analytics tool) to aggregate and exploit proprietary data in unique ways.
And while the venture markets and public markets are full of smart people competing away many analytical edges, moving earlier into the private markets offers more opportunities to be “right and non-consensus” by building deep expertise in emerging sectors and technologies that are poorly understood or overlooked.
On the behavioral side of things, both public and private markets (and any other market on earth) will be ripe for taking advantage as long as humans are key actors. If you need more convincing on how often smart people make bad decisions, I encourage you to spend some time digesting Charlie Munger’s thoughts on the psychology of human misjudgement.
As noted above, while these factors largely encompass the forms of potential competitive advantage in the public markets, they do not entirely cover the path to outperformance for early stage venture investors.
The Fourth Edge
Because the start conditions and early trajectory of a business plays such a major role in where it ultimately ends up and since the right relationship with a single hire, customer or commercial partner can have an outside impact on emerging companies that are desperately seeking product-market fit, there exists a fourth key source of alpha in the world of venture capital that investors have long sought to exploit: Strategic
This started with the Kleiner Perkins “Kieretsu” and evolved to today’s platform and services models pioneered by the likes of First Round Capital and Andreessen Horowitz. Other firms have taken more focused approaches to delivering strategic value to their portfolio companies and, by extension improved investment performance to their LPs. SignalFire’s technology-enabled hiring platform is a good example of this.
At TechNexus, our twist on strategic advantage rests in deep relationships with leading corporate partners across the industrial world who serve as both capital and commercialization partners for the early stage companies we back.
This is true whether we are talking with pre-launch companies looking for the right market to take their technology to or companies further down the path who need to prove value in an adjacent space in order to get in position for a strong Series A round.
Prior to even writing a check, we spend a significant amount of time with each founding team building a clear business case and execution plan for the proposed strategic relationship and leverage a tight feedback loop with the technology and business teams inside our corporate partners to validate the plan. In every case, and before taking an investment from us, we want the teams we back to have a clear, measurable understanding of the value we plan to deliver and a process for keeping everyone at the table (the corporate, the venture, TechNexus) accountable and engaged over the course of the relationship.
This strategic-first approach is our specific edge that allows us to be proactively helpful to the founders we back and the execution team we have built to scope and implement these plans gives us the operational bandwidth to make an impact on each startup we work with.
A Unique Strategic Advantage
As with any source of business advantage, competition (some credible, some less so) eventually moves in looking to stake a claim. This is no different than what has happened in the world of venture capital, which is why “value add investor” has entered the realm of overused, vapid business jargon alongside time tested favorites like “double click” and “win win”.
While firms like First Round and Andreessen Horowitz undoubtedly execute at a higher level than most, many other firms talk a good game despite a structural inability to perform on a similar level and deliver real value across an entire portfolio.
Most firms active in the pre Series A market — especially emerging firms — lack the financial and operational bandwidth as well as a specific strategic edge to take a proactive approach to supporting (and driving real value for) companies during the search for product/market fit.
Put slightly differently, it is tough to build a “platform” with $400k/year in management fees.
Instead, these firms fall into what I’ve previously called the trap of the Steph Curry Fallacy, which is to say that they copy the obvious things about what makes the First Rounds and A16Zs of the world successful without doing the work to dive deeper and develop what could become their own unique strategic edge.
For a long time, investors talking in broad strokes about being “value add” got a free pass, but the runway on that seems to be running out. Today’s founders have learned to see that messaging for the noise that it is and have become more savvy about getting to the signal of what makes a firm or specific investor unique as they determine who they want to work with over the long term.