Party Like it’s 1998!

So there I was, reading the announcement of the Skype IPO filing and scratching my head.  After all, a $100 million offering doesn’t sound like all that much when the current investors bought in at a $2.75B price a little while back.  How tiny a share of the company were they going to offer?  Two percent?  Three percent?

And after all, don’t you need some float for institutions to be interested?  And indeed, some industry watchers had previously speculated that the company might seek to raise a much larger offering: think north of a billion (one beeeeeeeeellllion dollars – said with pinky to corner of mouth.)  I was even bouncing it around with a banker buddy who suggested that institutional public market investors today demand 10-20% of the shares to be floated as part of an initial offering; if he saw a random company executing a $100M offering, he’d said his guess of the total market cap would be in the $500M-$750M range.  There’s no way that’s the case with Skype, particularly if they company is doing a couple of hundred million a year in “adjusted EBITDA” (also known as EBBS, Earnings Before, ahem, Bad Stuff.)

Now in fairness, I’m neither an investor in any fund that invested in Skype, nor am I a banker, so there may be a backstory to which I’m not privy.  And who knows: that $100M offering amount may even be a placeholder for another, larger, offering amount.  But the lunchtime conversations here in Silicon Valley keep coming back to the modest offering size.

But for me, it’s a case of deja vu all over again: it’s all about the magic of the thin float.  You see, I still bear scars from having been a fundamentally-oriented equity analyst at a hedge fund of sorts in the late 90s.  During that time, it was almost impossible to perform fundamental analysis and keep a beta-neutral book.  There was just so much liquidity in the system that things like sector rotation and technical factors almost always trumped hard-nosed, Graham and Dodd, old school analysis.  Try adding any short names to the portfolio!  If something had a whiff of broken-ness, it was cheap and anything that was cheap was an acquisition candidate for firms flush with cash and inexpensive public currency.  It seems that all of one’s short sales would get bought at a premium, wrecking performance.

And then, starting in earnest in 1997, the emerging tech firms got in on the action: pretty soon bankers figured out that floating only a tiny portion of a company set the stage for the stock to jump as retail investors would gladly pay up in the after-market, just to get in on the new, new thing (and the banks proudly touted their post-IPO performance in their pitchbooks).  Things didn’t catch fire for fundamental reasons, they burst into flame because the thin float acted as both the ignition source and the accelerant.  Just ask the guys at the who priced at $9 and opened in the $80s.

And once the price got fixed at a certain level, existing holders could trickle out their shares at inflated prices.  Of course, as we all know, that strategy worked until it didn’t.

Now, let’s be clear.  I’m not being crabby about Skype.  I’m keen for them to have a successful offering (if for no other reason, because their recent announcement of expansion plans in Palo Alto is probably good for my home value.)  But if we learned any lesson from the late ’90s (and, more recently, the late ’08 action offered a similar lesson on the downside,) it’s that stock prices are only vaguely related to fundamentals; it’s supply and demand that sets the price.  Maybe Old Man O’Malley’s Brooklyn wisdom had something to offer the public markets: “youse guys would pay twenny bucks for the last slice of dollah-fitty pizza at tree-toity in the morning when youse got your drink on . . .”

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.”

Private Equity, the Craps Tables, and the ’86 Mets

So I've been working on a blog post called the
Epistemology of Investing for about the past year.  Now, epistemology is a ten-dollar word that
those — like me — with five dollar brains rarely sling around, but sometimes
I think investing could be called applied epistemology.

 As investors — specifically, investors in opaque,
illiquid markets — we spend our days asking the epistemological questions:
what do we know about our investments, companies, markets, people?  How do we come to know what we know?  What are the sources and limits of our
knowledge?  How are our beliefs different
from The Truth?  Said another way: what
investing hypotheses do we form?  How do
we form them?  And how do we seek out,
analyze, and integrate the data we use to test those hypotheses?

 [As an aside, my sophomore-year philosophy professor (who
didn't see any irony in calling my mid-term paper sophomoric and didn't
appreciate my pointing out his lack of ironic sense) might be vaguely proud to
see that I'm still thinking about something I learned from him two decades ago,
although more likely he'd be surprised that I'm actually a contributing member
of society.]

 But every time I grasp my virtual pen to blather away on
the topic, I end up down a wordy path of nuanced nuances.  Instead of answers, there are only more
questions.  And one of the questions that
keep coming up is: why do good decisions sometimes have bad outcomes and

 Therein lies one of the tricky things about investing in
private equity funds.  We suffer the
brutal tyranny of the law of small numbers; sometimes there aren't enough
outcomes for skill to trump randomness. 
If a buyout fund has a dozen investments, or a venture fund has maybe
twice that many, a lot of exogenous factors, timing, and — dare I say — luck
can determine an individual fund's returns. 
It's sort of like taking a few hundred bones to the craps table and
rolling the dice only a couple of dozen times. 
Of course, a good craps player can play for quite a while, cleverly managing
their betting to (temporarily) defy the inexorable negative expected return of
about 1.5% per roll.  But most players
bet too heavily too quickly, lose their stakes, and leave the tables dejected.  And it's not the aggregation of those percent-and-a-halfs
that pays for the dancing fountains, replicas of the Eiffel Tower, or museums
dedicated to the tribal elders and their nearly-forgotten way of life.  Instead, it's the law of small numbers that overweights
the bad side of the binary outcomes.  If
the binary outcome comes up "1," you've only earned the right to roll
again (and perhaps walk away,) but if it comes up "0," you're done;
you can't toggle that PIK.  The casino's
1.5% vig can turn into a 50% or 100% tax. 
Even for a good player.  Trust
me.  Ahem.

 And since we're illiquid, we don't get to control when we
leave the casino.  We're forced to leave
that up to others, our GPs.  Which is why
we all spend so much time on people in our diligence.  When GPs ask me to talk about my
"process," I often say that I focus primarily on the people (devoting
considerable time to understanding their hopes, fears, dreams, and
motivations,) second on the strategy (and the resonance between the investors'
skills and their proposed strategy,) third, I take a deep dive into the existing
portfolio (because that's the people and the strategy in action,) and fourth on
performance (which is a lagging, not a leading, indicator, no?)  I like to think that if I'm doing my job
well, I have a fly-on-the-wall's insight into the Monday meeting machinations,
able to predict the reactions of each partner to different scenarios.

 And so all of us do a lot of reference calls.  We go off-list and try to get an unbiased
bead on people (a GP once offered me the "off-list list."  I replied that I'd have to then go off
off-list!)  But sometimes we're wrong and
sometimes we're just unlucky, despite all out hard work.  And it can be frustrating when everything
points to "no" and a fund blows the doors off.  You knew something shouldn't, but it
did.  Don't get me wrong; I never root
against anyone, but there are extreme cases like the one of the GP who tapped
his portfolio companies' CEOs phones and would just pay hush money whenever he
got caught (you can't make some of this madness up).  In that case, prudence tells you to steer far
clear, but those guys have actually done pretty darn well.  Despite that, there are scores of things we
find when we start turning over rocks and one's tingling Spidey Sense rarely
leads you astray.  But sometimes you kick
yourself.  Warren Buffett may say that,
"there are no called strikes in investing," though there are days when
it feels like that aphorism doesn't apply to PE, a business in which a handful
of winds drive industry-wide returns.

 But when you get that hinkey feeling, and you pass on
what becomes a big winner — a good decision leads to a bad outcome, i.e. a sin
of omission — you just have to think of the 1986 New York Mets.  Never has such a such a flawed team played
the game of baseball so brilliantly. 
Their off-field shenanigans were captured in a book entitled: The Bad
Guys Won!
  (As a lifelong Yankees fan, my
distaste for the Red Sox is matched only by my disdain of the Mets; that 1986
Boston-NYM World Series seemed like a fortnight of punishment.)  And in fact, some thought that the
talent-laden Mets could have been the winningest team of the 1980s, but their
personal demons prevented them from scaling the heights of lofty
expectations.  And indeed, if wins are
the currency of baseball, the workmanlike Yankees ended the decade with the
fattest wallets, but no championships. 
They were the great risk-adjusted bet of the 80s, even though the Mets,
Cardinals, Reds, and A's got more attention. 
The phone-tappers described above may dazzle, but they're likely little
more than the '86 Mets of Investing.

 And maybe that's the lesson from 1980s baseball and the
craps tables: sometimes the bad guys do win, but stick around long enough and
we, the LPs, do get enough rolls of the dice to let skill trump luck.  One just needs to have the patience,
conviction, and courage to not walk away at just the wrong moment; that's when
the casino wins.

[Repost w/ Commentary]: Tragic Kingdom Redux

I've always loved Willy Wonka's line: "the suspense is terrible, I hope it'll last!"  Unfortunately, that doesn't apply to blogger output, so I have to apologize.  It's been a slow start to the year, but I've got about a half dozen posts in various states of completion and a bunch of travel coming up (remember, about 105% of my annual productivity comes on planes!)  So stay tuned for some thoughts on "The Gong Show," "Why Asset Allocators Need to Keep Their 3-D Glasses after Seeing Avatar," "The Future of VC Funding ," and a handful of others . . .

In the meanwhile, I've been meaning to double-click on an old post. In June of 2008, I feared that some GPs were falling victim of Greek tragic cycle described below.  In goofing around on the topic, I suggested that the final stage, Nemesis, or punishment by the gods, wouldn't be so bad for the PE Tragic Heroes.  Instead of suffering eternal pecking like Prometheus, they'd just have to toggle some P-I-Ks.  Boy, was I wrong!  Think about it: the punishment being meted out today would merit Homeric mention. 

For example, GPs keep talking about having to do multiple "first meetings" with the same organization.  It sounds totally Sisyphean; this cartoon is perfect.

Or those Tantalus-like GPs with hard-circles from investors oh-so-close, but just out of reach. 

What about those cats who call and call and call potential investors without getting any return ring-backs?  Kind of like a poor, modern-day Echo who lost the power to speak first.

And pity the poor junior partner who's in charge of the draft pitchbook or PPM, gazing longingly at it forever, like ol' Narcissus.

It's almost enought to make you feel bad for some of the GPs wandering the countryside.  And the least we LPs can do is offer some Xenia, or hospitality.  Be a sport and remember, in mythical times the gods sometimes roamed the earth in disguise, lavishing gifts on those who offered hospitality while punishing those who didn't.

[Originally published 6/9/08]

Tragic Kingdom

When it comes to real twistedness – I mean deeds that are
way out in the tails of the normal distribution of human behavior – the
old-school Greek tragedies are heard to beat. 
Loathsome cunning and guile? 
Check.  Outlandish interpersonal
relationships?  Check.  Unbridled greed and lust for power?  Check.

Of course, the tragedies were morality plays that showed the
audiences of Epidaurus
what vices arose when virtues were taken to their extreme.  Remember that the Tragic Hero was a hero
first and tragic second.  And what made
these stories so compelling and spectacular and gut-wrenching was just this
journey from mortal to casualty of the gods.

A wise man once said that there were only a few dozen
archetypes in all fact and fiction. 
Lately, I’ve been wondering if some private equity pros might not fit
the Tragic Hero archetype.  Now don’t get
me wrong, there are a ton of virtuous and honorable people in private
equity.  I invest in people that are – to
a man (and woman) – decent and upright. 
That said, I sometimes think there are a handful of PE investors out
there that have fallen victim to the ancient unraveling . . . 

The cycle goes like this: first you have arete, which is some kind of
excellence.  Occasionally, this is known
as an outstanding Fund I or II or even VI (or even maybe a single headline
exit).  Once in a while, arete mutates into its sinister cousin: hubris. 
Things get really dicey when the excessive pride of this second step
leads to ate, an unruliness marked by
a loss of sense of human limitations and reckless behavior that offends the
gods.  Now the gods tolerate a lot of
horseplay, but mortals should act like mortals and those that get really out of
hand provoke nemesis, the vengeful
justice of Olympus.

The genius of the tragedies arose from the fact that the
behavior was so outrageous and the punishment so ghastly that the stories
offered powerful warnings of what might happen if folks got too far out of
line.  Of course, I never root against
anyone, but I do sometimes wonder if we’re not getting off too easy
nowadays.  Nemesis used to be pretty badass: offend the gods and you get your
liver pecked out by eagles.  Every
day.  Forever. 

Today, the PE Tragic Heroes who have incurred the wrath of
the gods (or their bankers) are simply consigned to slow their pace of
investment, toggle their PIKs, and maybe get an askance mention in the Wall
Street Enquirer Journal.  If
the fates are particularly unkind, the Journal’s ink dot hedcut of the
Fallen Hero transforms from cheerful and affable to frowning and consternated, a la Dick Grasso.  Not quite the kind of
metamorphosis that Ovid would write about, but I guess that’s the best we can
hope for in a modern world where all the options seem free (but someone else is
paying the price.)