The Babe Ruth Effect: What drives fund performance?

“How to hit home runs: I swing as hard as I can, and I try to swing right through the ball… The harder you grip the bat, the more you can swing it through the ball, and the farther the ball will go. I swing big, with everything I’ve got. I hit big or I miss big.” –Babe Ruth

Babe Ruth was one of America’s finest baseball batters, having played 22 seasons with 714 career home runs and 1,330 strikeouts out of 10,622 pitches. While venture capitalists face vastly different types of pitches, the home run mentality coined “the Babe Ruth effect” has seen widespread permanence throughout the venture industry. In Chris Dixon’s article, “The Babe Ruth Effect in Venture Capital,” he analyzes the performance of successful venture capital funds and determines that higher multiple fund performances are derived from higher proportions of investments returning >10x. As expected, there is also a strong correlation between investment return size and overall fund performance.

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What makes the Babe Ruth effect difficult to come to terms with for many unfamiliar with the venture asset class is the high level of “strikeouts” that come with the strategy. Dixon analyzed the same cohort of funds and found that even funds with great performance had a relatively high proportion of investments that lost money.

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A dangerous trend, especially with earlier funds, is emulating the investment strategies of billion dollar funds such as Sequoia, Andreessen Horowitz, and Softbank without building a differentiated competitive advantage. Often this imitation manifests itself in competition for “unicorns”, defined as privately held companies valued at over $1 billion. Regarding this “unicorn fever”, PitchBook noted that in 2018, startups achieved billion dollar valuations in less than 4.5 years, down from an approximate seven years in 2013. While unicorn valuations are nice to flaunt at dinner parties and are generally positively correlated to fund performance, there are many other key drivers of fund returns. What these funds need are not necessarily unicorns with billion-dollar valuations, but high exit multiples on select portfolio companies that can return the fund. Dan Primack, a business editor at Axios, recently tweeted:

To Dan’s point, some key factors to consider when defining your investment strategy to hit multiples include (but are not limited to):

  • Ownership stake (driven by check sizes, pre-money valuations, pro rata rights, and follow-on reserve capital)

  • Projected exit value

  • Deal terms (such as liquidation preferences)

  • Portfolio company capital efficiency

Rather than hunting for unicorns, investors and fund managers should focus on conducting proper due diligence (market opportunity/size, capital efficiency, potential upside investment returns), obtaining attractive deal terms (ownership stake derived from investment size, initial valuation and available follow-on capital), and providing portfolio company support to achieve higher multiples at exit. It’s also critical for emerging funds to properly define their investment thesis from a stage, industry, and business model perspective, enabling them to hone in on a competitive offering.

In addition, if you are investing in venture funds, make sure they have a distinct strategy to capture a unique segment of the VC pie whether it be in sourcing, vertical expertise or post-investment value-add. If you are interested in learning more about the Babe Ruth effect and the world of unicorns, please feel free to contact us at

Originally published in the February 2019 LVAM Newsletter.

Further Readings:

Who was Babe Ruth?

Unicorns aren't special anymore

The Babe Ruth Effect in VC

Coming to Terms: Understanding the Vocabulary of Term Sheets

A term sheet is often exactly that: a sheet full of terms. As an investor, these terms go beyond simply outlining the percentage of equity received. Investor rights establish the non-equity provisions that investors have to protect against downside risks, manage strategic decision-making, and mitigate future dilution. It is also imperative to understand the meaning of these terms to understand how your investment fares against other investors from preceding or succeeding rounds.

Being a Fund-of-Funds

Generally speaking, a fund-of-funds is any group that invests in other funds. In venture capital specifically, funds-of-funds function as limited partners (with very few exceptions). Those limited partners receive reports and due diligence documentation whenever the fund is making a new investment as well as periodic reports on the performance of the portfolio as a whole.

Investing in venture capital funds either directly as a limited partner or through a single fund-of-funds can be a great way to diversify your overall portfolio. The high level of risk associated with direct startup investments can make it difficult to start a venture capital arm of your own. Investing in or as a fund-of-funds mitigates that risk tremendously as you are investing in the venture capital fund’s entire portfolio, which could represent dozens of startups. You still have the ability to capitalize on the oversized returns that come from successful venture investing without having to take on the same degree of risk.

Due Diligence for Venture Capital

Venture capital can be a daunting asset class to analyze. If you are familiar with private equity, you are probably used to judging a company based on detailed financial modeling. With venture capital deals, the numbers and parameters you have for mature companies just don’t exist yet. That doesn’t mean that you can’t conduct a thorough analysis of a company before investing. What it does mean is that you need to have a formal and disciplined process for due diligence that is tailored specifically to early stage companies and startups.

How Venture Capital Differs from other Alternative Assets

If you are looking into venture capital as an investment opportunity, you are likely aware of other options like private equity and real estate. While these alternative asset classes share some similarities (illiquidity, long investment holding periods), there are distinct differences in structure and investment strategy that are important to consider as you dive into venture capital investing.

Venture Capital Provides Outsized Returns

In venture capital, returns follow the Pareto principle - 80% of the returns come from 20% of the investments. Early-stage venture capital firms have often been attractive to investors, providing lower valuations with the opportunity to obtain significant equity ownership in portfolio companies. 

In today's Topic of the Month, we take a deeper dive into the numbers posted for a couple investments prior to their IPOs and acquisitions.