Seeking Alpha: Second Level Thinking in Venture Capital

Contrarian thinking is required for investors to outperform the public markets. Innovation also relies on contrarian thinking. Yet the Gartner Hype Cycle shows that mimicry is prevalent in venture capital. Both the Consensus-Contrarian Matrix and Three Cardinal Sins of Investing remind venture investors to think differently.

Didi-Dache showed early signs of breaking out in China in 2012 as was Uber in the United States. After meeting with the executive team, we polled NGP Capital partners for their views on the company. All spoke in favor of investment until one of our local partners expressed skepticism. His well-articulated concerns gave us all pause, and we passed on the future ridesharing leader in China. That one voice of skepticism cost NGP Capital a potential fund making 1000x investment return. It also changed the way we made investment decisions. Shortly thereafter, we switched from a consensus driven voting system to one that permits and welcomes dissent.

Contrarian thinking is esteemed among investors and for good reason. As Howard Marks observed in I Beg to Differ, outperforming the stock market requires contrarian bets. Innovation relies on contrarian thinking as well but for different reasons than public market investing.

The Consensus-Contrarian Matrix that applies for stock market investing must be modified for the venture industry. The Three Cardinal Sins of Venture Investing also encourages investors to be alert for outsized opportunities. This article explains the two models and proposes that the latter model is a better lens through which to view venture capital decisions.

The Consensus-Contrarian Matrix: Outperforming in Public Market Investing

When Howard Marks introduced the Consensus-Contrarian Matrix for public market investing (see Figure 1), he explained, “You can’t take the same actions as everyone else and expect to outperform.” Indexes offer average market performance for investors who are content with standard market rates of return. Outperforming public markets requires second level thinking by assessing: (1) what the herd is doing; (2) why it’s doing it; (3) what’s wrong, if anything, with conventional thinking; and (4) what you should do about it.

Figure 1: The Consensus-Contrarian Matrix for Public Market Investing

But outperformance requires more than contrarian thinking: your thinking must be both different and better. The level of conviction and insight required for contrarian investing is substantially higher than consensus investing.

Most great investments begin in discomfort. Contrarian investing is lonely. Contrarian investing is doubly painful when wrong as it may involve both financial and reputational loss. Unless institutions maintain contrarian positions through difficult times, the resulting damage imposes severe financial and reputational costs on the institution.

Contrarian thinking isn’t for everyone. In addition to superior skill, contrarian investing requires the ability to look wrong for a while and survive some mistakes. Investors must assess whether circumstances — for employers, clients and capital adequacy — permit it.

The Consensus-Contrarian Matrix: Venture Market Adjustments

Innovation falters without contrarian thinking. Peter Thiel, founder of PayPal and Founders Fund, asks entrepreneurs, “What important truth do very few people agree with you on?” Disruptive innovation needs founders who think differently: the misfits, troublemakers, round pegs in square holes, the crazy ones who do not follow rules and who lack respect for the status quo.

Innovative startups rarely come from central casting. Steve Jobs was a college dropout and fired from his first company before founding Apple. Jack Ma failed a college entrance exam twice, was rejected for 31 jobs after college, failed in his first company and became a teacher before founding Alibaba. Even Jeff Bezos, who graduated summa cum laude at Princeton and performed well at a leading New York hedge fund, took over a year to raise a first round at Amazon.

Investors who overlook unconventional truths are likely to miss disruptive opportunities that produce the next generation of iconic companies. Yet investing in hot companies in hot spaces is standard practice in the venture industry. The Gartner Hype Cycle persists more prevalently now than when it was first observed three decades ago. The Gartner Hype Cycle is costly to investors who overpay in hot markets. Eager investors bid up those few startups that check all the boxes depressing the opportunity for outsized venture returns.

Mimicry is even more costly as it diverts attention from outliers that could return the fund. Over half of successful 0 to 1 startups that list publicly had difficulty raising their first investment round. Technology unicorns worth over $2.5 trillion have had difficulty raising first round funding, including AirBnB, Alibaba, Amazon, Bentley, Cisco, Datadog, Peloton, Pinterest, Robinhood, Squarespace, Uber, Udemy and UiPath. AirBnB, Pinterest, Robinhood and Udemy founders claimed that over 100 venture firms initially passed on their startups. John Foley said raising the first three rounds for Peloton was ‘bone crushing.’ Y Combinator rejected Alex Solomon, founder of PagerDuty, four times before admitting him on the fifth try after he had achieved product market fit. Bentley Systems, SquareSpace and UIPath founders bootstrapped their businesses for over fifty years cumulatively before raising financing. Venture investors who rely on prior industry experience would have missed over 49% of the market cap of recent IPOs.

Disruptive innovation relies on contrarian thinking from both entrepreneurs and early-stage investors, yet venture investors, who typically come from central casting, risk overlooking founders who are cut from a different cloth. This mismatch may persist as venture investors, unlike public stock investors, can outperform the market with a consensus-oriented investment strategy. While public shareholders make passive investments and do not materially influence companies in which they invest, active venture investors have many ways to enhance portfolio company outcomes. Lead investors can add value by influencing strategy, sourcing talent, facilitating strategic partnerships, and helping to raise additional financing.

The Consensus-Contrarian Matrix thus differs for venture and public stock investors. For lead investors who can positively influence company performance, odds shift toward consensus investing. Tier 1 investors often deliver outsized outcomes in hot spaces with lower risk than in contrarian investments. Successful investments in hot spaces unleash a virtuous cycle as entrepreneurs seek investors who have backed winners in adjacent markets. Tier 1 investors can also occasionally salvage underperforming firms in hot spaces through strategic sales while contrarian investments that disappoint have fewer options and risk becoming orphans without a viable path to exit. As Figure 2 illustrates, consensus investing is often rewarded in venture capital, though disruptive innovators need early investors who share their contrarian vision.

Figure 2: The Consensus-Contrarian Matrix in Venture Capital

Chasing hot companies in hot spaces is easier than contrarian investing. Hot companies in hot spaces raise up rounds more frequently, so investors can show early appreciation on investments. Attracting pedigreed co-investors is easier for hot companies. Recognition for prior investments in hot companies increases investor cache. It’s a lot easier when partners, peers and the press affirm you are in a hot company. Hot VCs investing in hot companies attract entrepreneurs for the next generation of hot companies unleashing a virtual cycle, at least until the music stops.

Everything is harder on the venture contrarian path. As Ed Suh from Alpine Ventures observed, the companies are funkier. They are chronically under-resourced and harder to sell to follow-on investors. Everyone doubts the category. Venture is a lonely job. Mistakes are magnified on the contrarian path. The only thing worse than losing money is being the only one that was wrong and lost money. Venture investors must live with mistaken illiquid investments for a long time in what often feels like reputational purgatory. Moreover, troubled companies consume more time and resources than winners.

Figure 3 from Raymond Luk illustrates well the challenges for both entrepreneurs and investors of contrarian startups. Hot companies with product market fit have ready access to capital, talent and partners. Contrarian disruptive startups often require pivots to find product market fit. The path for contrarian companies seems longer and more arduous requiring patience and persistence.

Figure 3: The Muddled Path of Founding and Investing in Contrarian Startups

The Three Cardinal Sins of Venture Investing: An Alternative Approach

Should venture investors avoid contrarian investing? The odds for a contrarian investor and founder are long and prospects for consensus investing seem rosier.

On the contrary, the venture industry relies on contrarian investors for outsized returns. Consensus investing works well for incremental (1 to N) advances, but disruptive (0 to 1) innovation requires contrarian investors.

Stepping up as a lead investor in an early-stage disruptive company is an exercise in contrarian investing. Dozens and perhaps hundreds of experienced, savvy investors are aware when a founder is in search of funding. If a founder is in market for long, there is often good reason to be skeptical. In such cases, any lead investor must overcome peer skepticism and make a contrarian bet on the founder and opportunity.

Fortunately, the venture industry does not work by consensus. Corporate innovators only need one no to stymy a new idea. But founders only need one yes from a venture investor to advance to the next round.

Risk and reward tradeoffs in venture favor bold, insightful investors. In debt markets, the upside is capped while the downside is full loss of capital. Venture markets have the same downside risk as lenders, but upside opportunity for early, contrarian investments are virtually uncapped. If one has a 10% likelihood of a 100x outcome, the investor should take that bet 100% of the time. The expected return for such a fund approaches 10x with a sufficiently large portfolio of such opportunities.

Venture capital is complicated, however, as fund making opportunities for outsized gains are rare and the upside potential is not readily visible. If the potential were readily apparent, eager investors would bid up the deal and depress expected market rates of return as is common for startups in the Gartner Hype Cycle. Investors realize 100x outcomes — or 10x outcomes for that matter — through contrarian judgments.

Rather than focusing on the contrarian nature of venture investing, investors may instead consider the consequences of passing on potential fund making investments. In Secrets of Sand Hill Road, Scott Kupor described the three cardinal sins of venture capital: (1) investing in the right team but wrong market; (2) investing in the right market but wrong team; and (3) not investing in the right market with the right team. Errors of omission — the third sin — are less visible but perhaps they are costliest as they indicate opportunities foregone in potential fund makers. Bessemer publicly retains an anti-portfolio as a reminder of such opportunities foregone.

Figure 4: The Three Cardinal Sins of Venture Investing

Working with visionary entrepreneurs is one of the joys of venture investing. It has been a pleasure to have invested in several exothermic entrepreneurs who have created unicorns from scratch.

Yet it is easy for investors to lapse into a consensus-oriented approach. Knowledge is not evenly distributed in the venture world as a sage investor often reminded me with his question: “Why are you so lucky?” Contrarian investing in venture as in public markets requires that one be both bold and right. A contrarian venture investor needs an edge — proprietary knowledge, access or insight.

Contrarian investing also requires a culture that supports thinking differently. Innovation flourishes in countries that celebrate rugged individualism and in venture firms that give partners latitude to bet big on iconoclasts. Both countries and venture firms must tolerate mistakes to nurture the freedom that allows entrepreneurs and investors to pursue untrodden paths.

Contrarian investing is a hard path for both public market and venture investors. It is often a lonely path that is muddled and riddled with risk. But second order thinking helps keep us alert to unconventional ideas emanating from quirky but brilliant founders who just might change their corner of the world.

Related Concepts:

High conviction contrarian investing requires insight. Thesis driven and thematic investing helps build proprietary knowledge and networks to unveil high potential, paradigm shifting opportunities that others may miss. Understanding Founder Fit and Product Market Fit help reduce the first two cardinal sins of investing: Type 1 errors in misjudging the market and Type 2 misjudging the team. The Fuzzy and the Techie reminds us that a diverse team may help us appreciate outliers that hide in plain sight.