Jamie Rhode - Embracing Emergence

Thank you, Benedikt, for your invitation to be a guest writer on Embracing Emergence, and congratulations on the birth of your second child! We met almost a year ago, when we both were still at a single-family office investing in emerging managers. I joined Screendoor to continue my journey of not only sourcing and investing in a significant number of new managers, but also to reduce the friction that LPs experience when investing in this space. At Screendoor, we believe in challenging the status quo of traditional venture capital to catalyze a new virtuous cycle. We believe a focus on thinking and investing differently has the potential to drive outsized economic returns. We do this by investing in early-stage emerging managers who are bringing new perspectives, ideas, and strategies to startup investing early in their firm life. We anchor their funds with not only capital, but also counsel through tailored mentorship from our experienced GP advisors, while providing LPs visibility, access, and exposure to new and developing venture firms that match a variety of unique portfolio goals.

I love the title of this blog, Embracing Emergence, because it's how I think about early-stage venture. In simple terms, emergence is the idea that the entirety of a system can be greater than the mere sum of its individual components. Even small, non-linear changes within these components can result in disproportionately large effects on the overall behavior of the system.

Let’s use an example of crowd behavior to help break down this complex topic: In a crowd, individuals may act differently than they would if alone, often influenced by the presence and actions of others around them. Emergent behavior in crowds has been observed at concerts, protests, and even sporting events - think the “wave” at a baseball game. Emergence leads to herd mentality because individuals in a crowd are influenced by the actions and emotions of those around them and they confirm their behavior/decisions to the majority. Reliance on others’ actions then becomes a cue for an individual’s own behavior, which rapidly spreads and drives information cascades where the choices of early adopters influence subsequent decisions by others. Ultimately, this can result in rapid shifts in behavior. 

Early-stage venture investing targets emerging technologies and industries where there is potential for significant disruption and non-linear growth via emergence. Typically, the novel functionalities or market opportunities from these technologies arise from the convergence of individual components, such as market trends, consumer behavior or regulatory changes. Think of some of the big venture winners like Uber, Airbnb, Facebook, Coinbase, and Instacart when they were raising seed rounds, and the various non-linear factors that needed to converge on their journey to success. Simple parts came together to create something more complex or significant, and that complexity or significance was not easy to predict just by looking at the individual parts.  Networks of startups, entrepreneurs, industry experts, and other stakeholders are the keys to venture investing that foster emergent properties because, when combined, they lead to knowledge sharing and collaboration that likely help fuel these types of big winners. Emergent crowd behavior plays a critical role in driving network effects by facilitating the spread of information, engagement, and adoption within the user base. This can allow a startup to scale quickly, creating an economic moat where its whole is greater than the sum of its parts and potentially becoming an outlier company that drives venture returns to be so attractive. To be an enduring successful early-stage investor, you need to invest through the lens of embracing emergence.

In venture, only a small number of startups, 2%¹ , become an outlier, but those winners make up for all the losses and drive the mean return to be highly attractive. This is why venture, specifically early-stage, has a power-law distribution, where the mean or average return is significantly greater than the unattractive median or the 50^th percentile (middle) return. Based on the most publicly available CA data (2Q20) of 1,970 US venture funds between 1981 and 2020, the horizon pooled net return (or mean return) is 36.2% for US VC. Drilling down into this group, the early-stage IRR return is 59.9%, while growth is only 11%. This means if you could invest in every single early-stage fund that exists in the CA database, you would earn a 59.9% IRR! A fascinating aspect of power law distributions is their connection to emergent behavior. To make this concept more accessible, consider an analogy such as the movie industry, which also follows a power law distribution. In the film industry, the success of a movie is influenced by various factors such as marketing, star power, genre, and word of mouth recommendations. Movies that perform well at the box office attract more viewers, generating higher revenues, leading to further publicity and success. This self-reinforcing dynamic results in a power law distribution of box office revenues, where a small number of blockbuster films earn disproportionately large revenues compared to the vast majority of films. This distribution is also referred to as the 80-20 rule or the pareto principle, where roughly 20% of movies generate 80% of the total box office revenue. The pareto principle also exists in early-stage venture² , where roughly 80% of early stage fund returns over the past 32 years are generated from only 20% of the funds. So how do you pick which venture funds to invest in and avoid the unattractive median return?

Finding managers that understand Emergence is crucial to success, but requires a wide sourcing funnel and strong opinions, loosely held. Outcomes in venture are very hard to predict when analyzing individual components in isolation, especially at the early stage. Seed stage investing is completely fragmented: Only two venture firms have historically invested into more than 2.8% of the outliers³ ! The data proves that exponential growth is difficult to identify early, as the slope of the growth curve is relatively flat - until it is not - and then it is too late to access as an early-stage VC outcome. I wouldn’t risk everything on a 2-3% chance in Vegas, but I don’t settle for median early-stage venture returns either.

Unfortunately, even LPs and GPs that seek to embrace emergence cannot always prevent behavioral biases from creeping in. Herd mentality, or following the crowd, happens often in investment management. When seeking exposure to the outliers, we believe you need to be investing in the edges or the far-right tail of the power-law distribution where the winners emerge. Separating the signal from the noise can be extremely hard, especially when the risk of adverse selection is so high. According to Pitchbook, there have been over 4,000 emerging manager funds since 2015. Looking at the last 40 years, 60%⁴ of venture capital funds $100M or less in size produced less than a 2x net TVPI. Only 20% produced a 3x net or greater. Classic pareto principle at play!

At Screendoor, we look for managers that play in these edges, the far-right tail of the venture capital distribution. To produce venture outcomes in this industry, we believe you need to be non-consensus and right, taking a leap to identify the emergence BEFORE the herd mentality sets in.  We are laser focused on investing in the ‘New’ because that’s where we believe these future outliers can be captured - outside of the firms, networks, and boundaries already recognized by the crowd. The New is hungry, adaptive, and differentiated from what exists in the marketplace today, but they don’t seem obvious to the untrained eye right now. How many ‘No’s’ did the last generation of outlier companies and firms first hear because they were different from the ‘Current’, yet each leaned into their non-consensus approach to later become highly successful venture outcomes and brands that ultimately created new industries. 

Screendoor underwrites every opportunity relative to the entire venture capital landscape and the potential role that prospective firm could play in the future of the ecosystem. We want to back managers whose whole is greater than the sum of its parts or 1+1 = 10. Is the team or individual building a firm and executing their strategy in spaces where they have an edge that’s uniquely aligned with their prior experience? Can they consistently attract the best founders, select, and win? Does their portfolio construction match their strategy and fund size, and does it position them to become a successful enduring firm? Or, at its core, does this potential fund demonstrate emergence: can the collective interactions from the system of this New Firm result in something more significant, and will it be so compelling that herd behavior will undoubtedly follow?

These are just some of the key attributes that we look for on our platform. We welcome all managers to share with us how they are bringing new perspectives to the ecosystem - please share your story with us here! We also love to collaborate with allocators in the ecosystem, both as an extension of your team providing exposure to new and developing funds and to share more about all of the managers we are fortunate enough to work with along the way. Please find me on LinkedIn to dive in more as expanding our networks allows us to leverage the spontaneous creation of new and promising opportunities - I look forward to connecting and embracing emergence with you!

1  https://www.linkedin.com/posts/ilyavcandpe_stanford-stanfordgsb-venturecapital-activity-7021853740760539136-jpgu?utm_source=share&utm_medium=member_desktop

2  https://www.linkedin.com/posts/jerrcfa_powerlaw-earlystageventure-pareto-activity-69856100250585907

3  https://techcrunch.com/2024/03/27/unicorn-founders/

4  https://www.linkedin.com/posts/jerrcfa_investmentmanagement-familyoffice-venturecapital-activity-7026972044361637888-00Lx/?utm_source=share&utm_medium=member_desktop