September 29, 2008

Economic Analysis, Silicon Valley Style

I dig lingo. Sure, a picture might be worth a thousand words, but a nice hunk of jargon has got to be worth at least a few hundred. And if it's jargon you're looking for, I'd bet there's no better place to find it than Silicon Valley. The cocktail of business and technology – with a splash of disregard for the rules of grammar and spelling – make this place a jargoneer's paradise. (Although sometimes the whole thing goes too far: One. Word. Sentences. Quit. It. Srsly. Hey, I wonder if grammr.com^beta is taken?)

Anyhow, there I was at the Fall potluck dinner at mini-LP's nursery school, feeling a smidge out of place since I was the only one not sporting gear emblazoned with the logo of a NASDAQ 100 company, and the topic turned to (bum bum bum buuuuuum) The Subprime Crisis! Suddenly, all eyes were on me: Financial Dude. One dad growled, "so how did it get to this?" in that same exasperated tone that TV detectives use as they toss the legal pad and bic pen toward the perp demanding: "write it all down, just like you told me."

And so I started talking about what I thought had really gone on. At first it was kind of cathartic, but then, the more I talked the worse I felt about the whole thing. It was like I was describing a case study in the principal-agent problem. Make that the World's Biggest Principal-Agent problem. And that's what got me down: professional investors should be attuned to agency issues. Everyone should've seen this coming, but the good times were rolling and there was always a greater fool in another time zone to take the mess off your hands. Of course, that's a game that works until it doesn't. But I digress.

So I'm going on and on about marginal borrowers (my favorites were the NINJAs: No Income, No Job or Assets), CDO tranches, investors looking for spread product, and mark-to-whatever accounting when I notice a few eyes starting to glaze over. And right then, one dad pipes up: "So it sounds like they were overclocking the financial system." Now I didn't quite know what that meant, but I sensed some good jargon coming on and I was eager to unpack that box like a kid on Christmas morning.

Your Humble Narrator: "Overclocking? What's that?"

Really Smart Dude: "It's when you mess with your computer's processor to get some more performance out of it."

YHN: "Why do that?"

RSD: "Well, most overclockers are gamers looking to push the limits. Exceeding the processor's specs can result in a major framerate bump. Others do it for ego reasons; you know, they just want to have the fastest processor on the block. And some people even go out and buy old processors on the cheap, overclock them and sell them as the latest chip to unsuspecting buyers."

YHN: "Srsly?"

RSD: "It gets pretty crazy! The problem is that overclocked processors run really hot – often hotter than conventional heat sinks can handle – so overclockers sometimes build crazy structures to keep the whole thing from blowing up."

YHN: "Blowing up? For real?"

RSD: "Well, blowing up is a bit extreme, but the processor can catch fire for sure. And once you get a fire inside the machine, the whole system could be at risk. Either way, if you get to that point it's an expensive fix."

Expensive, indeed. Aside from the magnitude of their blow-ups, overclockers of the processor and financial variety sounded a lot alike. Of course, it looked like the financial overclockers were going to get all of us to pick up the tab for their blow-up . . .

When I was a kid, a bank in my neighborhood got robbed and the block was abuzz with talk of the brazen heist. Among all the hand-wringing and fist-shaking, Old Man O'Malley, ever the neighborhood cynic, dropped a nugget through the fog of Garcia Y Vega smoke that continually encircled his head. "Morons," O'Malley growled, " . . . if you're going to rob a bank, don't take down the one on the corner, go hit the Federal Reserve. That's where the money is." I've thought of that line a lot recently and I can't help but feel that's exactly what just happened.

September 17, 2008

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.

September 8, 2008

Moving Parts

Psst! Hey you! Yeah you . . . the GP reading this blog to take a break from portfolio company panic attacks. Here’s a flash: you know those LPs of yours that totally dig the voodoo that you do and rank as your most stalwart supporters? Guess what: chances are that they’ll be on to the next thing (or even the thing after that) by the time your fund reaches the end of its 10 year (plus however-many-extensions) life. In fact, if you gave me 9 to 5 odds I’d bet that they’ll be gone by your next fundraise. Even money says they’re on to the next thing by the fundraise after that.

Whoa, whoa, whoa . . . don’t get me wrong: I’m not trying to stick a thumb in anyone’s eye. I’ve got a ton of respect for every last one of my Limited Partner brethren. People who live in glass houses shouldn’t throw stones or walk around in their skivvies and it wasn’t all that long ago that I left Old Ivy either (from Old Ivy’s perspective, it was probably addition by subtraction!)

It’s just that the velocity of money out there is so high and the velocity of people seems even higher. But it’s not just the bucks that cause people to move around: in some cases it’s taking ownership of a portfolio or starting with a clean slate; in others, it’s finding a better platform; in yet others it’s scratching that entrepreneurial itch; and sometimes, it’s just about better weather. Folks from endowments, foundations, pensions, funds of funds, you name it are on the move. The character of their moves may differ, but lots of people are staying one step ahead of the sheriff. And it’s all good; this is America, Land of Opportunity: God Bless It.

I do remember, though, when I first started thinking about becoming an institutional limited partner. My buddy Seth beguiled me with tales of long-term working relationships that transcended the transactional, yarns of robust institutional memory, stories of principals, not agents. These were stories of people with steady hands on the tiller who understood their GPs thoroughly, intimately, and sometimes worked hand in hand with those GPs to stretch the envelope of investing comfort. (And as you know, I think that there’s a risk premium to be had from the arbitrage of discomfort). The implication was that stable institutions had better results. At the very least, good GP-LP relationships (at the individual level) helped you to avoid a bunch of the time-wasting and aggravation that arises from intramural struggles and constant re-education.

So here we are, not quite a decade later and I see GPs fretting about having had nearly a half-dozen coverage people at some institutions over the past several years. And just the other day, I realized that one of my Advisory Boards (for a solid 2004 fund) has seen seven (!) of its ten institutional investor reps leave their institutions. Will it matter? Dunno.

But with so many moving parts, funky behaviors sometimes follow and that’s what worries me. Occasionally, you see increases in institutional inertia as new LPs take a light touch with “valued relationships” that might otherwise be dead wood. After all, who wants to run the risk of kicking a once-great (or maybe-someday-great) fund out of the portfolio? It’s easier just to re-up. ("Everyone else" is doing it anyhow.) Sometimes, you see the “new sheriff in town effect” where people seek to clean up the portfolios they inherited; sound and fury ensue! Babies get thrown out with bathwater and the last cat gets all the blame while the new cats think they’ve got a clean slate. Somewhere between those two extremes is the right approach, but the former is the path of least resistance while the secondary market keeps growing to help facilitate the latter.

But I fear there’s a casualty in all this: Partnership with a capital P. The best LPs are Partners, while the worst are just money. And with all the musical chairs out there, I do wonder if we LPs are training GPs to treat all of us like temporary placeholders? High-touch relationships marked by consistency and predictability lead to a better interactions while weak relationships are governed by the least common denominator: the legal docs. As an old-time VC once told me, “the minute we have to open the bottom drawer and pull out the fund docs, we’ve all lost.”

I’ve been lucky to see a whole lot of GPs end up doing what’s right, not just what’s allowed. I just fear, though, that as folks continue to bounce around – resulting in more tenuous relationships and more amnesiac institutional memory – that such behavior will become increasingly rare.

August 21, 2008

America the Blackboard

After thirty-six years of living on the East Coast, I packed up my possessions and followed the footsteps of pioneers, gold rushers, dust bowlers, and dot-commers in search of the West of the Imagination. In fairness, it’s a stretch to say that I packed since the rest of the family got stuck with the stuff while I set out on the annual PE pilgrimage, going from one annual meeting to the next in search of enlightenment and meaning.

As my punishment for sidestepping the heavy lifting, the family got to fly west while I was demoted to driving. Across country. Alone. In a minivan. With two guinea pigs. It probably doesn’t get any worse. Aside from a nice dinner in Evanston with some truly Super LPs, the trip was a grind: interminable stretches of open road punctuated by fast-food rest stops and one-night cheap hotels.

To pass the time during the mad dash across the endless expanse of the Republic, I played “wave to the portfolio company,” the LP version of license plate bingo. Initially, I’d hoped to take a leisurely journey and visit a bunch of companies along the way, but as the summer slipped away and the trip’s timetable tightened I settled for a hand-marked map and some dog-eared quarterly reports that I’d review each night; my hoped-for visits had turned into well-researched I-80 drive-bys.

It was still worthwhile, though. With many hundreds of underlying companies, it can be tough to keep up with those firms not lucky enough to be the “impact companies” that take center stage at annual meetings or those unfortunate enough to be the “problem children” that occupy our Advisory Board time. It was cool to contextualize (if perhaps from a couple of counties away) the businesses that we read about quarter after quarter in increasingly audited, but decreasingly informative, reports. Those companies – with their ups and downs – represent the pulsating, vital, thriving quintessence of the economy.

I’m lucky to be able to watch these companies strive and struggle and (hopefully) succeed. It’s almost as if we LPs get to be Olympic judges sitting in the best seat in the house, watching the action unfold right before us. Except that we’re not just judging one event; instead, we’re taking stock of the entirety of the Games. We get to gaze into the chaotic innards of the economy, and it’s thrilling, frightening, inspiring.

* * *

Since I sometimes seem so crabby about the PE asset class, people naturally ask me how I get up in the morning and put on my LP hat? The answer is simple (and it’s not just that I’m a curious dilettante): I’m privileged to know some really distinctive people who invest in endlessly interesting businesses. And I like to believe that these GPs are catalyzing change, helping their companies become more innovative, more competitive, more streamlined, more essential.

And that’s the beauty of private equity done right; you constantly feel the blowing of the Perennial Gales of Creative Destruction. And these winds of change are everywhere: from the whippy lake squalls of the industrial Midwest where manufacturers reinvent themselves daily, to the humid and earthy gusts of the heartland where agriculture is exciting again, to the hat-snatching howls out among Wyoming’s burgeoning coal beds and wind farms, to the jasmine-and redwood-scented breezes of Silicon Valley where every garage awaits a moment in the spotlight.

* * *

Before we left the East Coast, the kids and I hoofed it up to Brooklyn to visit the grandparents. (Every trip comes with a complimentary helping of immigrant wisdom slathered in portent: “son, where you’re going, I’ve been . . .”) And whenever we visit, I always walk my daughter, G, around the old ‘hood to give her a feel for a place that’s unlike the leafy college towns in which she’s grown up. I love telling her about the people who passed through the neighborhood, the teeming masses who started their American adventures right there. The storefronts help to tell the story:

“Check it, G. That’s where Giovanni’s shoe shop used to be. He came from Sicily at age 11 and started fixing shoes the same day he got off the boat . . . that Polish travel agency over on Church Avenue, I remember they gave away pierogies the day they opened . . . see that Bangladeshi grocery over there? That’s where the Ruiz family had their bodega before they moved up to New Rochelle . . .”

“Dad?”

“Yeah, G?”

"America’s like a blackboard, isn’t it?”

“How so, G?”

“People keep writing on it, erasing it, and writing on it again.”

“You know what G? You’re absolutely right.”

A breeze kicked up in the gloaming and we turned the corner onto McDonald Avenue. “Look around, G. By the time we get back here, some of this stuff will be gone, but most of it will still be around. You miss what’s gone, but appreciate the energy and the passion of the folks who are still there. That’s continuity and change, and it’s what makes this place and this time so much fun.”

July 31, 2008

Good Advice I’ve Gotten

I’ve gotten a lot of good advice over the years . . . it’s
really unfortunate that I’ve forgotten most of it. Two nuggets, however, keep rattling around
inside my otherwise sparsely-populated skull.

First, in my younger and more athletic years I played
baseball. Back then, I was a pitcher,
although not one of those fireballers-in-training that got all the attention
from the hotties and Division I-A coaches.
Nope, I was a dependable – but less flashy – finesse pitcher with a
tragic flaw: whenever I started getting roughed up (which was often!), I always
tried to overpower the opposing team’s hitters with fastballs.

Unfortunately, when your three pitch speeds are slow,
slower, and slowest, trying to blow the ball past someone can become a dicey
proposition. Whenever this madness set
in, Coach C. would come out and say, “don’t
compound your mistakes . . . you’re in a hole; stop digging. Get back to your game plan.”

The second chunk of wisdom was imparted in the early part of
this decade by an LBO pro who was reflecting on the just-past ebullience in
Venture World: “Always remember that any
form of value-added, hands-on investing works best when time is cheap and capital is expensive. Unfortunately,” he continued, “in frothy
environments time becomes very dear and capital becomes very cheap.”

Implicit to this statement was an assertion that a pendulum
swings between ebullience and sobriety, between spirited overextension and
thoughtful focus, between openhanded wagering and miserly risk aversion. Here’s my question, though: whatever happened
to the swinging of the pendulum?

Despite a hiccup here or there (including the recent
mega-cap buyout world lock-down,) the velocity of money has been accelerating
across PE world. Sure, the deal pace has
slowed lately, but transactions are still getting done and double-digit billion
dollar funds continue to get raised. And
all those dollars will have to go somewhere.

At the same time, we hear tales of woe about slouching
return expectations and I’ve lost countless hours of sleep worrying about
compressing risk premia. It’s a
prisoner’s dilemma, of course. Returns are
going down because too much money is being put out, but a sizeable number of GPs
(and LPs for that matter) don’t want to stop putting money out because they
don’t want to sit on idle cash.

And why not sit on idle cash? Because that prevents people from going out
and raising their next fund which in turn postpones the augmentation of their
fee stream. Maybe I’m painting with too
broad a brush, since I know plenty of managers who are still capital gains motivated
and not just W-2 focused, but it just seems that a handful of folks are
enjoying robust enough fee streams that they can look at their carry as a nifty free option owned at their limited partners’ expense.

Since all economic analysis is done on the margin, it’s
these current income focused cats who are inverting the time and money equation. You can’t begrudge them, though, since their
incentives are clear: get the money out fast, get involved in too many things,
see what sticks, and raise the next fund.
As long their investors allow them to keep raising subsequent funds,
there’s no disincentive to stop.

I just hope that along the way – when times inevitably get
tough – we all have the wisdom to know that we’re in the hole and should stop
digging. Compounding your mistakes is
the worst thing you can do when trying to compound capital.