When we first wrote about the future of private investing, we discussed how systematic investing benefits founders and investors through the efficiency and scalability that comes from such a strategy. We opened our ongoing discussion of the topic of systematic investing with that concept because it is core to our vision and our mission as a company to help entrepreneurs thrive. However, we also acknowledge that many stakeholders in the ecosystem, some of whom may not initially see systematic investing as benefiting them, have the potential to benefit from our investing approach. Specifically, we want to discuss how systematic investing can bring value to the following players: founders seeking to raise capital, other investors in the space, and Limited Partners (LPs) looking for exposure and upside in early-stage consumer.
Founders: Transforming what it means to raise equity
The next blog in this series will be all about how our systematic strategy will help entrepreneurs and founders, but we consider this the most important aspect of our work so we want to touch on it briefly here.
Systematic investing is, at its core, designed to help founders achieve their dreams in ways that traditional investing cannot. In our recent post, we discussed how the mechanics of systematic investing drive to a more efficient and transparent capital market for founders. But the benefits don’t stop with efficiency and transparency we will provide in our process.
Our systematic team will be powerful partners to founders through a differentiated approach to value creation. And by being more streamlined and efficient in how we invest, we are able to invest our efforts disproportionately into tools and resources to help entrepreneurs thrive. We’ve spoken before about bringing prescriptive insights to companies (including our CEO Ryan’s recent post on the Company’s broader vision). By allocating resources to deliver on that promise, our systematic initiative will create unique value for entrepreneurs.
Co-investors: Sharing the wealth
The early-stage consumer market presents an enormous opportunity for investors. Although it’s often overshadowed by the media’s hyper focus on Tech VC, we estimate that the US Consumer venture market is massive and only growing. This expanding market will demand more investors and more capital, and it creates an opening for a new approach to investing in private markets that complements traditional approaches to create more opportunity for entrepreneurs [and investors]. CircleUp’s systematic fund will be an important complement to traditional investors for that very reason.
Leading the way
Systematic or rules-based investing does not preclude us from leading rounds. As we outlined in The Operational Hurdle Of Valuing Companies At Scale, Helio enables the valuing of companies at scale, so that we aren’t forced to be price-takers from other investors, and a key component of our strategy will be to determine a scalable way to structure transactions with entrepreneurs. When we lead, we will always be interested in bringing in strong co-investors to the rounds. We believe that having other talented investors around the table to complement our own efforts will only improve a company’s outcomes.
Potential co-investors will benefit in two meaningful ways. First, we will share opportunities that many co-investors would not have been able to find otherwise. Second, our ability to accelerate the due-diligence process with our data also makes it possible to use our signal and insights to help accelerate time-to-close for co-investors, thus making smaller deals economically feasible to get done in ways that have historically not been possible.
As a lead, we also bring massive amounts of data into the entire investing process, not just for confirmatory diligence. Historically, when many VCs introduce data into their process, they do so to support a thesis they already have on a particular company. This phenomenon occurs for two primary reasons. First, after a Letter of Intent (LOI) or a term sheet is signed, there is a mandate to ‘go deeper’ into a company, which often leads investors to acquire third party data or conduct first-party research (surveys etc.). Second, once most firms undergo confirmatory due diligence, deal fees often get expensed back to Limited Partners (whereas expenses for sourcing and other work accrues to the general partnership). The result is twofold: 1) rigorous data analysis is seldom conducted at the top of the funnel; and 2) data is being used in ways that may fall victim to confirmation bias (an investor post-term sheet may be looking for data to support, not refute her initial thesis). As a lead investor, a systematic strategy can change the data-use paradigm by making data accessible to co-investors earlier.
Efficiency is a core facet of what makes systematic investing attractive to founders and also will be valuable to other investors when they are are leading rounds and seeking an expedient close. By both building conviction through our algorithms and through an efficient set of processes, we plan to be able to close within two weeks of contact with a company that already has a lead investor in-place. While it’s a lofty goal, it will be game-changing for co-investors and companies alike.
Complementary Value Creation
Our competitive advantage, Helio, can also be a comparative advantage in the domain of post-close value addition with co-investors in mind. Just as value creation with Helio is a valuable asset for founders, it is an approach to supporting companies that is complementary to the ways other investors add value. If an investor already is having impact through a less-scalable (but potentially impactful) means, we see that as potentially mutually beneficial for us should we co-invest systematically. Active board involvement from a General Partner, for example, isn’t a likely core tenet of systematic investing (in part because General Partners don’t exist in a systematic strategy). However, that doesn’t mean we don’t value governance. Rather, we see it as a complement to a systematic approach to creating value for a portfolio.
In the same vein our approach is inherently complementary to other investors. Bringing data science and analytic resources to the table will make it possible to be diagnostic and prescriptive (diagnostic refers to unpacking why something happened while prescriptive refers to helping make a desired future outcome happen) with companies. These will be invaluable addition for the other value-additions that a potential co-investor can bring. We will spend an entire post on this concept soon and are excited to share more on expanding our theory of value creation at scale.
As a result, we see the value systematic investing can bring to co-investors as game-changing, both in what it can bring to an investor’s funnel and in what value it can bring post-close. Growing the pie of opportunities will bring potential investments into the fold that other investors would not have considered. Additionally, complementary post-close value-add will make investments even more likely to be successful with our systematic platform as a co-investor.
Limited Partners: How we are changing the game
We also acknowledge that for systematic investing to be successful, it must be attractive to LPs. We discussed the scalability and repeatability of a systematic model previously and how these two core components of rules-based investing bring about access to a new asset class and eliminate “key person risk.” However, we haven’t really discussed the mechanics of why this approach actually improves outcomes for LPs. The answer resides in the fundamental law of active management (we will call this the “Fundamental Law”), a theory that is often used in the public markets, but that we are bringing to bear in the private markets.
My colleague Tuhin Ghosh recently published a post about how portfolio size and managing correlation, which is closely related to the concept around the Fundamental Law. At a high level, the Fundamental Law is a theorem that states that an investor’s advantage (often referred to as its Information Ratio (IR)) is a function of its competitive edge for selecting companies to invest behind (Selection Skill or SS) multiplied by the square root of the number of bets it makes (N), or IR=SS*N^½ .To simplify the concept, the theorem states that you can do well as an investor by: 1) being better than other investors; 2) making more bets with the same skill as other investors; or ideally 3) both.
Today Helio provides us with an opportunity to have a greater selection skill. When in the hands of a talented portfolio manager, we believe we will be able to make investment decisions that make us more effective. With the efficiency systematic investing can bring to the table, we can invest in a portfolio with 5-10x the number of companies of a traditional VC fund. We discuss this in our first post on systematic investing and will commit time to expanding on the mechanics of achieving such a large portfolio. By greatly reducing search and outreach time, collapsing our time to close by 75% from the average time it takes the average investor, we believe we can support a portfolio of 150 companies. In time, we think that number could scale to an even larger. The result is a product that is both unique and complementary to discretionary venture in the sector, where selection skill relies on pattern recognition and relationship management.
We have been exploring the best ways to create a fund that delivers immense value to founders and taps into an entirely new asset class for investors all while creating value for the entire ecosystem at-large. With our systematic fund, we think a rising tide can raise all ships and unlock the value and the potential that the emerging consumer landscape has to offer.