Tradecraft

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: 

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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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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?”

 

September 24, 2013

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.

May 10, 2013

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.

Screen Shot 2013-05-09 at 10.46.55 PMAnd 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!

May 25, 2011

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."