Given your background in engineering, why did you gravitate to private equity as an area of study?
I found it was understudied in a strange way. Risk capital and venture capital is so important in terms of commercialising technology, it is remarkable how little understanding we have of it. It's a very unusual field. It's this craft discipline that tries to create a professional cadre of entrepreneurs, which I felt was – if nothing else – ironic.
You've tried to assess the value of a venture capital firm's network. What have been some of your findings?
A lot of venture firms, especially second-tier venture firms, advertise their access to the first-tier firms. They say, “We have in our past syndicates of co-investors Kleiner Perkins, Oak, Sequoia, NEA.” The question was: is the venture industry structured in such a way that you can actually get access to first-tier investors by going to second- and third-tier folks who claim to have access. And if so, how does that affect returns?
So it was really a six-degrees-of-separation question. If I pick a random venture capitalist, how many steps does it take me to get to [Kleiner Perkins'] John Doerr?
One answer that we got – which wasn't too surprising – is that the venture industry is completely clubbish and hierarchical. The first-tier guys don't like to co-invest with people who aren't first-tier. The second-tier people, generally speaking, are stuck investing with second- and third-tier folks. About the only way to break the cycle is if you originate a deal. Because of the clubbish nature of the business, it is very important, if you want to gain access to the higher tiers in the industry, that you have proprietary deal flow.
Many venture capitalists and investors have sought you out recently for your views on fund size. What are you telling them?
Over the past 18 months, everyone has fallen down 70 to 80 percent from the size of their previous fund. And so the question is: where should we be? Venture capitalists and investors say they don't know the right number any more. Assuming the partners have pedigrees and track records, we found that for four partners, about $250 million under management is very close to being the optimal size, give or take a partner and $40 million to $50 million. It's a fairly narrow distribution.
Why that size? You quickly realise that it has to do with the structure of the business. The venture capital industry hasn't been institutionalised. It doesn't scale particularly well. You've got four partners who are running – I like to say – four dentist offices under one roof. They've all got their own little practices and they come together on Monday mornings and vote politely on each others' deals, and then they disappear to the four quarters of the earth for the rest of the week.
It's remarkable how many funds will tell you, “I never say no to another partner's deal on a Monday morning meeting.” Once you start getting up to six, seven, eight, nine, ten partners, the partners can't even begin to keep track of what each other is doing. Performance falls off dramatically as the number of partners and capital under management go up. There are exceptions, but as a rule, four partners and $250 million is not far off the optimal size of a venture fund in 2004.
What are some other topics you'd like to tackle over the next few years?
I'm interested in a lot of issues with respect to best practices. There's a huge difference across various countries in terms of how they deal with their portfolio companies. For example, US funds are merciless about firing CEOs. European and Canadian funds are much slower about terminating the most senior people. The US funds do it about twice as fast and twice as often, which is a huge difference. The question is: is that effective? Is it a best practice? Is impatience with senior management performance one of the reasons why US venture capital performance is so much higher than it is in the rest of the world?