While out in sunny San Francisco this week, I had interesting discussion with a colleague who has recently left the venture world to take a seat at the entrepreneurs' table. Much of our conversation centered on the emergence of capital marketplaces and the topic of venture fund vs. venture platform. After discussing the recent progress of some venture platforms like SeedInvest and AngelList, he asked if I think software will continue to eat away at the fund investment model and progress up to larger growth equity and buyout funds.
Here's what I told him:
It's a fair assumption to say that software and the web will have a large impact on the fund model, but the degree of impact will depend on the stage of investment. >
The web has served two key functions in the B2B space - enabling networks of individuals and data to connect to each other more efficiently, and reducing costs through productivity gains for repetitive activities.
The four basic activities of any fund manager - from seed stage to leveraged buyout - are generally:
- Raise capital from LPs
- Originate investment opportunities
- Structure the deals
- Manage the investment through to liquidity (hopefully)
So let's look at how these two functions of the web affects each of these 4 activities for fund managers:
Raise capital
Pretty similar process across funds - likely impact is that the web will enable funds looking to raise capital to connect to more and smaller individual pools. Traditionally funds have gone after large pools of capital (e.g., family offices, pensions, insurance companies), as raising capital is a time-consuming process and the prize needs to be sufficiently large to invest in building a relationship with any one institution. The web will change this by opening fund capital raising to many small investors.
Originate investment opportunities
As shown by AngelList, the Web can much more efficiently introduce the many companies seeking small seed investments to angel investors.
Though both the number of investment opportunities and their degrees of risk have decreased by the Venture stage, the Web continues to play an important research and analysis role. Take a look at what Paul Singh is doing at Dashboard.io to see how benchmarking data is going to change the Venture game.
By the growth stage, deal sizes are large enough that intermediaries (bankers) are involved to help the company procure financing to scale, meaning the Web's discovery capabilities are less valuable. It may help reduce cost by replacing human networks with digital ones, but it won't have quite the impact as in earlier stage investing.
Finally, in the Buyout phase, creative thinking drives deal origination (how do I take a company with X value and perform a series of actions to get a 3X return). As these actions are bespoke for every deal (e.g. leveraged buy out, roll up strategy) it will be difficult for web applications to find a natural fit.
Structuring the deals
Seed investments are pretty standard, and have been made even more standardized through documents such as series seed. Financing these rounds could easily be incorporated into a web application. Venture begins to get more complicated - as much as entrepreneurs would like to standardize this practice, it's likely to remain bespoke for the near future. In theory though, the venture community could decide on some standard legal structures similar to how the Investment Banks developed the ISDA contract around OTC derivative contracts. Growth and buyout transactions will remain bespoke given the high level of deal complexity.
Managing the investments
Investment management predominantly revolves around communication. In the seed stage, facilitating informal communication between a company and its many angels and/or strategic investors is a very useful role to play for the web (again see Paul's work at Dashboard.io as an example). In venture deals, there is some potential for the emergence of "Venture platforms" to provide an opportunity to change the current process. Growth and buyout deals rely on several team members communicating with a company. Often these discussions are highly strategic or complex in nature, meaning a web based communication platform may be a more difficult medium. An intranet-type of solution has potential, but it is unlikely to be highly disruptive.
Where the web may find a place in later stage private equity investing however is in facilitating ongoing communication with LPs. The first investment funds were essentially black boxes - money went in and came out (hopefully more of it!). Over time, the market has made steady strides towards transparency. This transparency provides an incredible benefit to LPs when evaluating overall risk positions, as well as evaluating where LPs choose to invest (or reinvest).
It's clear that software and the web will have varying levels of impact on the private market investment model. As web technology creeps further up the food chain, investors and entrepreneurs alike should expect to see platforms focusing on different elements of the investment process.
I've quickly outlined below a heat map of where we see the most powerful disruption. In future posts, we'll continue to explore how we see this heat map translating into tangible systemic changes to the private investing marketplace.
Note Dark Blue = significant impact, light blue indicates minimal impact