Hey everyone - been a bit, sike - it’s been a super long time since I’ve jammed out an article. In truth it’s been almost a year since I’ve published here on All Things Venture. What can I say? Things have been busy. A lot has happened in the world, and in my life, and I’ve been derelict in sharing my thoughts all of you wonderful people. Ce la vie. Anywho. I’m back. And today I want to talk/write/pontificate about the idea of out of distribution ideas. I’m not entirely sure where the kernel of this desire to write emerged from, but I think it was definitely influenced by the recent Invest like the Best episode with Alan Waxman of Sixth Street. It’s a super fascinating episode, and one element of the conversation stuck out to me about the philosophy of the Special Situations Group at Goldman that predated the creation of Sixth Street, and largely was where Waxman grew up as an investor.
I’m going to paraphrase here but when describing the experience and culture of investing at the Special Situations Group, it seemed like they had a singular mandate at Goldman: Don’t lose money. Now not losing money is a very clear, straightforward goal. In practice, when you invest, especially when you invest across different structures - that is very hard to do. In fact I think it’s unheard of. There are obviously some investors who have never lost money in aggregate - that’s why they’re money managers, but personally I’ve never heard of any investor, who has never lost money on any investment. If you know someone like this, even if it’s on a small n of investments, I’d be all ears. Nonetheless, one of the skills it sounds like Waxman and team sharpened over time was this idea of “unitizing risk” which I will largely paraphrase as the quantification and identification of potential losses within an investment. If you want the exact parlance of the idea, go listen to the episode, but the reason why I bring the concept up is because I think unitizing risk in the asset class of venture capital is actually the complete opposite behavior and skill set you want to develop.
Do we have any NBA 2K fans in the readership? Do you remember those game sliders that you could adjust on your create a player? Investing is kind of like NBA 2K. For different asset classes you’re going to want to have different skill sets that are maxed out. For venture capital in particular, yes you want to have a strong understanding of risk & reward. This is something critical for any investor, but for a VC in particular you’re much more oriented to the reward, to the payoff. As I’ve written about, and we’re seeing come to bear in the current cycle, VC is all about asymmetric returns. VCs want to turn a $7m investment into a $4bn return. VCs want to invest ~$4.5m in Scale AI at a ~$15m valuation, and have the company be bought at ~$30bn valuation.
What causes these astronomical returns to occur? Is it purely luck? No. It’s not, although luck plays a significant role for any given individual. Is it process? Maybe. But if it was process, then you’d argue that the capital markets at earliest stages would be much more efficient. Is it point in time? Also no because venture capital has existed since the 60s and only expanded since them, recently crossing ~$1tn of AUM making it one of the largest asset classes on earth. So what is it exactly? What is the core insight that drives the power law outcomes that the entire industry is built around?
My arguement is that it’s centered around another straightforward in theory, difficult in practice idea which is the pursuit of out of distribution businesses.
An out of distribution business, is a business that is outside the norms of what is done today. It bucks conventional market wisdom, it bucks conventional entrepreneurial instincts, and it largely centers itself around the pursuit and creation of something that is utterly new and novel. Increasingly, I think that spending material time out of the distribution is the best thing that any venture capitalist can do. Now in practice this is incredibly challenging to do. It’s a bit like telling a teenager that grows up in Florida that they should try snowboarding every weekend. It’s not impossible, but it’s going to take an incredible amount of discipline and effort to do.
When I think about out of distribution businesses, I think about hypothetical businesses that, in success, would be massive. And I think this type of consistent thinking, this orientation torward the art of the possible is the most important skill set an investor could develop. For arguments sake let’s take a clearly out of distribution idea like creating a new oil major to compete with the likes of Exxon, Shell, BP, and others. The combined market cap of these three businesses is well over $700b dollars. If you shot a cold e-mail out to 100 VCs, with the subject line: “AI Enabled Oil Major attacking $700bn Market (Ex- Exxon)” 95% of them would most likely dismiss the idea in it’s entirety whereas if you shot a cold e-mail out to 100 VCs with the subject line: “AI Native Code Review Tool (Ex-Github)” you’re probably getting a 100% hit rate with multiple people asking to meet same day.
Out of distribution ideas make careers in venture capital, but so much of the discourse within the industry collapses around consensus. Maybe it’s just mimetic theory in action, or maybe it’s the byproduct of a heavily network driven work environment, or maybe it’s people rightly guarding their best ideas for themselves. In any event it doesn’t disprove that when you’re thinking about venture outcomes, and venture investments - you should be thinking about the scenarios of what if this goes right? Much more than you should be thinking about what if this goes wrong? You should be thinking about the payoff, the ceiling of opportunity, and whether or not the problem space is constrained or unconstrained. You should be thinking about where the idea falls on the distribution curve of consensus, and what that means for you as an investor. In distribution ideas are within the distribution for a reason - they are working, there is evidence, there is momentum. Out of distribution ideas are similarly out of distribution for a reason. They are unproven, they are risky, they are unknown, but it’s not as if revenue for an industry dramatically emerges over night. Palantir and SpaceX both showed that the government is willing to pay tech native organizations for superior service. Flock Saferty did the same for police departments. Samsara for trucking.
The final thing I’ll say about out of distribution ideas is that they seem to come in two forms: 1) they apply something new that is gaining traction and exists today and works, but project out increased demand for said new thing in the future above and beyond what is expected today. Examples of this could be Coinbase or Airbnb. Or 2) they take on material technical risk to achieve a commercial outcome, and the technical risk is viewed by conventional wisdom as being impossible to achieve. Examples of this could be Waymo or SpaceX.
Now is any of what I’m saying truly novel? No. Every single VC investor you talk to would agree with almost everything that I have just said. What’s novel though is the application of this thinking. Ask a VC, what is your current, out of distribution idea? Or take the Theilian apporach and ask, “what important truth do very few people agree with you on?” See what happens. If you get blank stares or stammering, or a rambling of thoughts you’ll understand why private markets are still as inefficient as they are :) Hope this little essay sparked some thoughts. Was fun to get back into writing, and I hopefully won’t go another 9 months in between the next essay. Ciao!