January 16, 2024

Harvesting the Long Tail: A New Approach to Startup Investing

Harvesting the Long Tail: A New Approach to Startup Investing

The theory of the Long Tail, popularized by Chris Anderson in his book "The Long Tail: Why the Future of Business Is Selling Less of More," describes the economic phenomenon where the demand for niche products or services that are less popular or mainstream can collectively exceed the demand for popular ones. In simple terms, the aggregate sum of underserved or over looked markets will always outstrip or exceed the market for the most popular products or services.

We have seen the Long Tail play out in markets like music and books.

In traditional brick-and-mortar music stores, physical shelf space was limited, so they focused on stocking and promoting only the most popular albums or artists. This meant that niche music genres or lesser-known artists had limited visibility and availability, leading to lower sales. However, with the advent of online music platforms like iTunes and streaming services like Spotify, the cost of distribution and storage became significantly lower. This allowed for a larger catalog of music to be made available to consumers, including niche genres and lesser-known artists. As a result, the collective demand for these niche offerings started to surpass the demand for mainstream hits. For example, while a popular album may sell millions of copies, the combined sales of numerous niche albums can exceed those numbers.

Similarly, in traditional bookstores limited shelf space meant that only the most popular books were prominently displayed and sold. However, with the rise of online book retailers like Amazon, the physical constraints of shelf space were eliminated. This allowed for a much larger inventory of books to be offered, including books in niche categories or by lesser-known authors. As a result, the collective demand for these niche books began to compete with and sometimes even surpass the demand for mainstream bestsellers. Online retailers can stock and sell a wider variety of books, catering to specific interests and niche audiences.

Long Tail economic theory may hold a key to a new investment strategy for venture capital.

Power Law, also known as the Pareto principle or the 80/20 rule, is a statistical concept that describes a highly skewed distribution. In the context of venture capital, Power Law suggests that a small number of investments in a fund's portfolio will generate the majority of the fund's overall returns.

But in the last couple of decades Power Law has become more than a statistical observation of a venture capital firm's historical return patterns. Cult-like, it has become the basis of nearly every forward looking investment thesis. The strategy is sometimes referred to as “the Unicorn Investment Thesis,” where venture capital investors seek only to invest in early-stage startups with the potential to achieve a valuation of $1 billion or more.

Just how prevalent has this thesis become?

Over the last decade venture capital firms raised over $1.7 trillion, compared to just $406 million in the preceding decade. Much of this growth came from new venture capital funds seeking to market Power Law returns and Unicorn chasing. From 2016 to 2021, approximately 12,600 new venture funds were established, more than double the number formed in the previous six years.

The problem with generating such outsized returns is the lack of early-stage opportunities that can possibly fit the model. All other things being equal, in a capital-constrained environment with limited competition, venture funds can rely on the returns distribution and probability of outliers to generate excess returns. In the early days of modern venture capital, this was certainly true.

But data pertaining to venture fund returns suggests times have changed. As you might expect, venture capital as an asset class has suffered systematic fund underperformance. The Cambridge Associates US Venture Capital Index averaged just 5.06% per year between 2000 and 2022, compared to the S&P 500 at 5.91%.

The pursuit of skewed return distributions is to venture capital industry what bricks and mortar shelf space was to the music and books industry.

Coming out of the COVID-19 pandemic I began to quantify and qualify a unique opportunity to develop and invest in a larger pool of potential startups that collectively represent a substantial market opportunity. It is the Long Tail of venture capital, entirely outside the narrow window of hyperbolic Unicorn narratives. These are the startups that don't necessarily fit the investing criteria for contemporary VC firms perilously committed to Power Law hopes and Unicorns dreams, but still hold demonstrable promise of becoming profitable businesses.

Two years ago Next Wave Partners started identifying and backing these companies. Not surprisingly, early data indicates we have begun to unlock diverse, emerging markets and innovation. Just as online platforms found success by offering a wide variety of less popular books and music, we see a future in pivoting away from mystical distribution theories predicated on unrealistic, and arguably unhealthy, startup valuations.

Time will tell, but we contend harvesting the Long Tail of startup candidates shows greater promise of leading to more consistent returns above market for fund investors.