So I’ve got this presentation that I give every now and again to young VCs, LBO firm associates, business school students, or anyone who wants to listen. It attempts to describe the voodoo we institutional investors do. Back in 2004 when I first put the deck together, I included a slide called, “Many Hats,” which tried to enumerate some of the roles that LPs play: “high throughput screener,” “investigative journalist,” “professional skeptic,” and “good cocktail party guest,” among them.
So before heading up to Tuck to help out at the “Field Studies in Private Equity” class (what a great course name, by the way! I imagined the students would be wearing pith helmets and binoculars,) I revised that slide for the first time in five years. Boy, has the world changed! I added a “Many Hats, 2009 Update” to include some of the new roles we play: “referee,” “therapist,” “bargain hunter,” “accountant,” “whipping boy,” etc. You get the idea.
It turns out that I missed one major role that I’m playing nowadays: informal fundraising advisor. After all, it seems like everyone who’s raising a fund today is engaged in a Sisyphean rock-roll. And of course, I’m always glad to brainstorm with folks who have differentiated investing strategies about how they might magnetize some moolah.
But I've got a confession to make: I'm worried that I've been giving people the wrong blanket advice by telling cats who have some money raised — but perhaps not as much as they'd like — to wrap up fundraising, get back to investing, and live to fight another day. After all, fund size is a function of time. If you raise half the amount of capital you'd like, deploy it at the same pace in about half the time. Then come back when the sand has been lubricated out of the gears of the financial system. Sure, there's a bit of a fee stream impact, but the brain drain associated with dealing with institutional investors right now is just way too high.
But then I had this epiphany: it's not just that there's sand in the gears, it's also that many investors are changing their entire evaluation paradigm. Between the dreaded Denominator Effect, investor fatigue, and a new impulse to "Keep it Simple" while eschewing complex "modern" portfolio management, I think that the new normal will be "show me," not "tell me a story." During the recent market madness, the cost of illiquidity was so high that people will remember the sting for a long time.
And then it hit me (largely because I was sitting in a healthcare fund annual meeting at the time): I think a better metaphor isn't "live to fight another day," but rather, "you're in FDA trials."
Think about it: when developing a drug, there's the initial preclinical work: can you prove the concept? Phase I trials test for safety. Is this drug going to have any zany side effects? Phase II investigates efficacy: does the treatment work? And Phase III ascertains whether the treatment is better than the current standard.
Now, in a metaphor for the drug development process, young funds go through a period where the first handful of deals test the proof of concept. Can these cats pull this off? Then, you've got another bunch of deals that ask the question, can they scale their strategy without blowing up? Then, there's the next stretch of transactions — a larger number, not unlike the larger patient populations of Phase II trials — where you really start to get a sense for whether a fund is going to work or not. And then you get to the metaphor for Phase III (which, interestingly, often coincides with fund III) in which you can see a robust test of the hypothesis. Is this thing better than the alternatives? (Of course, by then, it's typically too late to get on the bandwagon, so the sweet spot is usually somewhat earlier.)
The challenge for younger funds, then, is to have some self-awareness of where they are on that curve; are they far enough along that a handful of additional deals might offer some incremental proof of efficacy or, perhaps some more time might allow an existing deal or two to ripen? Or are they so early in their evolution that the risk-averse might still consider them to be only in Phase I when they return to market a few years hence? In that case, those groups may want to forge ahead in raising money now while the field is relatively uncrowded. Those hard-won dollars could extend the runway just enough.
But I'm a bit bummed that my reasonong was flawed all along: I'd assumed that the market would generally be more receptive a few years hence when cats came back for their next fundraise. But I now think it's going to take a lot more than readiness; it'll take good progress in the clinical trials. Those groups that are tempted to say, "the readiness is all," and come back without making much progress in their portfolio might recall that Hamlet used those exact words and was dead a couple of pages later.