Herd Capital

Everyone’s aware of the herd mentality. Be it iPods, bigger and bigger cars, or even a Twitter account.
I’ve noticed similar mentalities in the VC industry. Why do we seek the safety of the herd?
Here are a few examples of it, and also the effects of the same on industries.

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Herd Capital

Everyone’s aware of the herd mentality. Be it iPods, bigger and bigger cars or houses. Or even a Twitter account (which doesn’t really make sense if you’re not actually gonna use it). Hell, even I got a Twitter account that I don’t use.

And many a times, it takes a while before a smart management guru finds the method behind some of the madness.

I’ve come across a few similar instances of herd mentality in the Venture Capital industry too in the past few years.

Before I mention them, I’d just like to state here, that the views below are only mine, and I don’t, in any way mean to undermine or insult the knowledge and strategies of my fellow members of the VC community. I’m merely expressing my concern about something I’ve observed.

Herd Mentality. Hmm.

Here’s one such example that comes to mind. The textile/ garment manufacturing and associated retail industry back from 2006 through most of 2008. Companies saw several Million $ of investment, and were doubling and tripling their manufacturing capacities – spinning, weaving, dyeing, printing, stitching; you name it… not to mention the number of retail outlets, adding customers (read big brands in apparel) with demands going into astronomical numbers of pieces of clothing.

And obviously all of this took the valuations of these companies pretty high. Just to give some perspective to the quantum of investing, this sector saw around 3% of the total $5.6 billion of VC investment in just the first six months of 2007. That’s roughly a whopping Rs.750 crore.!!

And then, with the collapse of the US economy, textile exporters suddenly lost one of their prime markets. What followed, quite instinctively, is that many of them came back home and focused their energies and capacities on the domestic market. A domestic market that was beyond saturated with all the domestic expansions that were funded.

That led to more n’ more discount malls springing up, running on wafer thin margins.

Then, there was the mad rush after clean n’ green businesses. Of course, there’s nothing bad about investing in technology that’ll help conserve the limited resources of the globe. But from a VC’s point of view, it’s about making money too, right? The focus on making those returns should be a fine filter through which great companies and amazing business models must pass.

However, here’s what happens with the herd mentality. Some companies with limited knowledge or capability, get invested into. And that’s only because some VC was probably not approached by the best companies in the sector yet. Or the VC did not want to miss out on the ‘gold rush’. And so they end up investing in the 20th company in the sunrise sector at a ridiculous valuation. The VC seeks the safety of the herd. Everyone’s doing it, so maybe I should too. This makes the top team at the company over-confident of their supposed capabilities. What’s worse, it makes it tougher to raise its next round of investment. Because of the already sky-high valuation it got its first round investment at.

So, we end up with:

  • Just a handful of the numerous funded companies actually adding reasonable value, globally
  • Several overconfident funded companies that just trudge along, finding it difficult to raise additional money
  • The sector very quickly becoming over-invested and going out of flavor with the VCs. This is due to high valuation expectations by other companies. This is resulting in less investment happening in creating more effective and widespread clean and green technologies and applications; something that was needed by the world on an urgent basis, to begin with

It would help if VCs invested after a well thought-out strategy rather than almost on impulse. Irrespective of whether it means missing the bus on a fad investment sector. This would result in the VC not making losses on a bad investment. At the same time, she or he could focus on understanding the sector quickly and perhaps support young companies with innovative products or solutions that they feel might significantly help preserve the planet. Instead of dumping money into just another solar-cell manufacturer. Or another wind turbine manufacturer, or something like that.

In the end, all this could be herd mentality, or perhaps even the wisdom of the crowds.

Only time and lots of investing will tell.

[Again, these are just my views on it, being strongly based on my belief that known and stable businesses or mass producing of products should be funded more by debt; and the risk investing in paradigm-shifting technologies and solutions should be left to VCs. I would like to get the views of promoters and fellow VCs on this. In the end, it’s all a part of our learning process.]

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