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!"

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?”


Scents in the Air

The economist Herbert Stein famously said, “trends that
can’t continue, won’t.”  That admonition
is often ignored, however, in the sunny and magical precincts of Silicon
Valley.  After all, it can be hard to
believe that trees do not grow to infinity when our redwoods fight a daily
skirmish against the clouds for dominance of the skies.

Yet the inexorable pull of gravity never fails to exert
itself and, perhaps, one such falling-to-earth moment seems to be at hand.  For several years now, fundraising by venture
capital firms has lagged the amount of capital that has been invested into
start-up companies.  Summarizing data
from the National Venture Capital Association’s fundraising surveys and Price
Waterhouse Coopers’ Money Tree Report, the chart below shows that for the last
several years, capital deployment has far outpaced funds raised by venture
capital firms.



To be sure, fundraising and deployment do not represent an
entirely closed system, as angels, corporate funds, strategic investors, governments,
investment banks, and other entities often augment the money invested in start-up
companies by pure venture capitalists. 
Yet, a longer view, visualized in the following chart, supports the
notion that VC fundraising and capital deployment typically exist in a rough



In fact, since 1995, in fact, the amount of capital raised
by start-ups has exceeded the amount raised by venture firms by only 13.9%.  By contrast, since the beginning of 2009,
companies have raised fully 50% more dollars than the venture capital funds
that are their primary backers.  Of
course, some of this over-deployment can be accounted for by the whittling away
of a modest surplus built up during the 2005-2007 timeframe, but ultimately the
industry cannot live beyond its means for very long, as the appetite of outside
(non VC-fund) funding sources to fund innovation can be fickle.  And unlike the Federal Government, which can
print money to satisfy a proclivity for spending more than it earns, the VC
industry is limited in its investing by its fundraising.

Indeed, the Lehman-induced financial crash of 2008 was a
watershed event, as fundraising became considerably more difficult for venture
firms; new fund formation has slowed to a trickle and many established funds
are worried about whether they will be able to ever raise a new fund.  This slowness in VC fundraising is putting a
damper on the otherwise buoyant mood here in Silicon Valley.  The double-whammy of a challenging overall
fundraising market coupled with the concentration of capital in fewer hands has
conspired to make many firms particularly thrifty as their fundraising efforts
languish and they worry about their next investment being their last.  Some estimate that the number of “active”
firms is below 100 today, a small fraction of the typical number of firms
making investments.  Additionally, this
year is also an important one in that those funds that were last able to raise
during the relatively flush times of 2007 and 2008 will find themselves at the
end of the five year investment periods during which they might make new
investments.  We expect a dislocation
over the next 12 to 18 months as the investing window for funds closes and
their management fees start to step down. 
As one General Partner recently asserted, “it feels like the Zombie
Apocalypse has started and I’ve only got two bullets left in my gun . . .”

Of course, an optimist might take comfort from the old claim
that, “value-added investing works best when capital is expensive and time is
cheap while bubbles are marked by cheap capital and expensive time.”  And, indeed, faced with a robust opportunity
set and scarce (and thus dear) capital, VCs seem to be working as hard as we’ve
seen them in recent memory.  There’s a
palpable anxiety in the air, though, that contrasts with the casual insouciance
that people typically ascribe to Silicon Valley.  The perennial gales of creative destruction
continue to blow here, but in addition to the typical Eucalyptus and Jasmine aromas
carried on those breezes, one can also smell a hint of fear, a scent not as
frequently perceived here.


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!