As record-breaking levels of money and talent continue to flow into venture, investors are increasingly forced to look for ways to differentiate themselves from the competition to attract start-up entrepreneurs and LPs, and improve returns.
The sad reality is that many VCs are more limited in options than you would expect. But let’s take a step back.
Globally, there is a small, yet powerful set of funds that do not face the challenge of differentiation. They are happy to remain “generalist” as they are able to differentiate themselves by their brand power, drawing from the partners’ track records an illustrious list of companies they’ve backed.
You can see this in Benchmark, which was an early investor in Uber and Tinder.
Benchmark’s website has only a single landing page with their logo and contact details. For VCs with such pedigree, people have to find their way to them, not the other way around. Their brand power grants them access to high-demand deals with the best founders, and lets them choose the best LPs to work with.
That sort of brand value is difficult to obtain and only comes with time and experience. For a VC without this brand power, they need to find other ways to sell themselves to founders and LPs to secure deals and funding.
This has pushed VCs towards specialization, focusing their investments in a particular stage, sector, region, or intersection of these three.
Specialization is a hard thing to build for venture funds. It comes with notable costs, since it means VCs have to deny themselves access to many investment opportunities from the start.
Specialization requires commitment over time, as the one key indicator for top founders is the size and quality of your portfolio in a given focus area. Assuming a typical fund model of 20 to 25 deals per fund every three years, many VCs need to make a stark choice: either double down on one or two sectors or stay a generalist.
Alongside the internal difficulties of setting up a specialized fund, many LPs have historically shied away from investing in them. Why invest in a “one trick pony” if innovation keeps accelerating and the “hot theme of last year” may not be as relevant in the future? Generalist VCs were seen as the safer bet.
On the other hand, if you specialize as a VC, there are great and obvious benefits. Funds are able to develop deep networks and expertise in their respective sectors or verticals, creating a more attractive proposition for founders and LPs.
Specialist credibility may be the only way to distinguish a VC brand from their competition. All things being equal, founders will always choose the specialist over the generalist. It saves time and energy to discuss your business eye-to-eye instead of educating your investor over and over again.
Founders have the power
This argument has always been around, but two interconnected trends have accelerated the tendency towards specialization.
First, the power equilibrium has swung towards founders. Given the abundance of capital, high pedigree founders can pick and choose their investors, not the other way around. Access via regional proximity or personal network tends to count less. Founders select VCs based on the value-add in their partners. The tables have truly turned.
The second trend is scale. The amount of capital flowing into VC is staggering. Many funds are using the abundance of capital entering the ecosystem to invest in multiple specialized sectors. Andreessen Horowitz exemplifies this strategy, with the team raising multiple thematic funds.
Funds that have access to capital are able to leave the “generalist” and “specialist” dichotomy behind them and build a multi-sector strategy. They can enjoy the best of both worlds: focused teams that can win through expertise, network and strength of their portfolios, and the ability to concurrently cover multiple sectors and themes.
As time goes on, we expect that more funds will move toward the specialist pole of the spectrum, as competition for founders and LP money will force greater degrees of differentiation.
In times of abundant capital, deep sector and domain expertise will be key to attracting top founders who are capable of generating outsized returns, which is a key draw for investors.
I believe we’ll see the trend towards specialization be most pronounced in VCs working at the earliest part of the start-up lifecycle. That’s because many start-ups find that they benefit most from specialization when they’re just getting off the ground.
Next to specialization, we also see a global convergence and consolidation of the VC industry, with the strongest funds going for scale to support their strategy. In the US, this change is already well under way, Europe is following its path. The big winners of this changing landscape are our start-up founders.
Oliver Holle is managing partner of Speedinvest.