Keeping the Window Open

Most people seem to have a favorite Saturday Night Live skit.  One of my favorites is, "Ruining It For Everybody," a 1993 masterwork that features John Malkovich and some cast members discussing how they did something to ruin things for everyone else.  The Adam Sandler character, for example, explains why many restaurant bathrooms are now, ahem, "for customers only."

Of course, finance is full of people who ruin things for everybody, too (thanks for the SarbOx, Enron!)  But the most insidious wreckers are those companies that go public and then miss their numbers within a few quarters (what's up, Rosetta Stone?!?)  It's those flubs that have a chilling effect on the market for emerging growth companies. 

And as the IPO backlog builds, I hope the bankers take out only those companies that can keep the momentum going, not just those that will pay enough fees to help them get out of arrears at The Stanwich Club.

I say this because, as institutional investors, we've seen that movie before.  And I worry that the IPO market for IT companies could start to look like the market for biotechs: long stretches of desolation punctuated by sporadic frenzies of activity that end when public investors start to feel snookered. 

There are some good companies in the IPO pipeline right now and I wish them all well.  Their success should lead to more opportunity for other companies.  I just hope that the backers and bankers of some of the hundreds of other companies considering a public offering think long and hard about pushing a marginal or unprepared company into the arena.

Please don't be that guy; don't ruin it for everybody.

Systemically Important

It's been thrilling to watch the Green Revolution unfold on Twitter.  It reminds me of those sweltering days of Tienanmen long ago.  You see, back then there was a Chinese immigrant-owned business over on Church Avenue and the fax machine in the back groaned nonstop as it disgorged furtively-sent messages on curly-thermal parchment.  Unofficial word of officially-banned events crept out of the top of the machine as a half-dozen men crowded around, anxious for news of home and breathless at each pause in the transmission.  Every break in the traffic gave smoke-stained fingers the chance to tear off the latest pages, place them on the backup fax (connected to a telephone jack in an apartment upstairs by a hundred feet of frayed cord), and relay the fresh news on to another clutch of emigres in Boston, Honolulu, Vancouver.

Such was the Fax Americana.  Technology in the service of information, democracy and freedom.

So here we are again, two decades later, watching voices from the other side of the globe cry out.  And with each Tweet, it becomes more evident that the United States has outsourced the public face of its foreign policy to Silicon Valley.  Of course, this is happening just as the bureaucrats in DC are contemplating a raft of regulations aimed at the types of firms that fund the companies that allow the administration to exercise soft power.  Ironic, no?

There's even talk in some quarters of venture firms being tangled up in yet more onerous regulations targeted at firms that pose systemic risk to the financial system.  Funny: the way I see it, the only systemic risk that Silicon Valley poses is to opacity and oppression everywhere.

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.

Justify My Love

My buddy Peter – a very smart cat – was a pure math major in
college. Once, I asked him what the
difference between pure and applied math was and he told me with an impish
grin: “the applied math guys know how to add . . .” Of course, Peter went to Brown University, a
very funky place, so I’m sure that he could’ve done an interpretive dance about
the Lebesgue Outer Measure and still gotten a passing grade on his senior
thesis (just kidding . . . feel the love, Providence!)

I, on the other hand, studied history in college which means
that I’m good with trivia at cocktail parties, but that’s about it. Every now and again, though, I get to
thinking about arithmetic; specifically, the arithmetic of the venture business
and I wonder if we’re all closer to the pure math end of the spectrum than the
applied end.

VC math should be pretty straightforward: send a dollar out
to a portfolio company and hope it comes back with a few of its friends. Do that often enough and you’ve got a good
fund-level return.

Unfortunately, the LPs who invest a Dollar and a Dream have
prevented the shakeout that we were all talking about in 2002 from happening
and there continue to be too many iffy $500 million “early stage” funds out
there. Now I’ve got nothing against $500
million funds in particular. Despite my
seed-stage and smaller-fund bias (I like being "long idiosyncrasy and short
momentum"), we’ve got a few investments in that size stratum and think those specific
guys have some distinctive advantages.

Here’s where it gets dicey for the masses, though (and I’ll
make some gross simplifying assumptions): if you’re an LP and investing in an
run-of-the-mill $500 million fund hoping to get a 3x net return, that fund has
to generate $1.75 billion in returns ($1.25B in profit less 20% carry equals two
turns of profit). Of course, that’s just
the capital that accrues to the firm’s ownership stake. Since a lot of firms end up owning only
10-15% of their companies at exit, you’ve typically got to gross the $1.75
billion up by a factor of between 6.67 and 10. That suggests that those firms need
to create between $12 and $17 billion of market
cap just to get a 3x
fund-level net return to their LPs. Caliente!

Let’s unpack that box a bit more: at the $15 billion midpoint of the exit range
above, a firm that invests in 25 early-stage companies will have to get, on
average, $600 million exit valuations for each and every one of them. That’s a pretty daunting number when you
consider that the typical M&A valuation has hovered in the high
double-digit millions for quite some time.

Of course, such a batting average would be unprecedented
(this is a slugging percentage business, after all), so if you assume that a
quarter of the companies generate all the returns while the other three
quarters collectively return the cost basis, each of those 6 home run companies has to enjoy an exit valuation
of $1.67 billion (roughly what Google paid for YouTube). That’s livin’ la vida loca!

The situation above is exacerbated by the fact that not all
firms invest 100% of their capital because they reserve up to 15% of capital for
fees. Also, you could make the argument
that the firms most likely to earn the above returns will charge premium
carries, making the hurdle higher for compelling net returns. To be fair, firms have a few levers to pull –
maintaining higher ownership percentages
(!) in companies and recycling capital – that can make the challenge less
daunting. They could also deploy less
capital per company, but that’s tough to do with a larger fund.

Like I said, though, I do still believe that some firms will
be the exceptions that prove the rule; some will be good while some others will
be lucky.

In the meanwhile, a lot of LPs will be serenading their GPs
with the line from that old Madonna song (cue the sensuous and moody bass line):
“I’m just wanting, needing, waiting for you to justify my love. Hoping, praying for you to justify my love .
. .”

A Dollar and a Dream

Anyone remember Curtis Sharp? A long time ago, Curtis won a $5 million New York Lottery jackpot and he spent the rest of the 1980s sashaying around New York in bespoke suits and bowler hats attracting crowds wherever he went. Curtis was the Man. Charismatic and impish, Curtis was the Toast of the Town.

I once saw Curtis at a Yankee game and the aura around him was palpable. He was Electric. People just wanted to touch Curtis. Maybe some of that luck would rub off.

That afternoon, a few rows behind us, a drunk kept yelling at no one in particular: “You can’t win if you don’t play!” I thought that the guy was pretty creative for exhorting the listless Yanks (it was 1989, after all) to get in the game by using the Lotto marketing slogan within earshot of Curtis. I appreciated the confluence.

I think of Curtis often . . . around my shop, I’ve started calling Curtis the patron saint of LPs who invest in venture capital funds. Don’t get me wrong, I love VC. We continue to find extraordinary people doing venture investing in extraordinary ways.

It just strikes me that when you push some LPs to articulate why they have outsize venture commitments when history shows that only the smallest slice of the business has rewarded the faith, they throw out New York Lottery slogans with Ivy League veneer. They use words like “optionality,” and “asymmetric payoff.” They might as well be mimicking the catchphrases from the Lotto TV commercials: “Hey, you never know,” or “All you need is a dollar and a dream.”

They just want to be Curtis: The Guy That Beat The Odds.

I hope that everyone makes loads of money and I never root against anyone. That’s bad karma. I do find myself asking, though, how many LPs who invest in venture firms are committing the fallacy of composition: Some people have made fabulous returns in venture, therefore venture will provide fabulous returns. But hey, as they say: you can’t win if you don’t play.