Back of the Napkin #3: Delusions of Grandeur

Back of the Napkin is an ongoing series by Brian Shih and Sebastian Park featuring a line-by-line deep dive of this interview with Jeremy Giffon on the Invest Like The Best podcast. You can find all previous posts in the series here.

Follow along here on Brian's Substack, or Seb’s LinkedIn. If you have any suggestions, comments, or want to join in as a collaborator on a particular topic, please reach out! You can reach Brian on Twitter and Sebastian on Twitter and TikTok.

Jeremy: There's nothing worse than all these VCs that have never promoted from within to a partner, but then you ask associates and analysts there, and they're like, "Oh, I'm going to be a partner one day," and it's like, "No, you're just totally wasting your time." I think that will be close to the perfect business because I guess what I'm after is leverage and the idea of basically being able to be compensated super highly for your words is pretty close to just speaking money into existence, which I think is very close to the perfect business.

Patrick: [00:03:51] My friend, Ali, said to me recently that the best way to think about a great merchant bank is that you literally make things more valuable just by investing in them, basically is what you're saying. I have the same question about the perfect investment. I would love you to take on this because you're pretty unique in -- I've talked to as many investors as anybody, and almost every investor will be focused on the asset or the thing that they're putting money into, whether that's equity or debt.

Dedicated readers will notice that we included Jeremy’s comment on promoting from within in our last piece on selection and treatment effects. We were planning to ignore it and plow ahead into the next section, but this one little line stuck out to us, and since we are gluttons for thoroughness, we decided to dwell just a little longer on the topic.

Last time we looked at why different organizations might opt for treatment vs selection effects, but what about from the perspective of the individual? If you’re working somewhere that never promotes from within to partner, are you “just totally wasting your time”?

It’s not exactly clear what point he’s making here. One interpretation is simply that if you think you’re joining a treatment-focused org – hoping they might train and promote from within – when it’s really a selection-focused org, you’re kidding yourself and wasting your time. Another interpretation is that it’s bad to ignore your Bayesian priors (they’ve never promoted from within to partner), and delude yourself into thinking you’re different.

Obviously both of these are bad. Delusion is generally not good!^[1] At the very least it’s bound to lead to disappointment.

But it’s hardly all downside for our poor associate stuck at their VC firm. Working somewhere that is known for being choosy (selection-effect focused), is great for your resume, even if you’ll never make partner. Just look at all those Twitter profiles advertising ex GOOG AMZN NFLX YC credentials.

I mean just look at this guy

These selection-effect orgs are making their hires more valuable just by hiring them, which is exactly what Patrick says about great merchant banks “literally making things more valuable just by investing in them”. Being selected by Google makes it more likely you’ll be selected by Facebook makes it more likely you’ll be selected by Apple makes it more likely you’ll be selected by Amazon…

Of course, Giffon is certainly aware of the brand halo effects picked up from joining a top-tier firm. So then why the pointed critique at our hypothetical associate here (besides delusion generally being bad)?

The fact that he singles out VC firms in his example is a clue: A critical difference between selection-effect orgs that Giffon uses as his earlier examples (Harvard, modeling agencies), and a VC firm is that people age out of the former.

No matter how good your prior experience is (whether via treatment or selection effect), you’re stuck competing for a tiny number of positions against people who have been doing it for longer than you and aren’t going anywhere soon.

Sports can again provide an example: Matt Cassel, the USC backup QB, saw no action in college, but was still drafted for his measurables^[2], and ended up having a seventeen year NFL career. So clearly he was good, despite somehow not getting much time at USC.^[3] A big part of that was that he was backing up two Heisman Trophy winners (Carson Palmer, Matt Leinart) – Cassel was good, but in an environment where you only need one QB, there was always someone (two people, actually!) better than him.^[4]

Perhaps the reason why VC firms don’t promote from within is that they’re a bit like a quarterback room - an associate may be good, but in a zero sum environment, they may just not be good enough to start for the varsity team. The sheer scarcity of open positions changes the dynamic, even for very talented people.

And it gets worse. Not only do VCs not age out like QBs – all that talking to founders and writing checks is tiring but not that tiring – they also accumulate more and more advantages over newcomers over time. Venture capital is a network effect business, and partners who have been in the game for longer have simply accrued larger and more valuable networks. When presented with the option, how many founders would rather have a recent Stanford GSB graduate on their board or a tenured world-crusher who has guided multiple companies to exits?

So was Cassel “wasting his time” hoping to be USC’s starting QB? In a sense yes (he never achieved it) ^[5]; in another, obviously not (see: seventeen year NFL career). Maybe then all that’s needed for our hypothetical associate who is never making partner is a good backup plan to convert that selection effect halo into leverage towards something else. Given Giffon’s love of leverage, that seems like something he could get behind.

Next time: We finally move on to question number two, the perfect investment.