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.”

The Suburban in the Garage, Or Big Investors and Their Funds

About 15 years ago, I learned a lesson I’ve carried around ever since: when I was a rookie consultant visiting an industrial firm in the Midwest I got in a discussion with our client-side project leader about why people sometimes buy things that don’t make obvious sense.  “For instance,” my client asked rhetorically, “why do you think the Chevy Suburban [the only extra-large SUV at the time] annually tops the owner loyalty and re-purchase rankings when there are so many great cars out there?  You'd think every once in a while some other car would topple the 'Burban, no?  And who wants to drive such a behemoth, anyhow?"  Before I could whip up a smart-sounding, yet hollow textbook answer about key buyer purchase criteria or some such noise, he answered his own question, “what the heck else are they going to buy, though?  If you've got four kids or three dogs or a snowmobile you have to tow, there's just no other choice.  What’s the alternative?  Buy two cars and split up the family when you go out?"  

I’ve thought a lot about that story lately, as it offers an important metaphor for investors.  After all, like large SUVs, big venture and private equity funds have been getting kicked around a lot lately.  (And I think I can credibly say that I’d been an early and consistent (and sometimes unfair?) fist-shaker in the direction of some large funds.  Sure, there are some big funds out there that will be successful — and to be clear, I don’t root against anyone; that’s bad karma — but the arithmetic facing sizable funds is daunting.)  Yet, despite my ever-mounting cynicism and some good research and analysis that bolsters the small-fund argument, I’ve actually started to feel some sympathy for big funds and their investors and I’ll (not-so) secretly express a hope that larger investors stay focused on bigger funds.  After all, they’re like the Suburban buyers of the story: if they must go out for a spin, it just makes sense for them to find larger vehicles.

See, if you have a gazillion dollars to put to work, it’s actually pretty hard to execute a smaller fund-oriented program, even though many large investors are currently fetishizing such a strategy.  And to those investors thinking about jumping on the small fund bandwagon, I’ll note that such funds tend to be hard to find, challenging to diligence, difficult to “sell” internally, expensive to monitor (at least in terms of time), and catalytic of insomnia.  Indeed, I love my managers like I love my children — all equally but differently — yet the younger ones tend to keep me up more at night.  For sure, the rewards can be great and I’ve got high hopes for all the kiddies, but people never let me forget that I’ve taken a lot of career risk . . .

And then you get to the practical challenge: if an institution is deploying a ba-jillion bucks a year, it’s hard to do it in $10 million chunks.  Even if one could write a bigger check to a smaller (sub-$200M?) fund how much more would you want to do?  Would you want to be 25% of the fund?  40%?  Would the GP want you to be that big?  And if an institution is writing a bunch of $10 million checks, are they writing too many of them and seeding a whole bunch of competitors in a space?  Are they ruining the experiment by participating in it?  Stretching our tiring metaphor, if everyone’s trading in their Suburbans for a pair of roadsters and taking two cars out on family trips instead, all those incremental cars on the road will snarl traffic, no?

So let’s raise a glass to big funds with a toast of sincere best wishes for their success . . . of course, I’ll be explicit about my ulterior motive: keeping the small fund space the preserve of the nimbletons.  If big players continue to focus on big funds, it’ll be more beer for us.

Raisins in the Sun

Memo to self: check in with the crystal ball repair joint.  (That blasted crystal ball of mine's been in the shop for way too long!  I do have to admit that that it never really worked all that well, but I'd hoped that they could've tuned it up by now.)

In the meanwhile, I've been trying to avoid daring forecasts.  But here's a prediction that's not too saucy: exits of venture-backed companies will continue to be modest for as far out as the eye can see.  Sure, a company or two might ring the bell every now and again, but I suspect that we'll continue to be disappointed with the number of start-ups that crack the hundred million dollar exit mark each year.  And in a bloated overcapitalized world, that just can't be enough return to keep the teeming masses of lottery players interested.

But they continue to play and show no signs of letting up.  And hey, everyone's got a strategy – or at least a rationalization.  Who am I to say that my play's better than anyone else's?  I've got no monopoly on wisdom (and a broken crystal ball, too!)

Here's what I do know, though: markets are price discovery mechanisms and right now things seem a bit out of whack since different markets are sending us wildly conflicting signals.  In exit markets, the stats are daunting: no venture backed IPOs in Q2, M&A volume down considerably, sophisticated strategic buyers beating down valuations simply because they can, dwindling numbers of investment banks available to serve as public offering bookrunners, etc.  Meanwhile, private markets remain firm with round-to-round valuations up meaningfully, according to law firm Fenwick and West.  What's up with that?

I know, I know: we invest for the long term and today's public market gyrations should not affect start-ups that just begun securing reference customers or whatnot.  Yes, yes, I know there's a haves-and-have-not financing market where some companies get multiple term sheets while others go hungry.
Now back in the day, when I was trading public securities, the oldsters would extend a craggy finger our way and admonish us that, "there's a fine line between being right and being early".  Yet, what I've always loved about VC is that you get paid for being early.

All that said, isn't it bizarre that there will likely be aggregate mark-ups in many LP portfolios while liquidity markets are (and will likely continue to be) so bad?  The year-over-year benchmarks keep chugging along in VC; sure, many start-up companies are progressing, but progressing to what?  It's almost as if the train is accelerating into the oncoming wreck.  Cue the surging violins: there's . . . just . . . so . . . much . . . tension!

And at some point, this tension needs to get resolved.  Or does it?  Are the mark-ups a portent of good things ahead or just a snooze bar that allows us to pull the velveteen covers up over our heads and momentarily ward off the pearl-gray chill of morning?  Without an effective price discovery mechanism, it's tough to tell if one's throwing good money after bad.  And in that kind of environment, folks can seek out (selectively) whatever data confirms their hypotheses.

And that’s what keeps the Dollar and a Dream guys coming back.  It can be easy to overlook a lack of distributions when the quarterly reports look rosy.  Like a late-inning rally that energizes those fans that haven’t yet started making their way for the B, D, or 4 trains, there might even be a distribution every now and again to ignite the bonfire of hope.  But that fire needs dollars to keep burning – not just paper – and eventually, the flames will burn down to smoldering embers.  Will investors bail out before we get to that point, or will they continue waiting, watching, hoping?  

"What happens to a dream deferred?" asked Langston Hughes.  "Maybe it just sags like a heavy load / Or does it explode?"  Given the disconnect between public and private markets, I'm betting that the Dollar and a Dream guys are going to get just enough positive feedback that the former of Langston's possible outcomes will be true, not the latter.

Good Advice I’ve Gotten

I’ve gotten a lot of good advice over the years . . . it’s
really unfortunate that I’ve forgotten most of it.  Two nuggets, however, keep rattling around
inside my otherwise sparsely-populated skull. 

First, in my younger and more athletic years I played
baseball.  Back then, I was a pitcher,
although not one of those fireballers-in-training that got all the attention
from the hotties and Division I-A coaches. 
Nope, I was a dependable – but less flashy – finesse pitcher with a
tragic flaw: whenever I started getting roughed up (which was often!), I always
tried to overpower the opposing team’s hitters with fastballs.

Unfortunately, when your three pitch speeds are slow,
slower, and slowest, trying to blow the ball past someone can become a dicey
proposition.  Whenever this madness set
in, Coach C. would come out and say, “don’t
compound your mistakes
. . . you’re in a hole; stop digging.  Get back to your game plan.”

The second chunk of wisdom was imparted in the early part of
this decade by an LBO pro who was reflecting on the just-past ebullience in
Venture World:  “Always remember that any
form of value-added, hands-on investing works best when time is cheap and capital is expensive.  Unfortunately,” he continued, “in frothy
environments time becomes very dear and capital becomes very cheap.”

Implicit to this statement was an assertion that a pendulum
swings between ebullience and sobriety, between spirited overextension and
thoughtful focus, between openhanded wagering and miserly risk aversion.  Here’s my question, though: whatever happened
to the swinging of the pendulum?

Despite a hiccup here or there (including the recent
mega-cap buyout world lock-down,) the velocity of money has been accelerating
across PE world.  Sure, the deal pace has
slowed lately, but transactions are still getting done and double-digit billion
dollar funds continue to get raised.  And
all those dollars will have to go somewhere.

At the same time, we hear tales of woe about slouching
return expectations and I’ve lost countless hours of sleep worrying about
compressing risk premia.  It’s a
prisoner’s dilemma, of course.  Returns are
going down because too much money is being put out, but a sizeable number of GPs
(and LPs for that matter) don’t want to stop putting money out because they
don’t want to sit on idle cash.

And why not sit on idle cash?  Because that prevents people from going out
and raising their next fund which in turn postpones the augmentation of their
fee stream.  Maybe I’m painting with too
broad a brush, since I know plenty of managers who are still capital gains motivated
and not just W-2 focused, but it just seems that a handful of folks are
enjoying robust enough fee streams that they can look at their carry as a nifty free option owned at their limited partners’ expense.

Since all economic analysis is done on the margin, it’s
these current income focused cats who are inverting the time and money equation.  You can’t begrudge them, though, since their
incentives are clear: get the money out fast, get involved in too many things,
see what sticks, and raise the next fund. 
As long their investors allow them to keep raising subsequent funds,
there’s no disincentive to stop.

I just hope that along the way – when times inevitably get
tough – we all have the wisdom to know that we’re in the hole and should stop
digging.  Compounding your mistakes is
the worst thing you can do when trying to compound capital.