The Science Behind Venture Capital with Frank Rotman (QED)

The name Frank Rotman should ring a bell for those within the VC, startup and LP ecosystems. The Co-Founder of QED Investors (one of the world’s best fintech investors) and one of the earliest hires at Capital One, Rotman is a highly renowned investor and operator in the fintech industry.

We sat down with Rotman to discuss his highly acclaimed research, The Three-Body Problem: Finding the New Stable Points in Venture Capital. One of the oldest and most famous physics problems, the Three-Body Problem, was more recently brought back to prominence by author Liu Cixin, who received the 2015 Hugo Award for his novel, The Three-Body Problem.

Rotman has used the Three-Body Problem for the past 15 years as a framework for understanding the evolving complexities within the venture capital industry over multiple market cycles. “This analogy is meant to be interpreted solely as research. I stay away from prognosticating. I write about what’s actually happening,” Rotman shares.

You’ll likely be surprised by the number of parallels between the Three-Body Problem and the modern-day venture capital industry…

How does the Three-Body Problem translate to the venture capital ecosystem?

The Three-Body Problem encompasses the mathematical equation of predicting the trajectory of three orbiting bodies, which move under no influence other than their own gravitational and centrifugal forces.

The three bodies in the VC ecosystem:

• LP Ecosystem – Allocators of capital.
• Startup Ecosystem – Founders building companies based off of their ideas.
• Venture Capital Ecosystem – The intermediary that raises capital from LPs to invest in winning startups to create outsized returns for LPs.

When one of the three bodies is smaller relative to the other two (with size defined as the quantity of firms within the context of this analogy), points of stability exist and the problem is far easier to solve. Within the VC ecosystem, the smaller body, VC: ~13k firms, is affected by what is happening in the two larger bodies LP: ~20k firms and Startup: ~127k firms (Source: Pitchbook Data).

In a simplistic sense, these three bodies are interrelated in that capital flows from LPs to → venture firms → to startups and eventually back to LPs upon liquidation.

How has the private market evolved over the last 15 years?

“The startup ecosystem has experienced a Cambrian explosion in availability of funding. This is an observable fact: you can see how much capital from LPs has flowed into the startup ecosystem,” states Rotman.

For the 2001 calendar year, there were 178 unique new companies founded that received funding from a US-headquartered investor. $930 million of capital was invested in over 182 deals (Source: Pitchbook data). Whereas for the 2021 calendar year, there were 1,897 unique new companies founded that received funding from a US-headquartered investor. $14.3 billion of capital was invested in over 2,120 deals (Source: Pitchbook data). From 2001 to 2021, US-headquartered VC funding grew by 14.4x.

The growth was catalyzed by a few key factors:

• Growing prevalence of infrastructure that enables startups to build faster and cheaper
• Larger talent pool of people who have launched and scaled startups
• The sheer quantity of available angel/seed funding has grown substantially

“Going from zero to one is no longer a dark art”

Today, there is more value being created than ever before in the private markets. There are 1,112 private companies valued at $1B or more. 520 unicorns on the global list were founded in 2021 alone (as of May 2022, source: Pitchbook data).

As more startups grow into seminal companies and generate liquidity, more capital is returned to LPs, and the capital gets redeployed. Public markets have performed well over the last two decades, so LPs have even more capital to allocate. Furthermore, because the private markets have generated outsized returns (relative to other asset classes), more capital has flowed into the VC asset class. Today, significant amounts of value that were historically captured in the public market have now shifted into the private market since companies are staying private longer - which is creating a record number of unicorns. This is a major change.

Denominator effects at the LP level caused by public market drops are impacting VC allocations; only the strongest VCs with the best track records are being funded; startups that need to go to market but have subpar business models or unit economics will struggle to raise.

Darwin returns from a 2-year vacation

Frank has referred to the idea of Darwin going on vacation for 2 years. Now he is back. How will natural selection begin to play out again and which VCs and startups will survive?

Over the past two decades, the LP and startup ecosystems have evolved while the VC ecosystem has remained stagnant. The typical VC firm today looks the same as it did 15 years ago. Each firm consists of 6-10, maybe 20 experienced investment professionals trying to figure out how to evaluate a team and idea, source capital, insert themselves and ultimately convince the best startups to take their capital.

15 years ago, startups sought out VCs. Almost all VCs were based on Sand Hill Road in San Francisco, so startup founders would drive up and down the road and meet with each VC. Nowadays, VCs have too many one-to-many matching problems; they need to (1) source capital from LPs, (2) figure out which startups are the best, and (3) compete with other VCs.

The sheer growth in the number of startups and VCs has added more complexity to each respective ecosystem.

If you’re not in a stable orbit – you need to work much harder

“If a potential LP had to select one VC firm to allocate capital to, would it be your firm? If a talented founder with an excellent idea needed to choose a VC firm, would they choose your firm first? If you answered no to either of these questions, your VC firm is in an unstable orbit,” says Rotman.

Within the context of the Three-Body Problem, it’s important to understand that when one of the three bodies is smaller (quantity of VC firms) relative to the other two, points of stability exist called stable points (L1-L5 pictured below). Under a stable environment, the gravitational and centrifugal forces of the two large bodies are in equilibrium, so few corrections are needed to maintain orbit.

For VC firms not operating at a stable point, failure is not necessarily guaranteed, but they will need to work harder to develop a repeatable value proposition in order to succeed.

The best VC firms are demanding ever-larger commitments from LPs which further strains capital availability. Thus begins the start of the death spiral for many VC firms that are unable to quickly move to a stable point.

Applying the Three-Body Problem analogy to the VC ecosystem requires solving for VCs’ points of stability. There are four stable points that a firm can operate in:

• Scale (multi-billion dollar funds)
• Non-consensus alpha (funds like Ensemble that use innovative/untraditional sourcing tactics, investing in non-obvious and/or highly risky businesses)
• Late-stage generalist (funds writing biggest checks into late-stage companies)
• Solo capitalist(funds organized around an individual)

Stable points: Achieving scale from a manufactured value proposition

VC firms with repeatable value propositions are at stable points. For VCs, successful fundraising is conditional on demonstrating a great investing track record. LPs allocate capital based on performance, so the better VCs are at investing, the more access they have to capital.

Scale is stable because it offers a compelling value proposition to both its customers: startups and LPs. The higher the deal volume that a VC firm sees, the higher the probability of investing in a winner. Having a variety of deeply skilled individuals on the team is a competitive edge because larger teams can source more deals.

In addition, the ability to invest in later rounds is a massive weapon of at-scale firms with access to seemingly unlimited capital. The sheer quantity of breakout winning startups will help VCs at scale win future deals because winners want to be associated with winners.

“Sequoia is a great example of a VC firm operating at scale, in that startups and LPs come to them, and they win the majority of their deals when up against other VC firms,” Rotman claims. This is largely due to word-of-mouth, unlimited capital at all times and being associated with winning investments. Imagine if you never had to worry about capital availability from LPs – what would your VC firm look like?

“QED is on a scale-path. We’re a $1B fund with half dedicated to early stage opportunities and half dedicated to rapidly scaling companies. We feel that $1B is the threshold scale in fintech because of the size and depth of the market. Being “at scale” has significant advantages that compound in predictable ways to generate top decile returns. And our ability to scale up winners as they prove themselves has proven very strategic during the current market correction. 75% of our growth fund has gone into existing portfolio companies that we would rank in our “top 25%”. This makes sense. We know these businesses, plans and teams extremely well,” states Rotman.

Manufacturing repeatable returns: Discipline. The right space. Process.

Rotman also walked us through his philosophy and methodology of manufacturing repeatable returns. “We started QED by investing our own money as an experiment. Nigel and I helped build Capital One which gave us confidence we were good operators. But we weren’t sure how good we were at investing. During the first 6 years, we developed a good track record which convinced us that our operator skills were relevant, which made it much easier to raise money from LPs. LPs liked our track record but understood who we were and how we operated after meeting us and diligencing the flywheel effects of our value proposition.

Discipline

It’s okay if we miss a $100B company. It happens to everyone that’s been investing long enough. But our funds need to invest in multiple $3-5B companies every fund. If we can raise capital and scale with investment discipline we can maintain consistency. This is one of the reasons I moved to Chief Investment Officer (a rare role in a VC firm), to help maintain discipline around our investment decision.

The right space

If you put a term sheet on the table, should the team take it? You need to be hunting in the areas where the answer is yes. For us, outside of fintech the answer would be no. I talk to companies about being in the right space all the time. Ask yourself this all-important question: If a rational consumer was faced with perfect information, would they pick your product?

Process

Funding a startup is like asking an author to create a book one chapter at a time. The seed investors pay for chapter 1, Series A for chapter 2, and so on. But every book is not for every reader. As an investor, the goal is to find and back a good founder and then work together to build a great company. Our process is to invest in founders who continue to execute according to plan. When we like how a story is unfolding and want to ensure the book gets finished, we’ll keep funding the startup to completion,” Rotman shared.

What’s standing in the way of VC ecosystem improvements?

Now that the VC and startup ecosystem has matured, with a record number of startups, it is incredibly hard to generate consistent and repeatable returns for LPs. VC firms need to find the stable point that plays to their strengths so founders are more likely to pick them over their VC competitors.

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