I’ve been learning more about successful investors. I want to know what led to their outsize success and why they’re able to repeat it. One common trait I’ve noticed is probabilistic thinking.

Most people are binary thinkers. They think only in terms of an outcome 100% happening or not happening. But binary thinking doesn’t reflect the reality of the world. Most outcomes aren’t 100% guaranteed because the world is full of randomness and uncertainty. There is usually more than one possible outcome, each with a probability of happening (even if it’s small).

These investors understand this and factor probabilities into their decision-making. Outsize returns usually result from betting on non-consensus outcomes that have a probability and return profile the investors like. For example, when the prices of assets are falling continually, most people think to sell to avoid further losses. These investors will buy (non-consensus) if the probability of these assets rising is higher than them falling further and the return could be outsize.

They also understand that probabilities and outcomes are different. The probabilities of an outcome can be on your side, but that doesn’t ensure a favorable outcome. Randomness and other factors are still present. When your desired outcome doesn’t happen, that isn’t a reflection on the quality of the decision. It just means the probabilities didn’t work out in your favor this time.

Yesterday’s post was about in-kind distributions that venture capital (VC) funds make to their limited partners (LPs). A friend pointed out that some larger funds, such as Sequoia, A16Z, Thrive, and a few others, may be focusing more on making in-kind distributions to their LPs. These and other firms are starting to become registered investment advisors (RIAs), which my friend assumes is related to making in-kind distributions. I’ve been reading about funds becoming RIAs, and I don’t think it’s related to making in-kind distributions to LPs.

A VC fund that makes an early-stage investment in a company doesn’t need to be an RIA to do in-kind distributions. If one of the fund’s portfolio companies goes public or is acquired in a deal where some or all the purchase price is paid in stock of the acquiring company, the general partners can distribute that equity to their LPs. There may be reasons to wait to do so: for example, an IPO lockup period or wanting the acquirer’s equity value to increase before distributing stock to LPs. There are nuanced rules around VC funds holding a material percentage of fund assets in something other than private companies, but I won’t get into those details.

All the firms my friend mentioned are run by very smart people who have had a lot of success over several years. I don’t have any inside information on their strategic reasons for becoming RIAs, and I’m curious and plan to learn more. I wouldn’t be surprised if it’s related to their ability to invest in and hold a broader variety of assets for a longer period. Said differently, I wouldn’t be surprised if it allows them to expand their firms into areas outside traditional venture capital investing.

I had a chat with a friend and fellow venture investor recently. He’s raising a fund and pitching lots of limited partners (LPs) to invest in it, which got me thinking about what LPs want.

In general, there are various types of limited partners: high-net-worth individuals, family offices, corporations, pensions, endowments, and more. LPs are motivated by different things. To understand whether your fund strategy is aligned with a particular LP, it’s important to understand their motivations.

In my conversations with LPs, I’ve noticed that returns matter to all LPs—but not always cash returns. Most people think that when a fund makes a distribution to its limited partners, it’s in cash. This is often the case. But general partners (GPs), who manage venture capital funds, can choose to distribute stock in a company to their limited partners. This is called an in-kind distribution. For example, if a company has an IPO and goes public, the GP can give the public shares to the fund’s LPs. The LPs can then choose to hold the stock or sell it based on their objectives.

Some LPs want their returns paid in equity. They want in-kind distributions. If a GP invested in a great early-stage company that will produce large profits and distribute dividends to equity owners, or that will continue to grow rapidly and increase in value, these LPs want to go along for the ride. They’re less interested in companies that have no clear path to profitability because they want to own assets for decades.

I’m not sure if this type of LP is in the majority or the minority. I suspect that most GPs target cash distributions (for a variety of reasons). If GPs target investing in companies that LPs can own for decades, I imagine that changes what companies GPs invest in and how they want the companies’ founders to grow their companies.

Imagine if the venture investors who seeded Apple or Microsoft distributed securities to their LPs and the LPs still held those shares today. Between appreciation and dividends, the returns would be amazing. So would the rate of compounding from the initial investment by the GP until today.

I wonder how many venture funds target in-kind distributions so their LPs can own the companies they’re investing in for decades?

I had a conversation with a friend about the difference between wealth and income. They’re not the same thing. I realized through this conversation that some people aren’t aware of the difference between the two.

Wealth is the value of the assets you own (minus your liabilities, or debts). Assets include real estate, personal property (art, jewelry, etc.), and equity (i.e., ownership) in public or private companies.

Income is the money generated from your labor, wealth, or ingenuity.

Money isn’t wealth. It’s more of a medium of exchange that facilitates trade. It allows you to buy goods and services.

One of the hardest concepts for people to understand is that you can have high income but not wealth. For example, if you make $1 million a year and have $999,999 of annual expenses, you’re not increasing your wealth.

Conversely, you can have wealth but not generate enough income to pay your living expenses, which depletes your wealth.

Wealth and income are different, and it’s important—especially for entrepreneurs—to understand why.

I spent time explaining to a friend how management fee recycling works for venture capital funds. Funds that recycle management fees can reinvest cash distributed to the fund into new start-ups. The alternative would be to distribute all cash back to their limited partners. For example, let’s say a fund invested $1 million into a start-up and received $1.5 million back after the company was sold. Depending on a variety of factors, a fund that recycles fees could deploy some or all the $1.5 million into a new start-up instead of returning it back to limited partners. If they don’t recycle, the entire $1.5 million would likely go back to limited partners.

Most funds have a ten-year life, meaning the goal is to deploy capital and return profits to limited partners within a ten-year window. And most funds have a management fee. This fee provides cash flow to pay operating expenses of the fund, such as salaries. The management fee is charged yearly, usually as a percentage of capital committed from limited partners. Two percent is what I’ve seen most funds charge, but it can be higher or lower. Two percent charged annually for a decade means that 20% of the capital committed by limited partners won’t be invested in start-ups.

The other venture fund fee is called carried interest. That’s a fancy way of saying profit sharing. The people managing the venture fund (general partners) split any profits generated with the limited partners. Twenty percent carry is what I’ve seen for most funds focused on investing directly into start-ups, but it can be higher or lower. Twenty percent carry means general partners get 20% of any profits earned. It’s important to understand that carry is usually earned after the initial capital is returned to limited partners. If the fund is a $10 fund, the general partners must return all $10 first; then any capital above that is eligible for carry. Said differently, the fund must be returned in its entirety before carry can be earned.

Let’s look at a hypothetical $100 million venture fund with a 10-year life cycle and a 2% management fee:

• Capital invested in companies: $80 million
• Capital to manage the fund: $20 million

Most funds aim to generate a 3x return (we’ll assume gross for simplicity) for their investors—$300 million for this hypothetical fund. Let’s run a few scenarios:

• If this fund doesn’t recycle fees, it must turn $80 million into $300 million. That means the general partners need a return of 3.75x the $80 million they invested into companies to achieve their 3x return target.
• If this fund recycles fees, they could end up deploying the full $100 million and need to triple the capital invested to achieve their target (3x) $300 million return.
• It’s possible to recycle to the point where the fund invests more capital into companies than was committed by limited partners. Imagine that the fund recycled enough to invest $115 million into companies. That’s $15 million more than limited partners invested in the fund. To achieve their 3x return target, they need to achieve a return of 2.6x the $115 million capital invested into companies.

From these three scenarios, you can see a range of 3.75x to 2.6x return on invested capital needed to achieve the same $300 million—3x return for a $100 million fund. That’s a big difference.

Venture capital is a power law business where one or two companies can generate a large portion of a fund’s returns. Recycling can allow general partners to place more bets on a single fund.

Fee recycling involves lots of nuances and details that I didn’t get into, but this is an important concept for fund managers (and even founders) to understand.

An investor shared details of a deal he’s been evaluating. He loves the sector, loves the founder, and loves the product. He hasn’t done the deal because he has concerns around the cap table—specifically, how much capital has been raised from investors in previous rounds and how much is being raised in the current round. The company has an enormous burn rate of around $400 thousand monthly, hasn’t achieved product–market fit yet, and doesn’t have much revenue from customers. Yet, it’s raising a third multimillion-dollar round of capital.

The major concern of this investor is the amount of dilution at such an early stage. The CEO-founder will own less than 20% of the company after the current raise. If the company can raise the current round, find product–market fit, and raise additional rounds of capital at later stages, the CEO-founder could have a small ownership stake in the company. This investor sees the CEO owning less than 10% as a real possibility. If that happens, it will take an enormous outcome and many more years for the CEO’s small equity position to have a major financial impact on his life. Rather than go down that path, the CEO might leave and pursue something else with a more attractive risk/reward ratio. That wouldn’t be ideal for those who invested in the company.

This isn’t the first time I’ve had an investor tell me this, and it likely won’t be the last time this year. Raising too much capital too early can cause lots of downstream problems if the company can’t achieve significant traction. This story highlights the excessive dilution problem and why investors are hesitant to invest when the founders don’t have material equity ownership in an early-stage company.

If you’re an early-stage founder, keep a close eye on your burn rate relative to company traction. If the traction isn’t there (i.e., you haven’t founder product–market fit), don’t be afraid to adjust the burn rate.

Today I spent time reflecting on past investments. I thought about what I did right and what I did wrong. I’ve done this before and made mental notes, but I realized that wasn’t consistently preventing me from making the same mistakes. Today I created a “lessons learned” doc to capture in one place all the learnings floating in my head.

I’m glad I did this exercise. Seeing everything I’ve learned in one place helped me pinpoint the areas I need to work on more.

I’m excited to add to this doc as I reflect more and use it to help me improve my evaluation of investments.

Over the last few years, I’ve had the opportunity to invest directly in start-ups as an angel investor, invest in venture capital funds as a limited partner, invest directly into start-ups as a Partner at a venture capital firm, and help organizations do their due diligence on direct investments into start-ups with strategic value.

I’ve learned a ton from all of it—but I’ve learned the most from investments when my personal capital has been on the line. This includes investments in funds and start-ups.

I learn best by doing, and in investing, “doing” means investing my own capital.

A venture capital investor shared this article with me. I won’t go into all the specifics of it, but it says that private equity fund managers are selling pieces of their firms to raise cash. Instead of investing by becoming a limited partner in the firm’s latest fund, some investors are seeking to buy part of the firm to gain exposure to the firm’s current and future investments.  

This isn’t new in private equity. Neuberger Berman started a division in 2010 to focus exclusively on this strategy. That division, Dyal Capital Partners, merged with Owl Rock Capital Group in 2021 to form publicly traded Blue Owl Capital Inc. Blue Owl just announced the closing of Dyal Capital Partners V, a $12.9 billion fund focused on taking ownership stakes in approximately 20 private equity firms.

I’ve been closely watching the world of buying stakes in private equity firms for a few years, and I have some thoughts:

• It was only a matter of time before this trend reached larger venture capital firms. It’s starting to happen more now, as evidenced by Thrive Capital’s recent news.
• This approach could provide emerging venture capital fund managers with the runway needed to continually execute on their strategies.
• Venture capital fund managers early in their firm’s life cycle see selling part of their firm as having a negative connotation. This leads to many VC firm founders having a bootstrap entrepreneur mentality and the industry being a cottage industry (there are other reasons for this too).
• As more established VC firm founders realize liquidity by selling parts of their firms, more founders of smaller firms will be open to taking capital in exchange for equity so they can grow their firms.

It’s often seven or more years before a start-up has a material liquidity event such as an IPO or acquisition. Founders should be comfortable with a journey of that length if they want to pursue entrepreneurship.

I recently had a chat with a venture investor who considered starting his own venture capital firm. One of the main reasons he hasn’t is the realization that it will commit him long-term. It will likely take twelve to twenty-four months to raise the fund. Funds usually have a ten-year life cycle, so once he begins investing that capital into start-ups, he’s committed to managing the fund for a minimum of ten years. That’s an eleven-year-plus commitment he’s not willing to make. Instead of writing larger checks from a VC fund, he plans to write small angel checks. He’s putting more of his own capital at risk, but he wants to preserve flexibility over the next decade.

This investor has deep domain experience and a strong network in a particular sector. Any early-stage founder he works with will get a tremendous amount of help and is more likely to achieve product–market fit.

Listening to this got me thinking. I wonder how many seed-stage venture investors (current or aspiring) who could help companies find product-market fit avoid starting a venture capital fund because of the decade-long commitment.