The Unholy Trinity of Venture Capital

Allocators, Agglomerators, and Absorbers

Nov 16, 2024

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As a senior in high school I had an English teacher, Mr. Malone, who had a huge impact on me. His class was, I think, the first time I was exposed to the idea of literature for the sake of literature. Reading because you wanted to, not just because you had to. Absorbing the written word for the feeling, not the grade. It was in his class that I wrote the first piece of writing that I was ever truly proud of. He was a very good guy and sadly passed away in 2014.

It was in his class that I read Mary Shelley's Frankenstein; or, The Modern Prometheus for the first time. While I only knew the Frankenstein story from the movies (particularly Young Frankenstein), I hadn't been exposed to the story as literature. I also learned about the richly tragic lives of Mary Shelley and her husband, Percy Bysshe Shelley, a poet. He's the author of an exceptional poem, Ozymandias (also the name of one of the best episodes of Breaking Bad).

While the story of Frankenstein is Mary's, the final product was a collaboration with Mary capturing the details of the arc and Percy enriching the language with poetic prose. I think about that relationship all the time. I don't know of too many power couples in literature, but for their brief 6 years together before Percy's tragic death, the Shelleys were certainly one of them.

I was thinking about Frankenstein and Mr. Malone today as I started to write this piece because I had, in my mind, a particular visual. A scientist, distraught and reflective. Pondering on the implications of his creation. And in the midst of his reflection, he had a great line. For a split second, I thought to myself, "I must be remembering that from Frankenstein right? The Shelleys. The literary power couple. What a thing."

Unfortunately, much to Mr. Malone's chagrin I'm sure, in the next second I realized. "Wait... that's not from Frankenstein. That's from Spy Kids 2: The Island of Lost Dreams..."

In the movie, Carmen and Juni (the aforementioned Spy Kids) meet a scientist named Dr. Romero who had created miniaturized hybrid animals but accidentally created an island of nightmares akin to Jurassic Park. Upon reflection of his creation, he utters the line that was rolling around in my head as I pondered today's topic:

"Do you think God stays in heaven because he, too, lives in fear of what he's created?"

Great literature can come in all shapes and forms.

What We Have Wrought

Say what you will about Yuval Noah Harari, but I've always appreciated a concept he framed that I've written about over and over again:

“There are no nations, no money, no human rights, no laws, and no justice outside the common imagination of human beings. Whether or not something is true doesn’t impact whether you believe it.”

We don't think about it enough, but concepts that come packaged with so much history and context are not naturally occurring phenomenon that exist independent of us. They are agreed upon concepts riddled with culture, for better or worse. Venture capital is no different.

From land explorations to whaling expeditions to semiconductors to B2B SaaS to Mars colonization. The concept of venture capital has taken many shapes, but the reality is that we, as participants, have shaped the concept by agreeing, explicitly or implicitly, about what it means.

That doesn't mean that venture capital has stayed the same. By all means, the game evolves over time. Culture shifts, economic dynamics take root, and we change what we agree venture capital is or isn't. From corporations funded by the Defense Department buying 45% of a startup for $500K that manufactures semiconductors to influencers buying <1% of a hyped pre-revenue concept of a startup for $5M—venture capital is nothing if not versatile.

Last September I wrote what, I think, is my favorite piece I've ever written, called Playing Different (Stupider) Games. In it, I explained an important concept. People often think games that are different than theirs are the "stupider" games. But that's not true. There are lots of way to do things. The stupider game is, as often is said, thinking you're playing checkers when your opponent is actually playing chess.

And when it comes to what venture capital is, we sometimes think that the right definition (or game) is the one we think venture capital should be. You talk to any investor, founder, or LP, and they'll have a definition of what they think venture capital should be. Unfortunately, that can be very dangerous. Because as venture capital evolves it often tilts not in the direction of what you think it should be, but what the loudest people with the most capital decide they want it to be.

Venture Capital's Unholy Trinity

Howard Marks, who has so famously written about being "contrarian and right," wrote a letter in 2022 called "I Beg To Differ." In it, he talked about a similar concept to what I'm describing. The loudest people with the most capital create the extremes:

"'The investment herd' refers to the masses of people (or institutions) that drive security prices one way or the other. It’s their actions that take asset prices to bull market highs and sometimes bubbles and, in the other direction, to bear market territory and occasional crashes. At these extremes, which are invariably overdone, it’s essential to act in a contrary fashion."

What Marks is describing is akin to a Buffettism about the market: “In the short run, the market is a voting machine but in the long run it is a weighing machine.” In the short run, the loudest people with the most capital are voting for what they want to happen. In the long run, a company has to stand on its own, for better or worse. And, in many cases, it will rise or fall despite the expectations of the masses. So you can attempt to make your contrarian bets, trusting in the long-term legitimacy of the market.

Unfortunately, venture capital is uniquely resilient to this somewhat natural law. Not immune, but more resilient than the public markets. Venture capital has a much more palatable "halo effect." Self-fulfilling prophecies are much more possible in private markets. Its probably a combination of limited information access, capable hype engines (especially in the internet age), and big success stories like Google and Amazon that fuel FOMO. As a result, the loudest people with the most capital in venture are a lot more influential than the loudest people with the most capital in the public markets or real estate or bonds (whatever nerd is getting loud about bonds.)

I've written before about a new type of firm: capital agglomerators. These are firms like a16z, General Catalyst, ICONIQ, Sequoia—firms that are raising billions of dollars at a time. Building out "global investment companies" that extend far beyond a simple venture fund.

And I've said before that there isn't necessarily anything wrong with these firms. Just like finding the stupider game, its not that these firms are stupider. It's that they're different. But the Unholy Trinity of Venture Capital isn't just the biggest three capital agglomerators. It's much more involved than that. But the existence of capital agglomerators is what invited the effect of the Unholy Trinity on venture. So that's where we'll start.

Capital Agglomerators

Like I said before, capital agglomerators are the one piece of this unholy trinity that I've written about a fair bit, both in general in a piece called The Blackstone of Innovation and specifically in The Puritans of Venture Capital. In that latter piece, I described agglomerators this way:

"Firms that are building their business around having more resources, more exposure, and more coverage are ultimately optimizing for one thing: fees. The more fees you have, the bigger the business you can build. And fees are a derivative of AUM. So in reality, you're focused on the AUM aggregation game."

Now, capital agglomerators are the first ones to say the last thing they're focused on is getting fat on fees. And I believe a lot of them. But the reality is that "what gets measured gets managed." And when you look at large publicly traded PE firms, like Apollo, KKR, or Blackstone, you see that they trade on a multiple of their management fees (fee-related earnings, or FRE).

Now, we don't yet have a venture capital firm that is publicly traded, but its not at all a stretch to think someday a16z, ICONIQ, or General Catalyst could be publicly traded. And I can almost guarantee they would also trade on fees rather than carry.

So, as an agglomerator, how do you maximize fees? You raise as much capital as humanly possible. More funds, more strategies, more geos, more investors, more investments.

And that's what we're seeing. a16z is getting exposure to buyouts for its wealth management clients (which is a new business they launched in 2023), General Catalyst bought a health system and launched a customer acquisition lending fund, Thrive is making $1B bets on late stage companies like Databricks that, arguably, should be public.

As agglomerators have become more and more common, people's biggest question is always "who are the LPs willing to invest in these multi-billion dollar funds?!" Well, let's just say they're not your mother's LPs.

Capital Allocators

People are skeptical of who these LPs could possibly be is, in large part, because there is quite a bit of evidence to support the fact that larger funds consistently have lower returns than smaller funds. In fact, smaller funds are 50% more likely to generate above a 2.5x return vs. a larger fund.

So who are these LPs who are putting money into these capital agglomerators? They typically fall into two buckets.

On the one hand, you have the IBM Effect. In other words, no one got fired for putting money into a16z. Will the returns be lower than trying to pick a smaller firm with a specialized strategy? Maybe. But if I pick a bad small fund, I could get fired. If I put money in a16z and get a lower return, nobody gets fired for that. Those LPs most certainly exist. But they're not who I'm focused on in this unholy trinity.

The LPs who really make these mega funds possible are the LPs managing ungodly amounts of capital:

CPP Investment Board (Public Pension Fund) Canada: $61B in private markets
Kuwait Investment Authority (Sovereign Wealth Fund) Kuwait: $60B in private
GIC (Sovereign Wealth Fund) Singapore: $44B in private
ADIA (Sovereign Wealth Fund) UAE: $34B in private
CDPQ (Public Pension) Canada: $28B in private
CalPERS (Public Pension) California: $27B in private
APG (Asset Manager) Netherlands: $27B in private
Ontario Teachers Pension Plan (Public Pension) Canada: $26B in private
La Banque Postale (Bank) France: $26B in private
China Investment Corporation (SWF) China: $23B in private

Just those 10 names represent $250B of capital that they're trying to park in private markets (that's not even their total AUM). Granted, a bunch of that will go into private equity vs. venture capital, but there are dozens of these massive institutions.

Let's say they're putting 20% of that $250B into venture: $50B that you need to deploy. Funds operate on a 2-4 year fundraising cycle so lets say they're deploying $50B every 3 years, that's ~$17B they're deploying each year. And let's say you don't want to be more than 15% of a fund, so $30M slugs. If you're responsible for deploying $17B and you wanted to deploy it into those higher return capable $200M funds, you have to find 560+ venture funds to invest in. In all of 2023, a total of 474 venture funds raised money.

That math just doesn't shake out. When you're deploying billions of dollars you need places to park money. And when you think about what the job of a capital allocator at a place like CalPERS is with their $27B pot, it isn't generating venture scale returns. It's generating yield.

These big institutions have warmed up to venture capital slowly but surely over the years. Pivotal shifts came with things like the passing of the Employee Retirement Income Security Act (ERISA) in 1974, which made it legal for pensions to invest in higher risk assets, and the Endowment Model made popular by Yale's Endowment in the 90s and 2000s. While the average endowment has ~14.7% of their assets in PE/VC, by 2019 Yale and others like it had 60% of assets in alternatives, including venture funds.

For a typical yield farmer, they don't need funds to put up 5x or 10x or 100x funds. Pensions and endowments are governed, at least in part, by their spending rate. Each year these institutions needs a specific amount of capital outflows (expenses, member payouts, charitable donations, etc.) and so they just need a rate of return that replenishes the fund. They're not swinging for the fences.

Now I'm a bit outside my depth here, so big institutional LPs are welcome to correct me if I'm wrong. But from what I've seen, a typical large institution is looking for a 7-8% annual return because they're usually spending around 4-5% of their assets. Remember those bigger funds that are 50% less likely to generate 2.5x+ returns? Well that same report indicated that they can put up "an average IRR of 9.7%, compared to the average 17.4% IRR of smaller [funds]." Well within a bigger institutions returns threshold.

So you have massive capital allocators looking for places they can farm yield and they don't want to be slinging hundreds of $30M checks. Capital agglomerators represent the perfect solution. Hit your 7-8% yield target, be able to park $250M a pop without being the majority of the fund, and sit back and relax.

Now if it was just a duality of capital agglomerators and capital allocators, then we would have the quintessential reality that every VC complains about: too much capital chasing too few deals. And in many instances there is truth to that. But to finally form our Unholy Trinity of Venture Capital, we've had the Capital Absorbers come along to complete the trifecta.

Capital Absorbers

There's a Bill Gurley quote from 2016 that I've used over and over again that hints at the emergence of these capital absorbers; the hungry, hungry hippos of raising money:

“Back in 1999, if a company raised $30mm before an IPO, that was considered a large historic raise. Today, private companies have raised 10x that amount and more. And consequently, the burn rates are 10x larger than they were back then. All of which creates a voraciously hungry Unicorn. One that needs lots and lots of capital (if it is to stay on the current trajectory).”

He calls them hungry Unicorns, I call them hungry, hungry hippos cause fat little hippos are funnier than chunky unicorns. But today we have hungry, hungry capital hippos that the 2016 mind of Bill Gurley could never comprehend. Enter: The AI Bubble.

OpenAI raising $6.6B at a $157B valuation. Anthropic raising almost $1B at a $40B valuation. Databricks raising $1B at a $55B valuation. Ilya's Safe Superintelligence (SSI) raised $1B at a $5B valuation because he *checks notes* said he was starting a company. If Mira Murati sneezes in a tissue, check it for AGI and give it a term sheet.

I've seen some hungry hippos in my day, but these hippos I can guarantee can't see their toes. This is a level of capital intensity that, in prior generations, built nations and put people on the moon. Sam Altman said he needed $7 TRILLION and we said "whoa" but we didn't say "no."

Now, its important to note that I don't mean to crap on AI as a technology or category. But its an unavoidable reality that these massive core AI companies are playing a fundamentally different game. And that game requires igniting exorbitant volumes of Uncle Sam's salad to play. And it couldn't have come at a better time to complete our Unholy Trinity.

The Great Unification

And thus, the Unholy Trinity of Venture Capital was born.

Agglomerators who could run further and faster with bigger funds, more fees, and bigger platforms.

Allocators who were looking to take massive chunky checks and have a shot at a good yield.

Absorbers who have an endless supply of places they can shove their cash, from training and inference to marketing or lobbying. It's expensive to rule the world.

A match made in heaven. Maybe not the heaven, but certainly a heaven.

And this all comes back to the point about the loudest people with the most capital shaping the future of a thing. Today, the loudest people are agglomerators like a16z and GC, allocators like UAE and CPP, and absorbers like OpenAI and Anthropic. And whether you like it or not, they are intent on shaping the game in their image.

I've said this before and I'll say it again. I am, by no means, saying that a16z or CPP or OpenAI are bad. But they are different. They are very different from the venture capital of yore. Granted, they may, literally, unlock artificial general intelligence in a way that will transform the world in ways unimaginable even in comparison to the renaissance, industrial revolution, or digital age. So maybe that's worth letting them dramatically reshape the face of how innovation gets funded.

But remember what a stupider game is—a stupider game is thinking you're playing the same game when your opponent is, in fact, playing a very different game. And its not just that checkers and chess are different. Its that checkers is a dramatically simpler game than chess. Think of it this way. The number of possible games that can be played in checkers is a 10 with 31 zeros after it. Feels like plenty. But the number of possible games in chess is a 10 with 120 ZEROS behind it.

10,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000

vs.

100,000,000,000,000,000,000,000,000,000,000

The reality of the Unholy Trinity of Venture Capital is that the players in that ring have (1) the most capital, (2) the loudest voices, and (3) are taking advantage of the pressure they can exert on how venture, as an asset class, operates. And they're doing it pretty well.

So if I'm not necessarily sayings its bad, then what am I saying?

Therefore, What?

Maybe I'm crazy... but I think traditional venture capital is the bookstores in 1997 that thought Amazon.com was a fad. I think traditional venture capital is the Mom & Pop grocers in the 70s right before Walmart popped off and they got friggin' Walton Rocked. And you can say "I stan independent bookstores" or "I shop local." But in 2023, Amazon and Walmart, respectively, had 574 billion and 648 billion reasons why you're lying.

Stated preference vs. revealed preference.

Granted. Today, founders don't universally choose capital agglomerators. And you have some capital agglomerators that aren't exactly acting like agglomerators cause they're doing stuff like shrinking the size of their funds. So I'm not saying the game is over any more than that Amazon is the only way you can buy books or Walmart is the only way you can buy groceries.

But a game is, as they say, the foot. Things are changing. And firms who say "we're sticking to our knitting. We're a local seed shop. We're a small, cottage-esque partnership making a select few investments. We're a specialist sports memorabilia and bait & tackle venture firm. Maybe that works out.

I certainly wouldn't say capital agglomerators, and their commensurate allocators and absorbers, are the only strategy that work. In a world of Amazon and Walmart, we still have other grocery stores and bookshops. But, by God, you know the only thing that is 100% certain to get sucked into a center of gravity like these behemoths? Something that isn't moving.

In the words of Jesus Christ himself, "because thou art lukewarm, and neither cold nor hot, I will spue thee out of my mouth." In other words, get busy livin' or get busy dyin'.

To end, I'll return to Dr. Romero of Spy Kids fame. After his existential ponderance about God's fear of his own creations, he turns to face his audience with the same response I assume I'll have for many of you when you finish reading this:

"Stop looking at me like that. I'm no loon."

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