Is it worth being contrarian in a consensus driven world?
Perception vs reality in Venture Capital
We are always told that the best investors are contrarian in their thinking and that the outlier investments that drive returns are often non obvious bets. But with such long feedback cycles in the world of venture capital, perceived success is often what keeps firms going until they are proved right and the returns come rolling in..
So how do you stay truly contrarian in your thinking, to give yourself a chance of asymmetric upside, whilst also playing the game on the field so to speak?
Love it or hate it, venture is largely a self congratulatory, image driven business these days. Vanity metrics, TechCrunch articles and funding announcements rule the day.
Incentives are what drive human behaviour - so what are the incentives at play in the venture world?
VCs are looking to prove to their LPs that they are good at their job by identifying and investing in the outlier startups of any given cohort. They need to point to something within a 3 year time horizon that show that they are on the right track, as year 3 is when they need to raise their next fund. Thats a tough ask when we know that it often takes 10+ years for a company to exit.
So unsurprisingly VCs look for metrics that indicate future success in the absence of actual success. This manifests in the form of follow-on funding rounds, debt raises, product launches, markups, increased paper returns. The more media hype you can develop around these milestones the more things you have to point your LPs towards when it comes time to raise the next fund.
Investing in hot companies, alongside brand name investors is often perceived as more important than focussing on the metrics that drive actual returns to LPs - entry price, ownership, business fundamentals, a path to exit etc.
This drives our industry to focus on vanity metrics that indicate perceived success rather than actual. VCs end up chasing companies in sectors that are in vogue - founders with shiny profiles - which in turn hopefully leads to more funding announcements, more press and eventually more mark-ups and greater internal paper gains (TVPI, IRR), in the absence of exits and DPI.
The problem is…. those deals that seem obvious early on, those that most investors are chasing and bidding up the entry price - that is the definition of a consensus deal - and as we said at the beginning its not consensus thinking that drives outsized returns, its contrarian thinking. Looking and investing where others are not. The non obvious bets.
So in an industry where the above is the norm, how do you zig when others zag? How do you have the courage of your convictions and wait to see if your contrarian bet proves right?
The first thing to highlight is that there is actually very little correlation between the hot / hyped seed stage companies and those that actually end up returning funds many times over.
This is because the hottest companies typically raise more money early on, (because they can) at higher valuations, (because they can) and (because they can) they raise more capital at later stages in the company’s lifecycle which often leads to them being less capital efficient, which leads to greater dilution of the cap table over time. Taken together, all of this is not good for generating outlier returns for their investors.
So what are we saying?
Sounds like being a truly contrarian investor is a pretty lonely endeavour. No confidence boosting vanity metrics to shout about. Long feedback loops. Nothing to point to apart from the solid execution of your unsexy portfolio companies who are grinding day in day out to prove the doubters wrong.
In reality, as a truly contrarian investor, who is backing non consensus teams, it’s not until you have realised successful outcomes that you start to look like a winner.
So pick your lane, stress test your strategy and get after it!
Focus on the fundamentals
Shut out the noise - It sounds simple, but there is a reason why some of the best public market investors in the world have physically removed themselves from the noise of their natural markets. Think the Oracle of Omaha. I’d bet if Warren Buffet was based in Manhattan his performance would be worse than what we’ve seen over the last 60 years.
Now obviously venture capital is a people business and it’s much harder not to be engaged in the communities that you are investing in - but that doesn’t mean you can’t shut out the noise and focus on signal.
Unique team & non obvious insight - The true contrarian companies are the ones that others aren’t paying attention to which allows you to get a combination of lower entry price, less dilution from greater capital efficiency and benefit from TAM expansion as they tend to create net new markets.
Know your stuff - I may be biased but I believe in venture, knowing more about a few things and focussing on that, is better than knowing very little about a lot of things. Investor market fit as I like to call it. As a contrarian investor this theoretically gives you an edge when looking for that outlier and if nothing else you arrive to the pitch call with a prepared mind.
Being concentrated - Over diversification is definitely a thing in most places in the world apart from maybe places like Silicon Valley where even the tiniest stake in a company can make up for all your mistakes. Owning enough of your outliers is key to actually returning top decile DPI. You can pick the right company but if you don’t own enough it may never matter. Hopefully if you are focussed on contrarian bets, the chances of getting to your desired ownership is more than likely.
Hindsight is 20/20, and in hindsight, particularly when you win big, people are often quick to agree that of course being contrarian is a good strategy.
But it is important to highlight, as Howard Marks does in one of his Memo’s:
“In a market that is even moderately efficient, everything you do to depart from the consensus in pursuit of above average returns has the potential to result in below average returns if your departure turns out to be a mistake.”
Said another way, if you get it right you can make serious outsized returns, but if you get it wrong, your returns could be worse than most.
The question is - do you have the patience, courage and conviction to follow the road less travelled?
Until next time.
Saludos,
Archie, Bernardo and Victor
If you are interested in learning more about what we are building at Nascent, please reach out!
Archie@nascent.vc
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