Investing Billions - E68: The Smithsonian Institution’s Venture Capital Edge

Episode Date: May 21, 2024

Jeff Smith, Managing Director of Private Investments at the Smithsonian’s endowment, sits down with David Weisburd to discuss the Smithsonian endowment’s advantage in accessing the best managers in venture capital. They also discuss the importance of continually allocating throughout cycles, knowing when to exit, and communicating effectively with LPs. They conclude by covering what Jeff looks for when evaluating new venture managers. The 10X Capital Podcast is part of the Turpentine podcast network. Learn more: turpentine.co -- X / Twitter: @smithsonian (Smithsonian) @dweisburd (David Weisburd) -- LinkedIn: Jeff Smith: https://www.linkedin.com/in/jeff-smith-1404ba1/ Smithsonian Institution: https://www.linkedin.com/company/smithsonian-institution/ David Weisburd: https://www.linkedin.com/in/dweisburd/  -- LINKS:  Smithsonian: https://www.si.edu/  -- NEWSLETTER: By popular demand, we’ve launched the 10X Capital Podcast newsletter, which offers this week’s venture capital and limited partner news in digestible news bites delivered straight to your email. To subscribe please visit: http://10xcapital.beehiiv.com/  -- Questions or topics you want us to discuss on The 10X Capital Podcast? Email us at [e-mail] -- TIMESTAMPS:  (0:00) Episode preview (0:57) How Jeff’s startup experience influences his perspective as an LP in venture capital (1:54) Capital allocation, exit strategies, and market trends in VC (6:12) The Smithsonian endowment’s advantage in venture capital (11:17) Criteria for investing in venture managers (15:28) Smithsonian's venture strategy (19:55) Considerations for investing in first time funds (21:40) The mission of the Smithsonian and closing remarks

You mentioned on your asset allocation that you're much more leaning in to venture versus buyout versus other private equity. Why is that? There's a number of reasons, but the ones that come to mind are that A, it's the juiciest part of the portfolio at the endowment. So we're going to make the highest returns or should make the highest returns in our venture portfolio. That has historically been the case. We have a great mission. The Smithsonian is loved across the country, across the world. I talk to people who've been to the museums. We represent a great organization. So the constraints to accessing these funds are a little bit lower for us. You're in some of the top funds.

I know we can't talk about them, but I know them. What would compel you to invest in a manager today? To me, for more ideas on how to raise venture capital in this market, make sure to subscribe below. Jeff, I've been really excited to chat. We had a great chat offline and I'm really excited to delve really deep into your strategy. Welcome to the 10X Capital Podcast. Thanks very much. I'm super excited to be on it. How does startup experience benefit you as an LP and venture? One of the things is just to know what happens when things go wrong and how over

exuberant the market can get that you need to be aware of when capital flows too easily. I think I've always been a little bit skeptical as a result of that scarring of folks that are deploying capital too quickly or are a little too cocky or a little too green. So I've generally liked people who have had a little bit more cycle experience to little too green. So I've generally liked people who have had a little bit more cycle experience to manage my money. I know there are some downsides to that, right? Sometimes it's better just to have fresh eyes to look at the world that way. However, I always have been worried that I'm the people I'm working with or that I would give money to. And we miss some things as a result are going to just blow our money, right?

They're going to spend it too quickly. They're going to like every and love everything they see. And they're going to get too caught up in the hype of the market. Bill Gurley famously said that when you have a bull market, the last couple of years, you know, return sometimes 25, 50% of all the returns. So getting out early can be as bad, if not worse, as going in late. You've been an investor in the SaaS class for many decades. How have you seen that play out? I think you need to be really careful about allocating your capital over time

and investing with really smart managers who know how to exit correctly. And we're not going to get this right. They're not going to get it right. I mean, 2021, our holiday party, I told our crew who outside of Amy and our CIO, a lot of our folks, we still have a relatively more experienced team, but we had some younger folks there who had definitely never seen a cycle like this before. And this is as good as it gets. It's not going to get any better than this. I can promise you that. Not knowing what was going to happen, but that was pretty spot on. It just felt like back in 2000 in a lot of ways, you can get out too early. That's definitely something you have to worry about. But if you allocate capital consistently over time and you have a diversified

asset base, you diversify across asset classes and you believe in your asset class diversification and your asset class modeling and your downside scenarios, you should be prepared for that. And I think what's good about endowment investors is typically we are doing that. We are allocating over time. We're not stopping in any binnage year. We may decrease our allocations by some percentage. We might tote it down by 20% and only allocate 80% in one year, but we're still allocating generally in every year. I always look at this at a micro level on a company. So you have to do it on a granular level, company level. Taking some money off the table makes a lot of sense. We were able to do a secondary sale using 93021 marks in 22, early in 12, about midway through 22

of some positions in which we hadn't re-upped with the manager for a few funds. And that ended up being a really, really great move for us because of the 2020 and 2021 run-ups, we were severely overweight venture. And then because of course the 22 reductions in public equity marks, right? You have this situation where you're significantly over your targeted allocation. And it's just, if you have an opportunity to take some money off the table and it's not that punitive, in this case, it was a manager we hadn't re-upped within a few fund cycles. I think it makes a lot of sense. Is it a denominator effect over in the market? I think so. I generally think so, at least. We're still overweight venture significantly,

but not as significantly as we were. And it's not a bad thing. It's generally overweight because of the run-up in values and the returns. So fast forward to Smithsonian Institution, you sit on the private side. How do you organize your private team? We're a bit of a hybrid model in general. There's seven investment professionals on the Smithsonian team, including myself. And we have three managing directors, one director, and our CIO. And our CIO floats back and forth between everything. So there's four of us that are generally focused on private. That would be our CIO, as again, kind of floats back and forth, I would say, but she's an integral part of everything we

do. Myself, director, who is based in Irvine, California, and a senior analyst. And the four of us try and decide Monday at 12 noon how to spend most of our time. Generally, that's the three of us, I should say, that are focused on privates exclusively. We can literally be looking at real estate and we can be looking at buyouts or we could be looking at venture. Venture is a large part of it because today, along with private equity buyout, it's 37%, but buyouts only 8% of that portfolio. So you're really talking about 29% of the endowment being in venture. And so most of our time is focused there. And that really is probably the most dynamic part of the market as well. How do you force rank? You have a real estate opportunity.

You have a venture opportunity. How do you prioritize and how do you filter those out? Yeah, it's tough. It depends what the priority is at the time for the portfolio. Right now, there's a lot going on in real estate. But in general, we have managers that we are comfortable with that are poised to take advantage of the distress in real estate right now. And so we're comfortable that we have the right group that are working on finding us great opportunities. And you mentioned on your asset allocation that you're much more leaning in to venture versus

buyout and versus other private equity. Why is that? It's a number of reasons, but the ones that come to mind are that A, it's the juiciest part of the portfolio at the endowment on whole. So we're going to make the highest returns or should make the highest returns in our venture portfolio. That is historically been the case. So I'd start there. Then we think we have somewhat of an advantage in venture investment. We have a great mission.

So the Smithsonian is loved across the country, across the world. I talk to people who've been to the museums. We represent the 21 Smithsonian museums, the National Zoo, and a great organization. So the constraints to accessing these funds are a little bit lower for us, or the bars for entering some of these funds are a little bit lower for us. And we have some great, great managers in that respect. One other reason leaning into it, I think we were talking about the other day, just how many of the great names of 20 years ago in the public markets are just shells of themselves. We were talking about Xerox. I mean, what is Xerox today? I don't even know. I don't even know who owns them. Is it private equity? Is it public? I'm not really sure. So, you know, we continue to believe in innovation. And finally, as I talked about the Smithsonian name, I think we also, as a brand, people identify the Smithsonian with innovation, right? So I think it works really well todo venture for us. And we've had great support from our investment committee to invest in the space as well, including by the former chair of the Regions, who's the Regions is our

board essentially of the Smithsonian, Steve Case, who's obviously pretty well-known in the tech community. Let's talk about relationships with GPs. You said you have a lot of great relationships. What's the best practice for how GPs should stay in contact with you? It's a great question. Reaching out and occasionally coming out to DC is not a bad idea. It's perfectly fine to have a great investor relations team, right? Or a great investor relations person. And for that person to do a lot of the interface is great. At which stage is it appropriate to have investor relations? Yeah. I think if you're raising a $50 million seed fund and you have an investor relations person, that's going to be a little bit skeptical. But on the other hand, I have been a little skeptical of some funds that are multi-billion dollars and have not had investor

relations personnel, how they are able to do it. Admiring as well that they spend the time with LPs, but also a little bit skeptical of if they couldn't leverage their time a little bit better by hiring at least one or two people. Yeah, absolutely. And ultimately, GPs, you want them to be meeting with startups and generating returns, right? So there's a trade-off there. Absolutely. I don't want to waste folks' time. I mean, I've often ended meetings with, okay, you probably should get back to work now. Thanks so much for your time. When you do get a chance to meet with GPs, what are you trying to ascertain? Are you just trying to ascertain where the portfolio is going,

the validity of the marks? Obviously there's a relationship aspect, but what does an in-person meeting really deliver to you as an LP? It really depends in the context of what we're concerned about. Are we concerned about valuations? Are we concerned about the team? Are we concerned about them being too aggressive, not having the right sourcing channels, the existing portfolio not being managed out well? Those are obviously somewhat negative concerns. And generally, a lot of the partners we have, we wouldn't share all of them, right?

We would share like one or two. How are they developing successors? Is the new generation of leadership taking over appropriately? Are people just getting along? So some of the smaller managers that we work with, and some people have problems with solo GPs or very two partners, you know, or a smaller team, we're more comfortable with doing that. You have less of those team dynamic issues to be concerned about, but how are they leveraging their time? Are they winning deals? Okay. So when's the last time you lost a deal? Are you getting the ownership that you want? What are you paying? I'm not foolish enough to think that top quality entrepreneurs and their rounds aren't going to be expensive and great companies aren't going to be expensive, but at the same time, are you overpaying for the risk that you're taking or are you getting good deals? Are you getting into the right companies? We're all opposite that you're getting great

ownership for a low price too, that you're getting in the right deals. This is like adverse selection going on. But these are the types of things that I like to cover. How many investments are you doing? How many boards are you on? Can you get everything you need to get done? Are you still working as hard? To me, I think venture is incredibly difficult. I'm glad I'm not a venture capitalist. I don't know why people want to do it, to be honest. It just seems like if you're really going to do it right, you need to be out every night eating pizza and drinking beers or kind of meeting people and whatever they like to do, schmoozing every night. And somehow you're still able to keep up on all the most relevant topics of what's going on. And you have to keep

up with a portfolio company. It's really hard work and I don't think it ever stops for the people who do it well. And speaking of ones that do it well, you have a mature book, you're in some of the top funds. I know we can't talk about them, but I know them. What would compel you to invest in a manager today? To me, the folks that are most interesting have some kind of differentiated approach to the market. So we've liked in the past sector funds, because the idea is that you know that sector really well, and you can hopefully add some kind of value. You're getting access, better access to quality deal flow in that sector. The problem has been a little bit

of which sectors do you want to be in and so forth, but what is your edge to getting deal flow? So I really want to see some kind of edge. And then what is your ability to pick well? But one of the problems with both of those is I want to see a model that works well. You're getting 10% to 15% ownership in pre-seed or seed rounds, such that I have an outsized potential to do well. I'd like to see a little bit more concentrated book. So, you know, if you're investing in 20 companies in your fund, that would be more interesting to me.

So what would I love for you to do? I'd love for you to have some kind of edge, to have a $30 million fund, virtually no fees, and all just to be upside based, carry or promote and investing at 10 to 15% ownership, ideally. You talked about real estate, right? You obviously invest a lot in real estate and you have this tiered structure starting with a hurdle, preferred hurdle, typically like 8%, then you do 20, 30, 40, 50. You could actually get a 50% promote as a manager if you deliver, right? If you're in the high 20s, low 30s. Would you want that to be the case for venture?

Would a tiered structure solve some of the misalignment issues in the industry? It would definitely solve some of it. I wouldn't mind it, but I will summarize the problem in this way. If you took a $100 million fund and you did 20X on it and you got a 30% carry or promote on that, you would make, what did we say, the $100 billion and you're making 30% on the $900 million. $300 million. more because if you're getting 2.5% on the $2 billion, and today without a preferred return, you're still making $50 million in management fees every year on that additional $2 billion. And if you're still able to make the 10X on the $100 million, you still end up with the same promote. And what's really frustrating, I think, is also that if we think about the power law effect of just a few companies driving all the returns, the incentive is also for you to raise that $2 billion because, you know, hey, if I do more companies, I have a better opportunity to get a hold of that one.

And as long as on that $2 billion, you return the fund, you know, a 1x net and management fees, you're in a better off position to raise $2.1 billion than to have raised $100 million and done a 10X return. It's actually even worse than you described because on 100X, you return a 10X fund. You might make 270 million, but you don't make that 270 million until 15 years later. With the management fees, you make it in year one and so much so that you can actually borrow against your management fees.

So you could borrow against, I think, up to five years out, year five, year six management fees. So it's as if you have like a $250 million blank check that somebody has given you on day one. It's like a lot of money today versus a hypothetical money in year 15. I think the constraint for managers to not raise the $2.1 billion in the past was that there was just limited money available from endowments and foundations and family offices and so forth that was out there to invest in the asset class, if you will. There's no problem these days because all the big pension funds with multi, multi-billion dollars are out there targeting the same funds. So the moment they get a great track record, they're now open to receiving any of that money. Institutions I interviewed in the state of New Jersey that are putting, you know,

they're in the check size of $100 million. So they have to go typically for larger funds. I honestly don't know the answer to whether or not they should be investing in the space. It's a good question given their scale, whether it really makes sense or not. But fortunately, that's not a problem I think about a lot, but it does cause me the problem on trying to constrain the terms of these managers or the size of the growth. Our team strategy at Smithsonian being, let's partner with the best platform firms, be very selective with that and who we're going to partner with there. These hard to access perennial winners in the venture landscape. And then let's partner on the other side with smaller funds or emerging managers, if you will, because that's going to balance us a little bit more towards the

early stage and just come to the realization that we're going to have a lot of turnover, unfortunately, on the manager space, because a lot of these managers are going to come to the same gravitational pull or magnetic pull of, hey, let me just raise a bigger fund and let me also do a growth fund or so forth. And there's a lot to unpack there. The consensus view is that there's this dumb money that comes to you when you're a $10 billion fund or $2 billion fund. But from a first principles standpoint, it is just a different cost of capital. Maybe they need their venture to return 12% to 14%. So there's just a different, I think, risk and return and brand and positioning in the market.

So it is a different ask class. What do you think about that? Well, get right back to the interview. But first, to stay updated on all things emerging managers and limited partners, including the very latest data on venture returns and insights on how to raise capital from limited partners, subscribe to our free newsletter at 10xcapitalpodcast.com. That's www.10xcapitalpodcast.com. The people that run these pension funds are actually very, very talented if I were in their shoes while not so I don't think about the answer to that question of whether they should be in the space or not. But I do recognize as you say they have different return objectives. So for them, maybe it makes perfect sense as long as they can deliver equity returns plus an illiquidity premium. And if they believe that there's some diversification benefits to venture,

which I do believe there are. I mean, people say that venture is pro cyclical. OK, but it's not completely correlated. The returns are not completely correlated with the market. You know, WhatsApp kind of came out of the blue. There's a number of these outlier events in the past for a venture where those are not completely correlated to the market. So it does provide you some diversification benefits.

Yeah. And in many ways, if you believe in the innovator's dilemma, which I do believe you're disrupting the incumbents, AI could disrupt Google. I think there is a sort of hedge there as well. What is the Smithsonian venture strategy? So the great part about being at an endowment and specifically with Smithsonian is that we have a blank slate. We can do just about anything. We can work with just about anybody, assuming you're ethical and all the things that you would obviously assume. But that gives us the ability to do a lot of different things. Invested a $15 million fund as an example, or do direct co-investments if we wanted to,

in any case. So it's always evolving what we are doing. And we've been more global in some respects, but I've kind of come back to the belief that the best opportunities for venture are still probably in the Bay Area. We're looking for a balance of those top tier platform firms, which have some kind of relative advantage to their peers. They have great names as partners. They have a great Rolodex, the ability to really help their companies. They have this franchise brand name right out there amongst the community that, hey, anything coming from XYZ firm is going to be something we need to look at. So there's that side of the portfolio. And then I think as the other side of the venture portfolio

for us is looking at these smaller firms and being part of that ecosystem so that we can balance out that the platforms are generally pushing a lot of your capital to the later stages. Just given that you're pirata investing alongside their growth in their growth fund and their early stage funds typically, and in early stage, historically, we've found the best returns there. Do you think about diversification within venture? You mentioned Bay Area. Bay Area is not an industry, but let's say you're heavily in AI or you're heavily in SaaS.

Do you ever think about it from a sector standpoint or are you just trying to invest in, you know, in just the best overall managers? No, we think about the sectors. We think about our sector diversification on the early, super early stage, pre-seed, seed. As I mentioned, we've invested in sector funds and we've thought a lot about where are these sectors we want to be in? And does it make sense to be in these?

Generally, it's when you put everything together, it's fairly diversified. It's not a big deal. But biotech as an example, I don't know if you would call that a sector fund. I don't necessarily think of it as a sector fund, but we have for the last five years have really loved biotech. Have been investing in it for a while, but it put more dollars behind it just because we think it gives us some broader diversification in our venture portfolio or some diversification there. And we love the tailwinds.

I love the things they're doing, the amazing drugs that they're coming out with. Were you guys investing in a fund one and how are you able to ascertain quality of a fund one? Yes, we've done a number of fund ones. It makes sense to be diversified in that respect. So these smaller funds, we don't put as much money behind as the platform funds because we know some of them are just not going to work. So you're going to do your best job, but ultimately some

of them are not going to work. And we've never really seen that where we've lost money, but we just have lost, there's opportunity costs, right? The returns aren't as great or aren't as good as you would hope that they would be. So what you look for in a fun one, there's obviously stuff that doesn't look like fun one. Michael Moritz, if he comes out with a fun one, I don't think you're going to consider that a fun one. Right. So you're, you know, that one, you might load up the truck on and try and get as big of an allocation as you can. But in general, we're looking at the quality of the person, trying to get to know the people and see why they're able to pick good companies, why companies want to work with them, and what's their edge. There are so many funds and so much money out there that if you don't have some kind of edge, I'm not really sure it makes sense for us to be talking. And you've been an LP since 2005, approaching 20 years.

Congrats. We'll have to celebrate. What do you wish you knew when you first started? Just some of the experiences that you have with things that go wrong. I wish I knew more about emerging markets when I started investing into emerging markets because I've learned how difficult it is. Yeah, don't do it. I've learned don't do it.

The prices just look cheap. Yeah, the price is exactly. Is that a VC thing or in general? In general, I think it's really difficult. I think public's really difficult. I think public markets are probably better suited for emerging markets investment in general. And in venture, I am not really sure it's the best place for your dollars.

In terms of our podcast and our community, what would you like our community to know about you, about Smithsonian, anything else you'd like to shine a light on? The Smithsonian is a great mission. We have 40 of the 50 top universities last I looked in the world right here in the United States. But there is a real problem with apathy towards learning. And the Smithsonian helps excite the learning in everyone. That's one of our taglines. It's a great place for youth to come through, for people of every walks of life and people of every age to come through for that matter and get excited about learning, about their country's history, about art, about the sciences and so forth. So the mission is fantastic. The team has been around on average for probably 15 years. Our CIO is somewhere around 18 years. I'm working my 14th year here at the Smithsonian. We're a very stable partner. If you think you have some kind

of edge in the venture market, we'd love to talk to you. We're always trying to enhance our network. You made a really important distinction as endowments we'll talk about, they've been around for 300 years, but that person might be in their seat on average for two years. And I think that's an important distinction that you made. Not just the stability and the evergreen nature of the institution, but also the longevity of the team. Our collective learnings really enhance our abilities.

What would I like to have had 20 years ago when I started that I don't have now is the experience, the experience of both winning and losing. A lot of LPs often say just the sheer power of a superpower outcome, how much it dwarfs that one investment that returns 400x or 1000x, how much it dwarfs everything else and makes everything else so meaningless. And it's all about really capturing that big outlier. Jeff, I really appreciate you jumping on the podcast. I'll definitely come visit you in DC. My family's there and I look forward to sitting down and having some pizza and beer.

David, let's do it. And let's make sure that we visit one of the museums in your next trip together. I would love that. I'm inviting my two nieces too. If they could tag along, I would love to bring them along as well. Sometimes I can set up special tours, whatever the years I've become a pretty good tour guide to and a few of the museums that you may be interested in.

That's amazing. I will definitely take you up on that. Thank you, Jeff. All right. Thanks, David. Take care.