Whaling Power Law, LP Incentives & VC 2 & 20 - E522

· VC and Angels,Angel Investor,Southeast Asia,Singapore

“When you're investing in a power law, think of it this way: it's like managing Manchester United, Chelsea, or Arsenal. Or better yet, like preparing for the Olympics. You're the swim coach, scouting for talent that can win gold. At the Olympics, there's gold, silver, and bronze—everything else earns nothing. Most people are average swimmers; some are above average, and others are good. But as a coach, you focus on the ten swimmers who truly have a shot at gold. That’s how portfolios are built—selecting only the best to represent their potential, just as countries carefully choose athletes for gymnastics or track and field to maximize their chances of success.” - Jeremy Au, Host of BRAVE Southeast Asia Tech Podcast


“If your fund size is too small, you can’t support the general partner, the team, or even the legal requirements. There’s a certain threshold that people need to meet. For instance, Silicon Valley Bank used to bankroll GP commits. They’d step in and say, “We’re happy to put up that half a million dollars, or even a million, so you can keep sending your kids to school or paying your mortgage.” They offered financing for that. Another example was mortgages. A lot of founders and VCs have their wealth tied up in stock, which you can’t use to secure a mortgage. Silicon Valley Bank was one of the few willing to lend against your paper stock and shares to make it happen.” - Jeremy Au, Host of BRAVE Southeast Asia Tech Podcast

“The term "general partners" is critical because, while many are called partners, general partners are the ones truly in charge. They receive the capital and commit to investing it in startups. Limited partners, on the other hand, are named so because their legal liability is limited. If something goes wrong—be it fiduciary issues or negligence—limited partners are not held legally responsible. However, general partners have unlimited legal liability for such mistakes.

General partners also have skin in the game. For example, in a $100 million fund, a GP typically invests 1%, which means putting in $1 million of their own money—this is called a GP commit. From the $100 million, 2% of the fund is allocated annually for expenses, providing $2 million per year over the next decade to cover operational costs. If the fund grows to $1 billion—achieving a $900 million gain—20% of that upside, or $180 million, goes to the general partners as their share of the profits.” - Jeremy Au, Host of BRAVE Southeast Asia Tech Podcast

Jeremy Au explored the nuances of venture capital through three lenses. He described how LPs, such as sovereign wealth funds and institutional investors, pursue diversification and long-term returns, often seeking a 25% net IRR to justify the high risks of VC, as seen in Southeast Asia's emerging tech ecosystem. Using the "2 and 20" model, Jeremy explained that a. general partners commit 1% of the fund size (e.g., $1M for a $100M fund) as skin in the game while limited partners provide 99% of the capital. b. GPs spend 2% of the fund size on operations for 10 years and c. GPs receive 20% of the fund exit upside and LPs 80%. He shared examples like Sequoia's $100M investment in Zoom, yielding 22x returns, and Facebook's acquisition of WhatsApp, which turned a $60M investment into $3B. Lastly, he likened VC to 19th-century whaling, where only 6% of deals produce 60% of returns, drawing parallels to how power-law distributions shape the industry’s focus on rare, high-value investments.

Jeremy Au: (00) the spread of motivations, as I said, one is primarily, of course, people are looking for a high ROI. Generally, there is a belief, and this may not necessarily be true, but in the U. S. side especially, that having VC as part of your portfolio will help you beat the public market returns by about 5 percent over a 20 year period.

Jeremy Au: I'll share that source, it's currently in the syllabus. But having some illiquid, long time horizon, high risk investments. is a good way for diversification if you have a very long time horizon.

Jeremy Au: So there's a perspective from a sovereign wealth fund or from an endowment, especially obviously diversification as well. You don't know, but you're like, okay, I don't know if, buying gold makes sense in the next six months. But if I put money in the VC fund, these companies will bear fruit in 10 to 15 years.

Jeremy Au: There's a diversification over time, because I don't know what I'm going to do, but I might as well put it in tech. And in 10 to 15 years, the world may be a better place. Obviously, strategic insights to geography and industry. We see a lot of folks actually in different parts of the world.

Jeremy Au: For example, I do know that I met (01:00) a VC fund manager for Southeast Asia. He had traveled to Europe and then he was talking to an LP, a large institutional LP. And the large institutional LP was like, oh yeah, she listens to the Brave Southeast Asia Tech Podcast because she's interested in diversifying out of Europe into Southeast Asia.

Jeremy Au: She can't really do China, all these other things, right? But she's thinking just in Southeast Asia. And so she's learning about Southeast Asia as a region through Listen to my podcast but the reason why she's doing that is also because she's interested in investing in a VC fund that will give her diversification into Southeast Asia.

Jeremy Au: And more specifically into Southeast Asia tech as an asset class, obviously not saying that she's going to make a decision, but that's part of her mandate, right? Obviously it's a sensor network. So for example If you are a corporate VC, corporate fund, you may choose not to make direct investments.

Jeremy Au: You may not have your own corporate VC fund. You may choose to invest that in VC funds that are more independent than yours because you're saying that I don't want to run this internally. I want to let these independent professionals and I literally had received a WhatsApp earlier today, but basically, there's a (02:00) company and then they have some market expansion plans to Japan, right?

Jeremy Au: And then the VC fund has Japanese LPs, and the Japanese LPs are like, we're interested in this because of the Japanese connection, and so forth, right? So there's a sensor network, there's the ears, and of course, Some corporate VCs or high level individuals may choose to invest in a VC fund first, just to learn the ropes, get to meet the VC fund, understand how it works for five years, three years, whatever it is, and then eventually may want to launch their own VC fund eventually as well.

Jeremy Au: So these are five general buckets of reasons why LPs may invest. And VCs as a result have a certain structure. We have the limited partners, we have the general partners, and the start ups. And I think that's how you should think about it, in terms of the money flowing down.

Jeremy Au: So the LPs that we talked about, these people who are very rich, or they want to diversify, or they want to concentrate their bets. or they have some sort of military or strategic mandate to it, they put their money and they pick the VC fund and they provide the capital. And normally they put in 99 percent of the capital into the company.

Jeremy Au: (03:00) And in general there's something called two and 20. We'll talk about it more in time to come, but basically they will get 80 percent of the upside. So if a 10 million fund let's say, becomes 100 million, right? So there's 90 million of gain. The LPs will get 80 percent of that 90 million. . But the key thing is that from a legal perspective this is governed by something called the limited partnership agreement, which is the legal side of it.

Jeremy Au: So basically it sets out the covenants, the agreements between both sides of it between the VCs and LPs. Now, the general partners and this is a very important term, because there's a lot of people who are called partners, but general partners are the ones that are really in charge. So they receive this capital and they agree to invest in startups, right?

Jeremy Au: The limited partners, they're called limited partners because they have limited legal liability, right? Does it make sense? If something goes wrong, fiduciary or whatever, the limited partners don't get any legal liability. But for the general partners, they have unlimited legal liability for bad mistakes, fiduciary, negligence, whatever it is.

Jeremy Au: Now, the GPs will invest 1 percent into their funds. A hundred million dollar fund and I invest (04:00) one percent of it. That means I have to put in one million dollars of my own money into the company as skin in the game, right?

Jeremy Au: It's called a GP commit. Now, out of the hundred million dollars, two percent of that fund is given to me every year to run expenses. So out of a hundred million, I'll get two million dollars per year for the next ten years to help me run my expenses. And then, If that hundred million fund becomes a billion dollars, right?

Jeremy Au: Nine hundred million dollars, about a game's twenty percent of the upside will go to me. We'll explain some of these economics more, but it is really important. That's why the structure is often called two and twenty. So you get, the managers get two percent of the fund raised. every year for 10 years, and then they get 20 percent of the upside of the quality of decisions they make,

Jeremy Au: and then of course, carried interest is treated as capital gains. For example, it is now known that the Saudis are negotiating a lot more harder. So they want a lot more of the upside.

Jeremy Au: They're like, we want you to get paid a salary. But we want more of the upside, for example. So other funds may choose the other way, which is they may choose to have a floor. You must hit a (05:00) certain level of return before you get a slice of it. And then some of it may be like some VCs might be like, I want to pay more cash in the early days because in the first few years, I'm doing more work.

Jeremy Au: But now that , after I've deployed my investments in the first three years, then I'm doing less work. So I should be paid less for this time. So there are some different permutations for these various provisions. But I think the key thing is that 2 and 20 is pretty much the general norm.

Jeremy Au: And then there are different ways to split it. I would say that in general It is primarily driven I think if you're the best VC, they're making a ton of money. You get to negotiate those clauses for yourself. They give you more upside. And if you're a very large LP that has a very large check, then you tend to have more bargaining power for these negotiations as well.

Jeremy Au: So I think you gotta be thoughtful about that.

Jeremy Au: In general I think the general yardstick is, you need about 25 to 50 million to feed one general partner , so I think there's a yardstick in VC land. It's because , if your fund size is too small, you can't feed the general partner, you can't feed the team, you can't feed the legal (06:00) requirements.

Jeremy Au: So there's a certain threshold that people have before they can go. So it depends on that as well. I think that Silicon Valley bank, bankroll GP commits so basically they would help so Silicon Valley was like, we're happy to help you put up that half a million dollars, for example, a million dollars, because you want to be able to continue sending your kids to school or pay your mortgage, whatever it is.

Jeremy Au: So they would actually have done some of that financing in Silicon Valley. That's one. The other version of that, for example, was they did it for mortgages. So a lot of founders and VCs, a lot of their money is in, Stock, and you can't use stock to do a mortgage. And so Silicon Valley Bank was the only one that was willing to lend you money for your mortgage, in order on your paper stock and share for that.

Jeremy Au: What I'm trying to say here is I think the financial stake is pretty much almost always there. I don't think there's sweat equity for GPs, but historically there were other ways to help finance that as well. So I think in general, for example I think I wouldn't say for Southeast Asia, but in America, for example, a GP of a new fund might be making only about 150, 000 to (07:00) 200, 000 U.

Jeremy Au: S. I think if you're an emerging fund manager. Because there's, I think there's a norms basis, the management fee, the salary will come out of the management fee as well. And then, but it'll be used to pay for our principals and all these other folks that's there. So when AngelList and the commoditization of the legal paperwork what happened to AngelList and all these other platforms to help create funds.

Jeremy Au: Then that legal fee dropped and then you see more emerging funds, smaller funds emerge because the legal fee of setting up a new fund dropped. And so you see some companies now in Southeast Asia, non public, Optimate, they're trying to do SPVs and other legal automation platforms to lower that fixed cost of running a fund.

Jeremy Au: So I think one thing to understand is that venture capital in many ways was born out of the private equity asset class.

Jeremy Au: Private equity obviously is also a type of private equity. Fund that's looking to invest in private firms to grow. But generally a private equity is about medium risk. Each port code is expected to generate about two to three X returns on average. And they, when they buy, they don't want to buy at least 51%, if not 100 percent of the entire company.

Jeremy Au: And then they'll probably write a check between a hundred (08:00) million to a billion dollars. I'm just generalizing here. These can be large in the U S for example. And if they go full control and then they parachute in the consultants the management team and I myself have been one of the consultants parachuted , in alongside Bain Capital to look at a company that was acquired to realize the full value of that, right?

Jeremy Au: And so the goal is that This company should turn around, fix everything that's been done, take on debt, and so forth. And the goal is to generate about 15 percent returns year on year. So that's like the target return profile. , and obviously the hold period may be 5 years, could be 10 years, but, there's a goal of that level of return.

Jeremy Au: For venture capital, , it's much higher risk. That means you're supposed to expect in private equity, if you make one investment and , the company closes, you'll never work again in private equity for the rest of your life, right? But in venture capital, it's wow , 19 out of your 20 companies failed?

Jeremy Au: , no big deal, right? One of the 19 that failed was FTX? Oh, okay, doesn't matter as long as you're 20th

Jeremy Au: maybe it's Ethereum or, Solana or something else. But, I think that's the perspective is it's high risk, only about 1 out of 20.

Jeremy Au: The norm for a successful VC (09:00) fund is 20 becomes a home run, which will generate about 20 to 100X returns. And normally, the VC fund will only have 20 percent of minority investment. They don't have control. They may have a board seat, but they don't have direct control of it. And then the goal as a result, if you look at that return profile, like 19 failures and one giant success, is that the goal for what the LPs are looking for in general, because they're looking for a 25%.

Jeremy Au: Net IRR, right? And for example, if you put your money in DBS, you're getting, what, 1 percent interest rate? I don't know what it is. So the goal is that if you're LP, you're supposed to be, like, a sovereign wealth fund, you need 25%. So this is, but it's very risky, right? Because there's a good chance that this fund may be 20 failures instead of 19 out of 20 failures.

Jeremy Au: So this is the risk of that portfolio that's there. . As a result, VCs are hunting for home run in terms to compensate for these portfolio losses, right?

Jeremy Au: So you're looking for companies that can grow at least 10x, if not 200x. And you also want to come in with a very reasonable valuation. Everyone looks at valuations, the newspaper is like, these are not (10:00) reasonable valuations.

Jeremy Au: The company I was looking at, they had about a million dollars of revenue, right?

Jeremy Au: They were losing money, but their evaluation was $3 million, right? Does it make sense? . But even though at Sequoia, and that's why they became famous in the us if you look at that, they made an investment in WhatsApp and it was at $60 million.

Jeremy Au: It was an investment in WhatsApp. At 75 times revenue multiple. Think about it, right? Basically, this company was making about half a million dollars, 500, 000 per year, right? For WhatsApp, basically. They put in 60 million but it was a 75x and then basically resulted in a 50x returns.

Jeremy Au: Sorry, I said, I gobbled up those numbers, but anyway, the key thing was, it was a very thing. And then they result in a 50 times returns because Facebook acquired WhatsApp for 3 billion, right? And the reason why was that Facebook was very happy to buy it. Because it was growing very fast, and so forth.

Jeremy Au: And I was talking to a product manager at Facebook, and I was like, oh, do you feel bad that nobody's using Facebook anymore? And then she was like, no, you're using Instagram and WhatsApp, so it's okay, you're still part of the ecosystem, right? That was a good investment for Facebook, right?

Jeremy Au: If WhatsApp was an independent company (11:00) from Facebook today, WhatsApp probably killed. Facebook by now, right? Probably Instagram as well. And if you look at Sequoia, it invested a hundred million dollars in Zoom, and that resulted in 22x returns, right? So I think you can see that these kind of investments can seem very large but these are quite doable return profiles in the right companies.

Jeremy Au: so as a result, the VC funds in general, the understanding of a VC fund is that investing based on a power law rather than a normal distribution. , most things in life are like the red curve.

Jeremy Au: So there'll be a bell curve. So most things are bell curve. If you look at height, it's a bell curve. If you look at weight, it's a bell curve. In general life, most life is a bell curve, in terms of the distribution of that. But in the VC side, it's a function of the power law, right? So they call it 80 20, but they're saying that 20 percent of investments will make, suppose, 80 percent of returns, or way more than that, actually.

Jeremy Au: but power law distribution is a function of saying that this small number of companies will generate. 100x, (12:00) 500x returns compared to everything else, and all of this will fail. And so I think this is actually quite interesting because if you think about it every day, if you're a VC, you're saying no to a lot of people who are average.

Jeremy Au: No. You're above average, you're also, no. If you're really good, maybe, and if you're a superstar, they'll invest, I would say that When you're investing in a power law, in some ways, the way you think about it is like, this is like Manchester United, this is Chelsea, or Arsenal, it's this is like Olympics, right?

Jeremy Au: You're like a swim coach, and you're trying to scout for talent. Who will get the gold, right? So if you think about Olympics, right? There's gold, silver, bronze, everything else, you get nothing, right? Most people are not, there are average swimmers, there's above average swimmers, there's good swimmers.

Jeremy Au: But , as a coach, maybe only 10 swimmers that you have that you think has a chance. To get the gold, right? So I think that's how people think about that portfolio and how even countries select who gets to represent their country on gymnastics or track and field, for example, because of that portfolio.

Jeremy Au: And so (13:00) we see that is statistically proven out in the U. S. returns.

Jeremy Au: for example, if you look at this, that 65 percent just fell out, , effectively. Then about 25 percent will get about 1 to 5X. Basically this company didn't do much with that money, it's just flat. This quantum here, you can say, the 6 percent would be about 5 to 10x, but if you get a company, your home run is this one, your fund is underwater because capital on everything else and you got one 10x.

Jeremy Au: You still lost money, right? ? So only 4% of companies actually get 10x or more. So this group, if you got one company that's 20x and 19 companies failed, then the math is you basically made back your money, so it's I raised 100 million and then I got back a return of 100 million.

Jeremy Au: So , people are really looking for that, 20 to 50x, which is about 1. 5%. This is the home run that people are really looking for. I think people just have to understand that VCs are not altruists. They are not general coaches. They are generally, you better think of (14:00) them as high performance scouts and coaches they are very similar to talent agencies. So you imagine like modeling agencies. Or Hollywood, you're looking for who's gonna be the next Ryan Reynolds, the next Brad Pitt, but these people will capture outsized returns, at the top of it, and then everyone else, there's a lot of B list, and then there's a long tail C list actors and actresses, right?

Jeremy Au: So there's very few A list actors who capture most of the returns in movies,

Jeremy Au: so as a result, if you think about the power law, it's another analysis that was done by Horsley Bridge. So basically 6 percent of deals produce 60 percent of returns and half lose money, so that's why we're looking at it. It's like this is gray is like these this column is deals done versus the cost of deals, like how much capital goes in.

Jeremy Au: So there's a number of companies you invested in, the amount of capital you invested in, and then this is the share of total returns, right? And then they separated yields into less than 1x, which you basically did. Then 1 to 2x, basically a zombie. 2 to 5x is also pretty much zombie, right? Over, imagine a company grew 5x over 10 years.(15:00)

Jeremy Au: That's like saying you were making a million dollars and you grew to 10 years, right? And then this blue line is 5 to 10x, and then over 10x is 6%, right? So this is another kind of bu cluster. So roughly the number of companies corresponds to the amount of capital to deploy. But if you look at returns, 60 percent of the returns actually come from , over the top 10x,

Jeremy Au: so this is another way of just saying like there is a power law dynamic, a very small number of companies. We'll eventually generate the returns. A very small number of A list actors and actresses will make most of the money in Hollywood. A very small number of movies will become blockbusters these days.

Jeremy Au: A very small number of athletes will win golds and silvers and bronzes out of all athletes in the world, right? And I think what's interesting is that this VC industry is actually quite similar to a historical industry. It's called the whaling industry. Obviously it's also similar has other parallels actually to again the Hollywood industry and so forth.

Jeremy Au: But it's very similar to the whaling industries, which is hundreds of years ago. And what you can see here (16:00) is that these ships would basically sail for one to two years, right? So they'll leave Boston or Massachusetts, et cetera. They would have to find a ship, they have a captain, they have to get a harpoon,

Jeremy Au: so Moby Dick,, the narrator, is somebody who signs up to be on this whaling ship, and then the story happens over the course of one to two years, while they hunt a whale, that's out there. And when they hunt a whale, all they have harpoon, kill the thing, and then this whole whale will get butchered into Ambergis, all these kind of like special products, right?

Jeremy Au: So like oil, meat, blubber all these other products that were needed. And then these ships would process them and bring them back. If you hunt a whale, which is what VCs use, hunt a unicorn, whale hunting, whatever you want to call it, but basically it's if your ship hunted one big whale, you made it.

Jeremy Au: You will go home and you'll be winners. But most ships didn't make it, right? And so if you look at this chart on the right, you see here is that if on the red is your whale returns and then on your yellow is the VC return, right? And you see the risk reward profile is quite (17:00) similar, right? Which is that, even like a 0 percent or less, it means like 35%, right?

Jeremy Au: And then a bunch of them basically hunted like some smaller whales or some other fish to cover the cost of the ship. Does that make sense? , After that, there was like a very small percentage let's say about, five percent that would basically cover the cost of more than a shipla, basically.

Jeremy Au: , this person who has a hundred percent return basically said, the cost of this expedition, they hunted a whale, and it's basically equivalent to two expeditions worth, if that makes sense, of the cost of the ship, right? So now you can fund two ships, for example. As a result, even back then if you read Moby Dick, it's a fun book to read, but, people knew there were good captains, people knew there were bad captains, right?

Jeremy Au: There's another character called Ishmael, the harpooner, he's an experienced executive on a whaling ship. And so he negotiates for a higher equity percentage. He was being paid in equity, right? So he's, if this return gets me a million dollars, I want, basically 0.

Jeremy Au: 3%, ? (18:00) Equity. They'll cut up the whale and give him, 0. 3 percent of that whale in terms of the cash proceeds, right? So now you're like, wow, but why is it happening, right? So the first thing you need to understand is that, of course, Why is whaling similar to the VC industry?

Jeremy Au: And the reason why is that hunting whales is risky. So either you hunt a whale, a big one, or you didn't, and it's a lot of risk. But if you hunt a whale, you get a lot of money and it pays off for multiple ships. So from a VC perspective, the whaling funders, these were bankers that were paying this, because, the captain comes up to them and says, I want to get a ship, I say, okay, I'm going to give you this amount of money to do this I'm going to give you more money because you're a successful captain before, you've done it before, you know where to go, so you need more money.

Jeremy Au: So they'll give more money, but the price will be higher, right? Does it make sense? Because their expected return is higher. So these whaling banks were basically saying I need to invest in 20 ships. Because out of these 20 ships, even the more experienced captain may not necessarily

Jeremy Au: land a (19:00) whale on this voyage, right? So they need to create a portfolio to lower that risk. Similar to how a lot of folks today are talking about public equities. You need to put it on ETF. You need to be on an index of funds in order to spread and diversify that risk. Of course, the second piece that's important is that if you're a bank and you're paying for 20 ships to go out, you don't have cash to pay them all the money up front.

Jeremy Au: That would be crazy, right? You can't give everybody that because if not, everybody's going to run away with your money, right? If you pay everybody okay, out of 20 ships, I expect one to come back with a whale. So I'm gonna, right now I'm gonna give you one whale divided by 20, I'll give you all the money each.

Jeremy Au: 19 out of 20 would just run away with the money, right? Because they already got the money up front. So you need to pay the money when they get the whale. And the people who are comfortable getting paid only when they get a whale, have to be people who are very confident, or naive, or experienced, or whatever it is, but they feel like they can get a whale!

Jeremy Au: They're willing to take the risk to have a whale, right? And so these people like the risk, but they feel confident about their performance. (20:00) And if you think to yourself that you probably can't get a whale, then you're not going to sign up to become a whaling captain, or harpoonist, or whatever, because you're going to be on a ship for one to two years, right?

Jeremy Au: And there are stories of captains who are very good or whatever, and then they could not find a whale for one year. Then they basically, Stayed out there for three years, because they're like, my reputation is I will get a whale no matter what. So imagine you're on a boat, right? You sign up the boat, you're a captain, and the captain's my reputation is I get a whale every single time.

Jeremy Au: So guys, I'm gonna spend another, as long as it takes for me to get a whale, when I come back, I want to be a hero, right? He spends another two years, he gets that big whale. But it took him three years to get a whale instead of one year. So the return profile is lower. But then this captain is the kind of captain that people like, right?

Jeremy Au: For example, right? So people have reputations. So again, it's quite similar. If you think about it to the VC and the startup industry is that if you think to yourself, I want to live a chill life, I don't work very hard. I don't believe in myself. You will not join a startup. You will not become a founder.

Jeremy Au: But if you want to be a founder, you'll be like, Luck is on my side. I've done (21:00) it before. I watched the social network, the movie, and I think I can do it, right? And people will become founders as a result.