The Paradox of Choice and the Saccharine in Your Diet Coke

Anyone who knows me knows that I drink a freakish amount of Diet Coke. I mean we’re talking ten to twelve can-equivalents per day. Usually in the form of a Double Big Gulp purchased at Palo Alto’s own Hamsterdam, the 7-Eleven on Lytton.

Anyhow, I’ve been really dismayed of late because these hi-tech Coke Freestyle machines keep popping up. Have you seen them? As sexy as a Ferrari (they’re designed by Pinninfarina) and smart as heck (cool technology abounds, like microdosing from DEKA and RFID from Impinj), these machines can dispense up to 127 different products and variants.

Normally, I can resist anything but temptation, yet these touch-screened temptresses have me really flummoxed. Here’s my problem: their straight Diet Coke tends to taste too fizzy for my tender palate, so the soda dispensed from a Freestyle machine cries out for some mellowing flavor. But when I get to the DC sub-menu, this is what I see: 


Really? I have to choose between Cherry Diet Coke, Vanilla Diet Coke, and Cherry Vanilla Diet Coke among other putatively tasty concoctions. Sometimes I stand there for a moment and imagine the mouthfeel of Raspberry Diet Coke; will it be sprightly and delightful, or too tart? I’ve never had the nerve to try it.

OK, ok . . . maybe I’m being a little silly, but the whole episode just reeks of the Paradox of Choice, right? For those of you don’t know it, the P.O.C. is a thesis that increased choice leads to increased anxiety. Sometimes, even, too many choices can paralyze and repel us. (Check out the TED Talk given by the idea’s progenitor, Barry Schwartz.)

So what does this have to do with investing? Well here’s the problem: there are a ton of funds out there raising capital right now. This is especially true in Micro-VC, an area where I’ve been spending a good bit of time since 2005. After all, barriers to entry are really low; anyone with a couple of successes on AngelList can try to rustle up $10 or $25 or $50 million for a fund.  This year alone, I've met with over 50 such groups looking to raise capital.  Some days, Silicon Valley seems like Hollywood North, except the streets aren’t thick with people hawking scripts; rather University Café is abuzz with pitches from cats in search of OPM.

To be fair, every last one’s got a story or some alleged edge and, quite frankly, it can be exhausting to parse the nuance sometimes.  The sheer noise in the market stands in stark contrast to something a mentor of mine once said: he’d been an early employee at one of the Endowments Everyone Tries To Emulate and I asked him once how they'd built their portfolio?  He replied, “in those early days, we'd just formulate a thesis (say lower mid-market industrial buyouts), meet all the managers (there weren’t that many) and invest in something like one-third to one-half of them.”  I bet in 1985 he could have scarcely have imagined the sheer quantity of funds competing for capital today.

And I think LPs are starting to demonstrate the paralytic anxiety associated with too many choices. I had a conversation the other day with a GP who told me that he’d been turned down by an unnamed endowment that reasoned, “VC is a tough space for us because we can’t really tell a credible story around why one firm might prospectively be better than the next.” In response to his frustration, I replied that I thought it took courage for the LP to more or less say, “we don’t know how to distinguish the different varieties of snow.”

Indeed, it can be particularly tough for those flying in from places like Lake Charles looking for investments on behalf of the Southwest Louisiana Janitors Union. The sunny and magical lands of Silicon Valley can be mesmerizing and bewildering for those who swoop in and out.

And I think Micro-VC –- arguably one of the most exciting niches of opportunity right now -– can be a particularly hard place to discern the most opportune risk-adjusted returns, particularly because there are some non-obvious and difficult to ascertain risks specific to the space. Having feet on the street is an important start in making sense of it all. And history and experience make a big difference, too. There are a lot of changes afoot generally in VC right now and if one believes that well-executed venture program can be return enhancing, one is incurring opportunity costs by not participating.

Adding to the anxiety is this gnawing Fear Of Missing Out.  Things move pretty quickly; all a $25 million fund needs to get oversubscribed is for a domino or two to fall.  Folks raising these funds are quick to remind potential investors that groups like First Round have basically been closed to new investors after their first institutional fundraise.  It's kind of reminiscent of the Freestyle machine again.  After you've chosen your base beverage, you only get 5 seconds to choose a flavor before returning back to the home screen.  If you lolly gag, you're back to square one.  At least in the case of a Freestyle, you can punch the Diet Coke button again, it's not gone forever.

Of course one can be overwhelmed by choice and return to the table without a drink and say, “there was just too much going on with that blasted Freestyle machine,” or one can get up to speed themselves or choose a good partner to help them that’s experienced and savvy and can offer inside knowledge like the fact that fountain Diet Coke still contains Saccharin — in addition to the NutraSweet that sweetens canned and bottled DC –- and that’s what makes it oh-so delicious.

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Speak Like the Locals, Redux

[I don't love reposting stuff, but this riff from 2010 seemed appropriate since I spent part of last week talking to folks about the the sources of indifference towards private equity in institutional portfolios . . . ]

Speak Like the Locals

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?”


All About the Benjamins

It’s said that the most meaningless number in sports is the score at the end of the first quarter of a football game; so much will happen before the final whistle sounds, that the first quarter score is a specious predictor at best.  Lately, I’ve been feeling that the private equity equivalent of that oft-misleading tally is Total Value to Paid In Capital (TVPI).  I get it . . . we have to gesture in the direction of a comprehensive interim measure of performance, but look folks (and I’m talking to you, GPs): all we LPs really care about is cash in cash out, moolah in da coolah, ducats in the buckets, and pennies in the piggies.

Now it’s always been clear that interim valuations are prone to tinkering, throwing TVPIs into question.  No surprise there.  But such shenanigans seem to be most frequent as fundraises approach.  We didn’t need academic studies to confirm our suspicions, but they’re out there.  And even if we’re feeling charitable, the vagaries of subsequent financing rounds and the occasional undulations that all business experience can send NAVs gyrating.  No matter what the fair value police (thank you, Accountants and Auditors Full Employment Act of 2002) have to say about it, it’s an incredibly imprecise science.

Advocates of TVPI sometimes say that it’s one of the least-worst quantifications of performance.  And indeed, the perfect may be the enemy of the very good.  Yet TVPI has been feeling pretty useless as a predictor of final performance unless the D(distributions relative to)PI quotient is pretty high.

So what’s a poor LP to do?  How might we think about the success (or lack thereof) of a particular fund?  Setting aside the fact that performance is a lagging indicator, not a leading one, how do we institutional private equity portfolio managers show our face in our Monday meetings when the hedge fund cats speak in tongues, regularly dropping Greek, Sanskrit, and Cuneiform in their discourses on performance?  We need to bring something more compelling to the table than: “check out this new new thing . . .”

To be sure, there are some nifty performance measures that have gained some currency, including public market equivalent and real time discounting analyses, but most are subject to the appraisal effects that can be so confounding.  So here’s my simple proposal: rather than looking at what a portfolio might be worth by guessing at current (or future) company valuations and summing them, what if we instead asked how large an exit each and every investment needed to achieve to return a certain meaningful portion of the fund and then reality checking those putative outcomes?  What if we were to turn the coin on its head?

In venture world, one might ask, how big a company needs to be created in order to return half the fund?  One times the fund?  Those may seem like high hurdles for any one company, but given the high expected loss rates endemic to VC such a discontinuous outcome — or several such big exits — has historically been a prerequisite of generating the types of returns we LPs crave.  My buddy, Brad Svrluga, calls this hurdle the "RTFE," or "Return The Fund Exit.")  In buyout world, one might ask: how big a return do we need for each of our, say, 10-15 portfolio companies to each return twenty to thirty percent of the fund? 

By way of example, here’s what such a table might look like for a $150 million VC fund that wants each company to return half the fund:


                    Amt Invested            Stake            Valuation        Required Exit           

Company A    $3,000,000               13.4%            $22.5M            $562.5M

Company B    $1,000,000                3.1%             $32.3M              $2.4B

Company X    $1,500,000                26.0%            $5.8M            $290.0M


Now Company B might seem like a sporty play, but such an outcome might be in the realm of possible given its progress and potential while Company X may have already seen the market for its new fangled rotary-dial telephone pass it by . . . You see where I’m going with this.  (Of course, dilution needs to be considered in due course, although ownership percentage is one lever that can be pulled; he who owns most of the pot of gold at the lowest basis is the King of the Leprechauns.) 

Indeed, one of the side-benefits of these analyses has been that GPs are forced to think about their underwriting of deals.  An occasional outcome I've experienced on asking GPs to perform this analysis is something along the lines of, “yikes!  Our most exciting company is only poised to return a quarter of the fund using reasonable exit assumptions!  The rest of the portfolio has to work pretty darn hard for us to get a carry-generating return!” 

Now, I’m not hoping (although secretly maybe I am) that thinking rigorously and systematically about exits and fund arithmetic will introduce a value (or at least a GARP) perspective to private investing, but at the very least, I’m hoping we can start to reframe the conversation from what LPs currently are thinking (i.e. “how are you trying to pull the wool over my eyes?”) into a real discussion that starts to unpack assumptions and drive the intimacy and engagement that is so sorely lacking in today’s LP-GP relationship.

Cindy Crawford in a Bar

So Cindy Crawford walks into a bar and a swarm of dudes approach her, brandishing their best pick-up lines:  "Was your father a thief?  Was your uncle a robber?  Well if not, who stole the sparkle from the stars and put it in your eyes?" or, "My, what a beautiful mole you have" and even, "Well, aren't you MILF-y tonight?"

Sounds like the beginning of a joke, no?  Well, actually, welcome to my life!  Well, not just my life, but actually the life of any LP . .  . after all, being the cat with the checkbook can make you the most attractive girl in the bar. And being the hottie of the honky-tonk comes with a cost: an endless stream of pick-up attempts.

And the lines we hear from GPs can be remarkable for their homogeneity.  In fact, when I hear a buyout fund talk about Proprietary Dealflow or Operating Partners, or a healthcare fund talk about the Aging Population or the Patent Expiration Timebomb, I can't help but think that I've heard this story several (hundred) times before.  In fact, I've got a visual reminder in the form of my oppressive inbox of just how many times I've heard some such story.  Here's a sampling:


As you can see, the leftmost column contains the folders I've created for funds that have sent me information since I started at my current employer in mid-2004.  In this view, you can see about 30 of the 452 VC firms with whom I've corresponded.  I have a similar LBO/growth capital folder that contains another 377 firms and an international folder that contains stuff from about 275 additional fund managers.  Add in the 75 managers that are in my "active" bucket (running the gamut from the latest GP over whom I'm breathless to the oldest, most tired fund that 's in run-off mode) and that's close to 1200 funds from San Francisco to Stockholm to Shanghai.  Throw in my tenure at Old Ivy and I probably saw another 300 incremental funds over and above those 1200.  And compared to some other folks on the LP side, that tally of 1500 seems like a rookie's breakfast.  

Speaking of Old Ivy, when I was just starting out as an apprentice in the craft of PE investing I asked an Old Timer in the office about the early days of institutional investments in PE — I mean, this guy was my Hubble Space Telescope back to the cottage industry-era of the PE universe.  And one thing that he said stuck with me all these years: "in those days, we kind of figured out what kinds of strategies we wanted to back, looked around at the four of five managers who were doing those kinds of things and then invested in about half of them."  Remarkable . . . when I think about my "funnel" today, the line we used in my Old Ivy days seems to ring ever more true with each passing day: "It's harder to get into our portfolio than it is to get into our college."

And I believe that all the competition has to be challenging for overall returns.  Or maybe, paradoxically, overall returns won't suffer as tradecraft generally improves, but instead the dispersion of those returns tightens as the industry professionalizes and best practices are copied and losers fade away and become exemplars of survivorship bias.  In that vein, I'm reminded of a great Stephen Jay Gould article I read about 25 years ago in which he talks about the maturation of an endeavor (in that case baseball) and the disappearance of outcomes that are several standard deviations (positive or negative) off the mean:

"Variation in batting averages must decrease as improving play eliminates the rough edges that great players could exploit, and as average performance moves toward the limits of human possibility … Declining variation arises as a general property of systems that stabilize and improve while maintaining constant rules of performance through time. The extinction of .400 hitting is, paradoxically, a mark of increasingly better play."

What if that's true?  What if the fabled dispersion of top-to-bottom quartile returns starts to narrow, (like the pennant-shaped graphs exhibited by many styles of investing that show wide dispersions in the early, pioneering, wild west years on the left side and narrower spreads in more recent years)? 

Well, one implication may be that the "better execution" story (i.e. "we're good at this") becomes commoditized while the "we're doing something different" story becomes even more compelling.  After all, do I need an n-th mid market buyout fund with operating partners and a geographic focus?  Or the m-th early stage Sand Hill Road firm?  Maybe, maybe not.  That's just post-heroic private equity and there's indeed a place for that in a portfolio as a return enhancer.  But I fear that those types of firms in the aggregate are slouching toward an paradigm of little more than what the public market guys would call enhanced-indexing.

But what about someone who's doing something innovative in style?  Structure?  Terms?  That might add some spice to the portfolio.  That's where the true octane (on a risk-adjusted basis) might lie.  It's definitely the higher volatility play, both in potential returns (for the LP) and in fundraising success (for the GP,) but to do something outstanding takes audacity.  And indeed, private equity should be all about audacity.  After all, heroic investing lives at the intersection of courage and conviction. 

Hey, Hotshot

Remember that epic “Get the Feeling” ad campaign that Sports Illustrated ran during the mid-1980s? I seem to recall some print advertisements and perhaps a television spot or two, but it’s the billboards that peppered Brooklyn during those summers that seared themselves into my memory.

Maybe it was the in-action pictures of larger than life heroes rendered at 14 by 48 foot scale? Or perhaps the provocative captions that asked questions most mortals would never be able to answer? One of my favorites accompanied a mid-swing picture of slugger Don Mattingly: “How Does It Feel To Turn a Slider Into a Souvenir? Get the Feeling. Sports Illustrated.” Then there was the one featuring base stealer extraordinaire Rickey Henderson in his classic “I’m about to run” pose: “How Does It Feel To Know You’re About To Break the Eighth Commandment? Get the Feeling.” Of course, that question was a bit less remote in a neighborhood where “thou shalt not steal” was considered more of a suggestion than a hard-and-fast rule.

But it was an over-head shot of some over-sized state college football stadium that captured my imagination. Splayed out across every inch of Astroturf were dozens upon dozens upon dozens of corn-fed Midwestern boys stretching before an early-season practice, all with one question on their mind: “will I make the squad?” The caption below asked, “How Does It Feel To Know You’re Just Another High School Hotshot?

And lately, when the day's FexEx drop is particularly bountiful and several more private placement memoranda are added to the pile already strewn about the sidetable in the office, I've wondered if that ad might work just as well for the private equity world.  After all, top quartile funds are as plentiful as fleet-footed recievers out of Ottumwa or Odessa.

Indeed, in 2011 a bumper crop of freshmen will be vying for a limited number of open roster spots.  What factors will seperate the starters from the bench-warmers from the water boys?  This year, simply being good won't be close to being good enough; my own two cents is that too few GPs think critically about what makes them and their strategy truly distinctive and defensble. 

So in honor of the new year — and the inevitable flood of funds expected to come to market in 2011 — I thought I'd focus the first few posts of the year on fundraising, offering over the coming weeks some going-to-market observations, tips, and maybe even best and worst practices. 

After all, there's little comfort in knowing that the number four quarterback at BCS-bound State U probably has the raw tools to play in the NFL if you actually happen to be that number four quarterback.  Maybe over the next several posts we can work through throwing mechanics and defense-reading a bit in hopes that the competition for the scarce roster spots will be more robust.