Want to get lucky?
So often, when an investor gets a big hit, people refer to their success as getting lucky. In this sense, “getting lucky” is what we strive for as investors. However, there is alot behind both the decision making on the initial investment as well as the path along the way that creates those sparkles we see from the outside. It is important not to take this for granted. While luck is often a part of the journey, getting smart on the investment opportunity and strategy is the foundation that delivers the ultimate outcome. This is why “luck” is often repeatable for those savvy investors who spend time really getting to know their investments. Having a higher hit rate of luck is why we do so much diligence as LPs and why we expect our GPs to spend a meaningful amount of time getting to know their prospective portfolio companies. It establishes educated and informed decision-making around who we choose to partner with. We are able to back up our decisions (both yays and nays) with data and logic. While we can’t predict the exact future, I would argue that diligence gets us 80% of the way there and reduces the unknowns substantially. (but those unknowns still make me hold my breath every time I send a commitment email or Indication of Interest (IOI) to a GP!).
“So often, when an investor gets a big hit, people refer to their success as getting lucky. But often there is a strong diligence that creates repeatable luck.”
Diligence, knowledge, and hard work create the repeatable “luck” that we are looking for. Our diligence period takes about 3 months. This is after we’ve typically been tracking a GP for several years. This “get to know you” time is important. It helps us see a firm's hustle, how they make investment decisions, what they are thinking about, and what kind of partners they would be. The 3 months of diligence helps us see where the pitfalls are and get comfort around relative weaknesses with the firm. There are several times when we have been tracking a GP for years only to launch diligence and decline because there was in issue we couldn’t see from the outside. Had we not conducted thorough diligence and just invested based on relationship, we would have missed crucial items that can impact future returns. Conversely, and more typically, when we launch diligence, we are quickly able to see where there might be weak spots and address those together with the GP before moving forward. This creates a stronger partnership on both sides.
To make better investment decisions, we have crafted a diligence process we can rely on and refine it over time. We are continually looking at what we missed in the past to incorporate it into our process moving forward.
Our diligence really focuses on three things:
Is he/she making good investment decisions? (attribution, portfolio construction, track record)
Do we believe he/she will continue to make investment decisions the same way moving forward? (partnership dynamics, strategy/thesis, pipeline)
Is there a competitive advantage? (network effects, geography, brand)
Of course, there are >100 other very boring subcategories, both qualitative and quantitative. Sapphire Ventures posted a fantastic article about how to build a data room along with diligence templates to help VC’s see how LPs analyze their performance and track record along with other qualitative features like strategy, geography, and co-investors.
"After several years of knowing a VC and 3 months of intense diligence, the surprises are rare. We are able to reduce the unknowns to roughly 20% of the total decision.”
After 3 months of diligence, the surprises are rare. While there are still suprises, both on the upside and on the downside, they are minimal and most of the time, because we know what the pitfalls might be, we can see them coming well in advance. Of the 28 funds we’ve committed to, we’ve been surprised by 4 of them: 3 have performed better than expected and 1 has performed worse than expected. The others are all *so far* performing where we thought they would (so far…because these are very long-term relationships). This is about a 14% "surprise rate." Without an optimized diligence process, I would peg this closer to a 50% surprise rate.
These surprises help inform and refine our diligence process to increase the frequency of “getting lucky.” The downside surprise we ran into was really fundamental to the fund's portfolio construction, something we should have seen and been more aware of. We have since incorporated a more thorough analysis of the portfolio construction strategy into our diligence process.
☘️ Of course, “getting lucky” has a much better ring to it than “doing diligence” so I understand why its easier to identify luck as the cause of the outcome vs. smart, educated decision making (and sophisticated investment management, which we will cover in a future post). The notion of luck, in most cases, is erroneous. It should be reserved for finding pots of gold under the rainbow. Luck isn’t luck at all. Big hits take a lot of work, continuous optimization, and educated decision making. Savvy investors know this, but often, from the outside, we attribute their success to luck.