Super LP

Midas, Son of Gordias

People think of the Midas Touch as a good thing . . . So did King Midas of Phrygia -- for a while.  After all, what could be better than having everything you touch turn to gold.  Forget quantitative easing and other modern-day Federal Reserve shenanigans; King Midas is the archetype for printing money first and asking questions later . . . 

And, indeed, not thinking through things was the beginning of the end for the good King.  After all, a Golden Touch is an epic gift right up until you need to eat (or in later recountings, hug your daughter.)  So there sat poor Midas with a glass of golden ice where his water had been and plate of gleaming food before him . . . and that's when his belly started getting rumbly.  Pretty soon, Midas cried out to Dionysus to reverse the gift the wine-god had given him (the Touch was payback for helping sober up a lushy-pants satyr.)  Dionysus -- never one to pass up a glass of wine or a chance to teach a lesson -- told Midas to head down to the banks of the river Pactolus and wash everything in its waters, thus returning the gilded items to their original states.  In the end, Midas was poorer, but wiser (for the moment.)

But some cats never learn: Midas decided to take his newfound wisdom and go hang out in the woods for a while with Pan, the god of mischief.  Always feisty, Pan challenged Apollo to a music contest.  Of course, Pan with his rustic pipes stood no chance against Apollo and his Golden Lyre on that week's episode of Olympian Idol.  When the notes were played, all the judges raved that Apollo had the better tune . . . except for Midas.  And not only did he vote against Apollo, but Midas also got mouthy with the Patron of Delphi much like an ancient Simon Cowell.  For his insolence, Apollo said, "you have an ass's ears!" and a pair of floppy donkey ears grew from Midas's head that stuck with him the rest of his days.

Aside from being a great exemplar of the Greek Tragic Cycle, what does this parable have to do with investing?  

Well, first off, you've got to admire Midas for his willingness to be contrarian during the Pan vs. Apollo battle of the bands.  I often note that the fear of being wrong and alone pushes people in finance to do conventional stuff and run with the crowd.  But in doing so, they take the possibility of being right and alone out of play.  This is what Lord Keynes was talking about when he said, "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”.  But being non-consensus right is where fortunes and reputations are made; that's the heroic investing quardant.  Of course, Midas probably pushed it a bit far in defying an Olympian god.  Indeed, while Mr. Market can be a harsh taskmaster, underperformance is rarely punished with the rageful pique that the Immortals could muster.  The two-by-two matrix below lays out the scope of outcomes for the financier.

And that's where this post comes full-circle: Back in 2005, I was pitching our then-latest private equity fund of funds offering to a salty investment committee.  Toward the tail end of the discussion, one of the most cynical of the members of that committee asked, "but how many Midas Listers are in your portfolio?" in referring to Forbes' annual ranking of venture captialists.  I started giving an answer that approximated a 2005 version of Dan Primack's critique from this morning, but after a few moments, I stopped and said, "but wait a second: you're not paying us to invest in the Midas List of 1999 -- that's just conventional wisdom --you're really paying us to invest in the people who will be on the Midas List in the 2010s, that's the real challenge.  Some of them might be the same, but many will be different."  I didn't really believe in the Midas List, but the line made for great rhetoric.  I remember that discussion vividly because immedaitely after, I met my friend Josh Kopelman from a then-nascent First Round Capital for the first time for memorable lunch outside of Philadelphia.  

And indeed, while it seemed like a really contrarian move back then to invest in First Round's pre-institutional funds -- among other things we did in those heady early days of the micro-VC movement -- I always knew that there was something disruptive about the voodoo those guys were up to collectively.  Even though I remain pretty cynical about the Midas List, it has been gratifying to see some of the folks I've known for a while in the micro-cap VC space like Josh and now his partner Rob Hayes, Mike Maples and Steve Anderson (and cats like Bryce Roberts in recent years) get some well-deserved recongition.  Congrats to everyone on the List (even if I don't buy into it entirely.)  And thanks for making all of us that invested in you look good.  Keep putting that moolah in the coolah!

Dispatches from the Disruption, Part 2

Here's the second half of last week's post:

Now, let's get back to one of my favorite topics: disregard for convention.  A wise man once told me that most investors follow a set of rules that typically make them middle-of-road, B-level investors, but in breaking their rules they can become either  A-level investors (rarely), or (more frequently) C-minus investors.  And indeed, I've always been a bit insouciantly petulant about rules, but as far as guidelines go, but I've got to give James Montier from GMO a tip of the cap for The Seven Immutable Rules of Investing:

1. Always insist on a margin of safety

2. This time is never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. Be leery of leverage

7. Never invest in something you don't understand

And, generally, those are pretty darn good rules.  The value investor in me swoons.  But the Californian in me wonders if these rules are little more than a wind-break against the perennial gales of creative destruction?  In this zip code, after all, those rules are more honored in the breach than in the observance.   And surely, if investors had followed those rules exclusively all along, we'd still be communicating via horse-mounted couriers as we farmed the Appalachian Watershed with oxen, oppressed by the inexorable tyranny of the seasons and the immutable fright of nightfall.  Instead, we live, work, and play in ways that are scarcely recognizable to our parents and would've been unimaginable to our forebears.  Much of that progress was financed by the investors who broke their rules; some made mints while most didn't.

Now, I don't mean to critique value-oriented investing, as assets need an anchor around which to contextualize their valuation.  But if the last century, with its optimists triumphant, suggested anything to us, maybe it's that the value of businesses isn't really the discounted value of their dividends?  Perhaps businesses are better thought of as portfolios of options, some of which are very long-dated and way out-of-the-money.  And maybe the central wonder of the American economy, with California as its exemplar, is that it offers the best framework for capturing the random forward lurch of progress?  After all, the US economy, more so than that of any other nation, seems geared around exercising profitable options while letting unprofitable ones expire, often (and hopefully) cheaply.  This asymmetry is getting even more acute as value chains continue to fragment and the cost of hatching and nurturing an idea continues to drop.  The resulting left- and right-tail opportunities may be hard to differentiate from each other, but those who are unafraid of being wrong and alone will give themselves the electric opportunity of being right and alone. 

I love working on a street thick with start-ups and it's been fun to watch these companies strive and stumble and pivot and grow.  I love visiting them when engineers are piled up on top of each other in a too-cramped space; its a visceral and sensory experience when a startup finds its cadence.  The old east coast value investor in me wonders aloud, "who would invest in this stuff?  It's bananas!  These guys are violating at least four of The Seven Rules!" 

But the west coast Chris hears an echo of Steinbeck's description of Cannery Row: "[Silicon Valley] in California is a poem, a stink, a grating noise, a quality of light, a tone, a habit, a nostalgia, a dream."

Indiana Jones, Investor

Sorry I haven’t posted in a while; it’s been a hectic stretch.  And I also have to admit that I’ve been watching a lot of Indiana Jones movies with LittleLP lately.  Every now and again, I’ll wonder if I should be doing something productive like scribbling down a blog post or paying some bills -- but the moment I see that fedora, I’m frozen in place like one of Indy’s antagonists in the presence of some ancient and mystical idol.  And I’ve long thought that the best of the bunch is The Last Crusade, but only recently did I realize that the last scene of that movie offers a metaphor for the craft of investing.  Stick with me on this for a moment:

As you’ll recall, the movie reaches its climax when the good guys catch up to the baddies in the Canyon of the Crescent Moon, where the Holy Grail has been hidden for centuries.  Seekers of the Grail must pass three challenges of worthiness.  Bodies littering the floor of the temple attest to the high cost of failing these tests, so it’s fortunate that Indy’s dad, Professor Jones, Sr., has dedicated his life to The Search and chronicled his findings.  After watching the movie for what seemed like the 16th time, I finally realized that the tests are like an investor's roadmap.

Challenge #1: The Breath of God -- Only the penitent man shall pass.  As he tiptoes among a jumble of beheaded precursors, Indy realizes that a penitent humbles himself before God, and he drops to his knees just as a spinning blade whirrs by at neck level. 

This challenge is a warning that bad things can befall overconfident people.  A mentor of mine once told me that a great analyst has no ego; one must be wary of confirmation bias and remember that big ideas often come from unexpected places.  With each passing day, he concluded, you’ll realize that you know less and less, for there is no business as constantly humbling as investments. 

Challenge #2:  The Word of God -- Only in the footsteps of God will he proceed.  Having just survived a close shave, Indy now casts his gaze on a floor-tile grid of random letters.  Pretty quickly, he realizes that this clue instructs him to hopscotch across the letters, stepping only on the ones that spell, “Jehovah.”  But, he momentarily forgets that the Latinate spelling is “Iehovah” and he nearly falls to his doom as he steps on a “J” instead of an "I" and the ground gives way.  (Indiana Jones aficionados will recall that his father made young Indy chew garlic when he made an error in Latin or Greek.) 

I’ve been thinking that this challenge is a metaphor for the diligence process: you’ve got to ask the right questions and call upon your experience and skills to get the answers.  Agility, wit (in both senses), patience, and confidence will serve you well as you traverse uncertain terrain.

Challenge # 3: The Path of God -- Only in the leap from the lion's head will he prove his worth.  Indy now finds himself facing a chasm separating him from the entrance to the Grail room.  The protectors of the Grail, had, however, created an optical illusion by disguising the bridge such that the surface blended with the rockscape surrounding it.  Indy inhales deeply as he steps out onto the ersatz gulf, only to find a bridge of faith below his feet. 

Indeed, sometimes investors just need to take a breath and step into the abyss, knowing that their preparation was sound.  After all, risk isn't a dirty word; investing is about optimizing discomfort, and we spend our lives seeking appropriate compensation for the risks that we do take (at least those that can’t be mitigated).  If you never take the leap, the Grail will forever be out of your reach.

Having met the challenges, Indy now finds himself in the Chamber of the Grail, where he is met by an ageless knight and a room full of putative Grails.  “Choose wisely,” admonishes the old knight just as the antagonist, the turncoat Walter Donovan, enters the room.  Donovan grabs a bejeweled chalice, “a cup worthy of the King of Kings,” he says, drinks deeply, and perishes in a gruesome way.  He chose poorly.  Indy then searches for the Cup of a Carpenter, finds a modest vessel, fills it with holy water, and drinks.  “You have chosen . . . wisely,” says the knight. 

Now maybe I’m reading into this too much, but I saw this scene as an admonition against rashly investing in the new, new thing.  Investors love shiny new pennies, but often, it’s the tried and true staples, arrived at deliberately, not snatched in haste, that offer the best outcomes. 

I also recalled my days at Old Ivy’s endowment.  With each investment, we felt the burden of being a bell-cow.  We were proud that we did good, thorough work, but were sometimes surprised at how hastily people followed us in our investments, much like Donovan follows closely on the heels of Indy's pioneering footsteps.  Of course, I was always quick to tell people that they were chasing our second-best ideas, since we kept our best ones close to the vest for as long as we could since those funds rarely had enough capacity to sate our entire appetite, not to mention the appetites of all of our friends. 

It's true that the courageous investor must follow an adventuresome path in search of outsized returns.  After all, the benefit of being right and alone with some frequency can generate outsized overall returns, but blazing a pioneering trail comes at the risk of being wrong and alone, as well.  And for those of us who focus on long-dated asset classes, we, unfortunately, don't get the benefit of a knight that nods approvingly as we write investment memos.   Only in the fullness of time will we know whether we chose wisely . . .

Strategy 101

Let's talk about strategy for a second. 

Now, strategy is a topic near to my heart since, you see, I was a young strategy consultant -- one of the "Kids in the Conference Room" during the mid and late 1990s (that New Yorker article -- linked here again in case you missed the link a dozen words back -- offered some menacing portent for the subsequent "The Smartest Guys in the Room.")  Now, I wasn't one of the McKinsey cats, but I was at another of the "B's and M's" (the en vogue catch-all for the then-hip consulting firms.)  And indeed, that article struck just a bit too close to home, as it kept quoting clients talking about "snot-nosed 25-year olds" and I could take cold comfort from the fact that I was almost 27 at the time.

(It was a great experience, though, and one of the most valuable things I learned during those years was the Mike Porter definition of strategy: "strategy is an integrated set of choices that inform timely action."  You couldn't leave an offsite training confab without being able to recite the definition when asked. The lazy, petulant, or merely hung-over soon found that they could get away simply saying: "informed choice/timely action."  Four words and you were on your way . . . )

And so what?  Well, I'm writing about it because I'm amazed at how often companies confuse strategy and tactics.  Tactics are not strategy; tactics arise from strategy.  I'm seeing this muddling a lot of late.

But I don't want to get pedantic about it; I'm really bringing it up to amplify the concept that strategy is a set of choices.  And choices are about the things that you don't do, as well as about the things you do decide to do.  The problem is that deciding not to do things is hard and, in particular, deciding to take a decision to stop doing things that you're currently doing can be even harder.

As you'll recall, I wrote about focus a while back and it seems now that focus is a lot more critical as 2011 business plans are getting finalized and people are starting to get (maybe?) more optimistic about business conditions.  The temptation exists to start doing a lot of things that weren't being done during times of belt-tightening.  And I'm not saying to not to do those things, rather, I'm asking folks to think about doing things in the context of the inegrated set of choices they're making and how they inform timely action that has the Great End and Real Business of optimizing shareholders' (or stakeholders') success functions.   

 

Private Equity Lessons from the Subway

So I've been riding the New York subways pretty frequently lately.  Between annual meetings, conferences, and the entrepreneurial scene, there's been a lot to do in The Big Apple this fall.  And every time I hop on the train, it takes me back to my childhood.  You see, a quarter-century ago I rode the subway to middle school.  Imagine that: a 12 year old with an overdeveloped sense of adventure and a transit pass that offered unlimited access to the lurid expanses of Metropolis!

(Let me take a moment to apologize to Mr. Criscuolo and my other afternoon-class teachers.  A fake bellyache and a hangdog look was all I needed to get permission from the school nurse to go home after lunch.  And as my time in middle school began to wane, I started scooting out about once a week in an effort to see the entire city, one subway stop at a time . . .)

But, despite my school-skipping, I actually did learn stuff on the subway, my very own classroom on rails.  And who knew I could apply those lessons to private equity and even investing more broadly?  Only recently have some of those lessons come into focus.  Let me run you through five scenarios and their associated learnings in what may be the first in a series of "Lessons From The Subway":

* * *

Scenario #1: Have you ever been barreling through a tunnel on the local train as an express pulls up alongside you between stops?  For several seconds, the two trains hurtle down the tracks together side-by-side before the local starts its inexorable deceleration into the next local station while the express pulls away, charging ahead to the next express stop.  For a moment, there's an intimacy with some of the passengers in the express train.  It's almost a voyeuristic feeling, like looking into someone's living room window; sometimes you even make eye contact with one of the passengers in the other train.  Do not give that person the finger or stick your tongue out or make menacing gestures.  There's a chance that they will get off at the next stop, wait for the local to pull in, and kick your behind.

Lesson: Life is a multi-period interaction.  What happens at one moment resonates into the next.  Even the most random encounters can presage subsequent ones.  Don't be a jerk and always have integrity.  Why soil the canvas?

 

Scenario #2:  Your train pulls into the station on one of those muggy summer days that seem all the hotter and more acrid below ground.  Car after car blurs by, stuffed with people; as the train starts to slow, one car is nearly empty.  But hold on a second; today's not your lucky day, the day you get a seat for the long ride.  Rather, the odds are that the air conditioning simply isn't working and that car is hotter and stuffier than August in Houston.

Lesson: There's information in crowds.  While one never wants to be a lemming, there can be limits to being a contrarian.  Sometimes, leaning against the gales can work, other times, it just gets you windburn and a face full of leaves and other wind-blown detritus.

 

Corollary / Scenario #2a:  Speaking of reasons why cars might be empty, sometimes there's an, ahem, stinky dude on a train car that clears out all the people.  Again, there's a reason that train car is empty and, odds are, that funky cat is going nowhere.

Lesson:  If something stinks, it's likely that the stink will linger, no matter how you try to rationalize away that hinkey feeling about, say, the GP that does't feel right or the story that doesn't quite hang together.  Trust your nose.

 

Scenario #3:  Don’t give the finger to a policeman. Ever.  Catch me sometime offline and I'll tell you a story . . .

Lesson:  The people who make and enforce the laws know and understand them far better than you do.  And even if they're wrong, they're right.  And they can make your day a lot more aggravating than you can imagine.  You get a lot further by smiling and saying "yes, sir" than you do by being petulant.  This may be a good thing for our industry to remember as the shadow of regulation lengthens across our sun-kissed land of private investments.

 

Scenario #4:  If someone starts talking to you on the train, it's likely that they're a looney toon, but there's a chance that they're lost or want to talk about something interesting.  Subway philosophers end up having a lot of things to say, some of which are worthwhile.  Once, though, I talked to old Brit about what to see on holiday and he gave me a 50p coin as a souvenir.  It was the coolest thing I'd ever seen.  Another time a kid told me about a pizzeria over on Ditmas Avenue that had a Space Invaders game that would give you 10 credits if you held the coin return while you put in your quarter.  Needless to say, I became the master of Space Invaders that spring.

Lesson:  Be generous with your time.  You have to be careful, but you never know what you might find out.

 

Scenario #5:  Every mass transit system seems to have a few stops that are central nexuses (nexi?) of the tangle of lines that ferry people to the disrparate and far-flung reaches of their city.  At these stops the trains disgorge their contents and refil with cats connecting to elsewhere.  Jay Street - Borough Hall in Brooklyn was the one that occupied my imagination (where exactly does that exotic A train go?  Why do people write songs about it?) but 42nd Street/Grand Central and Fulton Street/Broadway-Nassau were other such network nodes, full of hurly-burly.  Here's the thing: if you're leaning against the door and not paying attention as the train arrives at one of these stations, you're likely to get pushed out.  And getting back in to your train can be as challenging as swimming upstream with the salmon. 

Lesson: Don't block the exits!  Sometimes, people need to get off the train.  There may indeed be better connection options for them (like West 4th Street,) but sometimes people need a bird in the hand instead of two in the bush.  This is a big concern right now, as I worry that GPs may be suboptimizing exits, but if there's an A train waiting at Jay Street, it probably makes sense to hop off the F train and change, because you never know if you'll wait in vain at West 4th for a delayed A train that never comes . . .

 

 

Office Hours

When I moved to California, people told me I'd miss the seasons.  And indeed, it can be hard to tell when one season bustles aside another; time passes like mellow west coasters waving each other through at a 4-way stop intersection.  But, alas, I've got the unofficial private equity calendar to keep me in tune with the rhythm of nature.  Instead of falling leaves, I always know its autumn when my wallet grows fat with receipts for cab rides and drycleaning claim checks in the far-flung and disparate cities that comprise the LP rota.

And since I'm going to be in the usual haunts with some regularity and a bit of free time, I thought I'd hold office hours for private equity and venture capital GPs who might have random questions about anything from fundraising pitchbooks to annex funds to partnership tumult -- it can be anything that you wanted to confidentially ask a live LP, but were afraid to ask one of your own.   

But here's the deal: no pitching!  Let me be clear: this isn't an opportunity to get in front of me to sell your fund.  Doing so will dump you in the interminable expanse of despair known as my to-do list.  In fact, just like your introductory macroeconomics or organic chemistry professor, I will probably not even remember your name afterwards, but I will take comfort from having been able to dispense a pearl or two of wisdom in 15 minutes or so.

Here's a good description of what to expect, pilfered from some orientation materials at Cornell:

Most professors and teaching assistants do not have lessons planned for office hours. They expect students to “drive” these meetings with their questions and their thoughts . . . Do not be surprised when the professors and teaching assistants reply to your questions with questions of their own. They are working with you to uncover the source of your questions . . .  They may ask you to generate alternative ways to solve a problem. Hopefully they will help you change how you think about the material so that you can answer many different kinds of questions about it – not just the question on the homework that is stumping you. Don’t be surprised if they ask you to solve another problem before you leave the office.

So here's the lineup (you will know me by the crimson of my t-shirt):

[times and locations may change; I'll post updates the day before]

New York City: Weds 10/6 in the Lobby of the Marriott Marquis (1535 B'Way) 1130AM-1PM.

Boston: Thurs 10/7 in the lobby of the Mandarin Oriental (776 Boylston) 6-730PM.

NYC: Tues 11/2 location TBD 1030-noon.

Boston: Thurs 11/4 location TBD 230-4PM.

Chicago: Weds 11/17 in the lobby of the Peninsula (108 E Superior St) 830-1030AM

Dallas: Thurs 11/18 in the lobby of the Rosewood Crescent (400 Crescent Court) 10AM-noon.

I may add a Seattle time and may do a "home game" in Palo Alto.  I look forward to seeing you.

Speak Like the Locals

[Originally written as the guest column for the PEHub Wire, Sept 22, 2010]

In Brooklyn, Old O’Malley would tell us boys about being a Flatbush kid in the Marines in 1942.  He often laughed about meeting hundreds of guys from around America who didn't seem to speak any English.  "Fugghedabouit!  Dose guys all spoke Texan!"

And, indeed, such a language divergence plagues private equity today.  After all, our performance touchstones – quartiles – emphasize the relative in an increasingly absolute world; we’re speaking one dialect and the asset allocators another.  Interestingly, relative metrics gained sway because of the dis-integration of portfolios.  Armed with copies of Pioneering Portfolio Management, asset allocators knew they wanted PE, but they found it challenging to integrate the asset class – with its illiquidity, irregular cashflows, and stale prices – into portfolio analytics.  As a result, this thrilling, but naughty asset became a part of the portfolio, while apart from it in many ways.

Having been a source of illiquid heartache during the downturn, private equity entered its post-heroic phase and many investment committees are contemplating how to re-integrate PE into their portfolios so they can think holistically again; as a result, crises of confidence abound with respect to taking on new commitments.  And perhaps the most serious problem right now is that people around the asset allocation table all speak different languages. 

In fact, a Monday meeting at an endowment or plan sponsor can be like a European Parliament meeting: there's the cat that covers VC, he's speaking a sun-drenched, passionate language analogous to Italian ("sprazzo di sole" has the same hopeful cadence as "cashflow breakeven.")  The real estate manager speaks the frenetic Merseyside Scouse of a BBC sportscaster who's seen too much hooliganism.  Meanwhile, the public market folks speak a frugal Dutch, as they haggle over single basis points in manager fees.  The hedge fund team speaks a precise, formal language that is the finance equivalent of German (too much time thinking about Sortino Ratio can give you weltschmerz, no?)

In such an environment, crowing about top quartile performance, or telling stories about “impact companies” can fall on deaf ears, particularly with the liquid asset constituents of the portfolio still resent that their portfolios were used as ATMs for increasingly frequent PE capital calls between 2004 and 2008.

So how can a GP raising a fund speak in terms that resonate across the portfolio?  First, I think we all in PE need to be more thoughtful in articulating our return expectations while taking an honest accounting of risks.  Focus not just on rear-view performance – which should properly be considered a lagging indicator, not a leading one – but also on implicit assumptions: why are your returns achievable?  In what environments will the fund outperform?  Underperform?    

Said another way, asset allocators live in worlds of probability distributions, observed risks, and well-established performance calculation; they measure and predict performance.  By failing to give thought to their metrics, we are perceived as soft and non-rigorous.  They speak the language of efficiency while we tout inefficiency; they’re from Mars and we’re from Venus.

Remember, PE is a return enhancing asset, one that must be considered in the context of the opportunity cost of equity capital; for asset allocators that cost includes the drag from the cash they have to keep at the ready for PE capital calls. 

To that end, it can be helpful to give people a sense for expectations of capital calls and distributions, with a particular eye toward what one’s doing to accelerate cashflows.  Today, liquidity is prized and it seems most folks are trying to shorten the duration of their portfolios.  Asset allocators worry about facing negative PE cashflows ad infinitum; any visibility into when cash might come back is critical.  After all, there’s nothing like returns to silence critics.  A little “moolah in the coolah” goes a long way toward answering the question on everyone’s lips when it comes to PE: “why bother?”

Party Like it's 1998!

So there I was, reading the announcement of the Skype IPO filing and scratching my head.  After all, a $100 million offering doesn't sound like all that much when the current investors bought in at a $2.75B price a little while back.  How tiny a share of the company were they going to offer?  Two percent?  Three percent?

And after all, don't you need some float for institutions to be interested?  And indeed, some industry watchers had previously speculated that the company might seek to raise a much larger offering: think north of a billion (one beeeeeeeeellllion dollars - said with pinky to corner of mouth.)  I was even bouncing it around with a banker buddy who suggested that institutional public market investors today demand 10-20% of the shares to be floated as part of an initial offering; if he saw a random company executing a $100M offering, he'd said his guess of the total market cap would be in the $500M-$750M range.  There's no way that's the case with Skype, particularly if they company is doing a couple of hundred million a year in "adjusted EBITDA" (also known as EBBS, Earnings Before, ahem, Bad Stuff.)

Now in fairness, I'm neither an investor in any fund that invested in Skype, nor am I a banker, so there may be a backstory to which I'm not privy.  And who knows: that $100M offering amount may even be a placeholder for another, larger, offering amount.  But the lunchtime conversations here in Silicon Valley keep coming back to the modest offering size.

But for me, it's a case of deja vu all over again: it's all about the magic of the thin float.  You see, I still bear scars from having been a fundamentally-oriented equity analyst at a hedge fund of sorts in the late 90s.  During that time, it was almost impossible to perform fundamental analysis and keep a beta-neutral book.  There was just so much liquidity in the system that things like sector rotation and technical factors almost always trumped hard-nosed, Graham and Dodd, old school analysis.  Try adding any short names to the portfolio!  If something had a whiff of broken-ness, it was cheap and anything that was cheap was an acquisition candidate for firms flush with cash and inexpensive public currency.  It seems that all of one's short sales would get bought at a premium, wrecking performance.

And then, starting in earnest in 1997, the emerging tech firms got in on the action: pretty soon bankers figured out that floating only a tiny portion of a company set the stage for the stock to jump as retail investors would gladly pay up in the after-market, just to get in on the new, new thing (and the banks proudly touted their post-IPO performance in their pitchbooks).  Things didn't catch fire for fundamental reasons, they burst into flame because the thin float acted as both the ignition source and the accelerant.  Just ask the guys at the Globe.com who priced at $9 and opened in the $80s.

And once the price got fixed at a certain level, existing holders could trickle out their shares at inflated prices.  Of course, as we all know, that strategy worked until it didn't.

Now, let's be clear.  I'm not being crabby about Skype.  I'm keen for them to have a successful offering (if for no other reason, because their recent announcement of expansion plans in Palo Alto is probably good for my home value.)  But if we learned any lesson from the late '90s (and, more recently, the late '08 action offered a similar lesson on the downside,) it's that stock prices are only vaguely related to fundamentals; it's supply and demand that sets the price.  Maybe Old Man O'Malley's Brooklyn wisdom had something to offer the public markets: "youse guys would pay twenny bucks for the last slice of dollah-fitty pizza at tree-toity in the morning when youse got your drink on . . ."

One View of the Future of VC Allocations

So I'm working on a blog post with some fundraising tips for PE and VC pros that are making the rounds.  The thesis is: you've got to come to meetings armed with better rhetoric, as many institutions have become wildly cynical about private equity strategies after feeling the acute sting of illiquidity during the downturn.  Said another way, people realized that the cost of illiquidity was much higher than they had estimated and many asset allocators are now (re)asking the questions: "are we getting adequately compensated for the risk and illiquidity of privates?" and, more importantly, "why bother?"  Talking about being top quartile will get you nowhere when the person across the table reports to a CIO who's obsessed with the opportunity costs of their capital. 

But before I finished that post, I thought I'd put up a slide deck that I pulled together a few months ago; I've presented variants of this storyline to a few different groups since the beginning of the year.  It's a review of some dynamics that impact institutional investor attitudes towards VC, but I think several of the thoughts are generalizable across private equity. 

Now, I don't think there are necessarily any earth-shattering insights embedded in the slides; it's more of a refresher of first principles.  On the other hand, I continue to be surprised at the number of GPs with whom I speak that think LPs will return en masse with open checkbooks at any moment.  I didn't want to be all gloomy and doom-y, so I tried to end the presentation on a optimistic note, but I do hope that people understand that we've crossed over to a new paradigm that's different from the illiquidity bull market that marked the better part of the last 15 years.  This isn't just a "get-a-mulligan" detour on the way back to 2006; instead, I think the fundraising equilibrium we find over the coming quarters and years will feel a lot more like the tough slogs of the late 80s and early 90s.

I sometimes teach "The Yale Case" (insert reverent pause here,) at business schools and I always open by asking the students what they think the key lessons are.  "Diversification!"  "Equity Bias!"  "Asset Allocation!" come the cries from the well-scrubbed students.  "Nope," I tell them.  "the real lesson of the Yale Case is: don't try this at home . . . "  I fear that many institutions have now learned that lesson the hard way and may be reluctant to return for some time.  And, as always, people will return when they see money being made, but, as with the lottery, the worst time to buy a ticket is typically just after somebody else has won the big jackpot . . .

VC Presentation May 2010

Fat Startups, BMI and The Lorax

So, there I was hanging out in Denver airport again, reading the back-and-forth between Ben Horowitz and Fred Wilson on fat versus thin startups.  They’re both cats that I respect and I think they both make carefully reasoned, nuanced arguments that have far more depth than a quick summary can articulate. 

But all this talk of heft got me thinking about the Body Mass Index; those hip to the BMI calculation know that it's a measure of weight relative to height.  Doctors tend to be fans because it's a decent indicator of body fat which correlates with increased risk of morbidity and mortality.

And BMI tends to work pretty well, except when it doesn't.  For example, serious athletes tend to have more muscle per unit of height than the rest of us and thus have unusually high BMIs: Arnold Schwarzenegger's BMI clocks in at 33 (the "ideal weight range" runs from 18.5 to 24.9).  Even George Clooney clocks in at 29, just shy of the "obese" cutoff of 29.9.

The beauty of muscle, though, is that it's so much more metabolically active than fat.  That's why one can be heavy, but fit; the two are not mutually exclusive.  And  neither, necessarily, are capital efficiency and cash abundance in the startup world.  Indeed, while I do find myself more firmly in Fred's "lean" camp, I am sympathetic to the notion that sometimes a company with a lot of dollars on hand can pivot more quickly as business conditions change, or scale faster to discourage new entrants or build competitive advantages that give them a leg up on existing rivals.  Companies can be well-funded but hungry.  I get it.

But here's my question: sure, bigger companies can earn bigger exits, but if they burn more cash on the way to a big outcome, isn't it almost inevitable that return multiples will be depressed?  Indeed, there can be some positive externalities associated with a big outcome, but as an LP -- the money behind the money -- what I care most about is multiple on investment.  I'm focused on the numerator and the denominator.

And then I started thinking about some of the cleavages of interest that may arise from fatter startups.  Most directly, the dollar value of carry to a GP of 2x outcome on a $100 million investment is greater than that of a 5x on $10 million.  I know which outcome I would rather have, but I'm not sure that a random GP's answer would be the same.  Then you get into non-economic motivations: having big outcomes can help build a brand, almost regardless of the profits.  Few people know what multiple Sequoia, for example, generated on Cisco's IPO twenty years ago, It could be a 100x, or it could be a 2x.  Most likely, it's somewhere in between, but either way it's an awfully spiffy logo to have on the web page.  Entrepreneurs, too, can get a lot of jazz from landing a big round of funding; it's an endorsement of their idea and the vote of confidence that makes for good press releases and generates respect.

Further, aiming to build a large enterprise fundamentally changes a startup's optionality profile.  No longer are a wide range of exit scenarios compelling; suddenly, a happy outcome for all becomes limited to one of the handful of large exits that take place in a given year.  With expectations of a modest number of IPOs (which I fear is a structural thing,) and a few dozen M&A transactions in excess of $250M, all those fat startups are like so many well-prepped high school seniors looking to land a spot at Top College.  It's just tough arithmetic.  It may be a fun ride for the entrepreneurs and GPs, but it can be nerve-racking for us LPs at the tail end of the whip.

And the risks are different, as well.  "Fatter" startups imply either fewer portfolio investments or larger funds (or perhaps even imbalanced funds where a few large bets compete for GP time with many small ones).  None of these are particularly positive outcomes for fund investors. 

I could go on, but it would start to stress me out.  And one of my sources of stress is that entrepreneurs and GPs are pretty well represented in these discussions, but we LPs tend to be distant observers.  Who speaks for us? I wondered out loud.  And just at that moment a little man appeared out of the breeze:

[With apologies to Dr. Seuss]

“Mister!” he said with a sawdusty sneeze,
“I am the Lorax.  I speak for LPs
I speak for LPs for LPs have no tongues.
And I’m asking you sir, at the top of my lungs” –
He was extremely upset as he warned retribution –
“What’s that THING they have done with our cash contribution?”

“Look, Lorax,” I said, “it's easy to get crotchety.
GPs deploy billions; it sometimes still bothers me.
In fact,” I continued, “some think it’s a lottery.
A lottery whose tickets can be a new social network,
A diversion to give cube-dwellers ways to shuck work.
But it has other uses.  No, we’re not out of the woods.
You can use it to serve ads or sell virtual goods.
Or crowdsource a date or find homes in new ‘hoods.”

The Lorax said,
“Sir! You are crazy from drinking the potion.
There is no one on earth who would buy that fool notion!”

But the very next moment we were shown to be wrong.
For, just at that moment, a ‘tween came along.
And she thought that the club we’d just ridiculed was great.
She happily subscribed for thirty-three ninety-eight.

I laughed with the Lorax.  “You poor stupid guy!
You never can tell what some people will buy.”

“I repeat,” cried the Lorax,
“I speak for LPs!”

“All GPs are top quartile,” I told him.
“Those marks are a tease.”