April 27, 2015

Syndrome Syndrome

You know you’ve watched too much Pixar when your 10-year old can quote lines from Cars the way we all used to quote Caddyshack in college. (Don’t get me started: I once decided it would be cheaper to rent Pixar flicks a couple of times each rather than buy them; needless to say I’m on the wrong side of that bet.)

And like many parents, my favorite film of the bunch is The Incredibles (aside from Big Hero 6, which I love because Baymax the soft robot reminds me of the cool stuff that my friends at OtherLab are working on.)

April 9, 2015

Tradecraft, AE (After Ellen)

Almost exactly twenty years ago, my buddies and I skulked out of our client-presentable East Cambridge office to watch the OJ Simpson verdict at Lechmere.

(For New Englanders of a certain era, Lechmere – that’s pronounced LEECH-mere – was “Best Buy with Benefits”. The store’s extremely generous no-questions asked return policy engendered a verb: To Lechmere. Everyone knew someone who would lechmere a huge TV on Friday to return on Monday with nary a question about the inevitable nacho cheese stains or beer rings on top of the cabinet. There’s no doubt that “lechmering” led to the eventual demise of everyone’s favorite no-cost electronics rental shop . . . but I digress)

October 31, 2014

Annex Shenanigans

The word “annex” is a loaded one for me. You see, junior year in college my buddies and I had a terrible room draw and the seven of us got sent to our dorm’s annex space on the freshman quad. While I’d like to say that hilarity ensued – and, indeed, it did – living among an battalion of guileless freshmen and a platoon of fretful Senior Counselors sometimes made us feel like merry pranksters exiled to the Nanny State.

Late one evening, one of our buddies found a box of circular fluorescent lights in an unlocked maintenance closet. Inspired by a then-popular David Letterman skit that involved throwing things off of roofs, we found that GE Circlines made spectacular explosions when hitting the flagstone four stories below. Needless to say, our Wanton Disregard for Souls and Property summoned our entryway’s Counselor, an earnest Midwestern pre-med major in late-night cold cream and pig tails. Surveying our room with dismay, she turned to John Moussach (names changed to protect the guilty) and barked, “What the heck are you doing?” His reply caused us grief in the hours and weeks ahead: “We’re drunk. Care to join us?” The post-midnight cleanup crew and subsequent work details to which we were conscripted combined with the ensuing stint on Double-Secret Probation to teach a valuable lesson: good times have limits.

And indeed, when I think about the current trend for small funds to raise Annex – or Opportunity – funds, the same thought crosses my mind: good times always have limits.

For those who haven’t followed this trend, a bunch of smaller funds have raised annexes to provide capital to companies that are showing breakout potential. An early and classically transparent one of these efforts was Union Square’s Opportunity Fund. Another thoughtful effort was Foundry’s Select Fund. Indeed, as both Fred Wilson and Brad Feld had discussed in their respective blog posts, there are many very good reasons for raising such a fund.

Yet, there are reasons for LPs to be circumspect, as well. It takes a lot of discipline for any kind of investor (but especially those in echo chambers) to not fall into a common trap: an opportunistic investment here or there can become a gateway drug to a full-blown addiction to capital-intensive late stage deals. After all, many of the small funds that now are raising more money for larger follow-on, or later-stage investments once sang from the Capital Efficiency songbook and now risk contradicting the tune they sang for others since one of the greatest hits in that canon is, “Give an Entrepreneur a Dollar and They’ll Spend It.” It’s the lyrical version of the Maples Rule: “a B-round will last a start-up 18 months, no matter how much or how little the investors put in.”

Then there’s the valuation question: throughout history, many investors have convinced themselves that some company was worth an outrageous price simply because a high-flying comp commanded a higher price. I remember one of the first portfolio companies I met when I became an LP in 2001 – we’ll call them Spacely Sprockets – had just raised a monster round at a ten-figure valuation. A few years later, after the assets and intellectual property had been sold off for pennies to Cogswell Cogs, the VC backer justified the once reasonable, but obscene-in-retrospect valuation by saying that a large public comp was trading at a $60 billion valuation at the time and that the start-up’s post-money seemed reasonable in that context. I’m sometimes prone to feeling like a value investor lost in the Valley, but I’m often reminded of the words of a mentor of mine from my pre-B-school hedge fund days: “it’s ok to fall in love with companies,” he admonished. “Just don’t fall in love with the pieces of paper that represent ownership stakes in those companies, as the love those pieces of paper offer in return tends to be inversely correlated with price.” It’s a lesson often forgotten during heady times. Remember, good times have limits.

Lastly, there’s the Stephen Bochco Effect. Just as Union Square Ventures and Foundry Group pioneered new areas, Bochco changed television. He made dramas more gritty and real. These shows had visceral impact because they showed real life in raw formats; in the service of art, Bochco was unafraid to show a buttock or drop a swear word. The censors looked askance at such boundary pushing, but eventually acquiesced because the troubling content was consistent with the entirety of the tableau. But once the floodgates opened, artless imitators picked up the standard and pushed boundaries for shock and effect, not art. Thus, there’s a straight line from Hill Street Blues and NYPD Blue to Jersey Shore and Naked Dating. Financial markets have seen their fair share of “pioneering art” devolve into base commercialism with some regularity, so in the words of one of Bochco's most loved characters, Hill Street's Seargeant Phil Esterhaus, "Let's be careful out there!"

November 5, 2013

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.

Cindy Crawford in a Bar

Midas, Son of Gordias

October 14, 2013

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?”

Super LP

Adventures in Investing

Talking to GPs