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!

A Dollar and a Dream — Redux

So it's been a bit slow on the blogging front, but I'm getting back in the saddle.  My latest is over on (link).  Chickity-check it out . . . 

A Dollar And A Dream: Making The Case For Venture Capital

Guest post written by Chris Douvos

Chris Douvos is managing director at Venture Investment Associates, a fund of funds that invests in private equity, venture capital and other funds. 

Here in Silicon Valley, we’re all about using lottery slogans with Ivy League veneer. After all, isn’t talking about “optionality” just a fancy way of saying “ya gotta be in it to win it?”  And “asymmetric payoff” is just a spiffy way of saying, “hey, you never know,” right?

That’s why I was taken aback when I got invited to give a talk at the CFA Institute’s Annual Financial Analyst’s Seminar this summer. I mean, these are the cats that studied Greek during B-School so that they could do better in Advanced Derivatives class. Meanwhile, I’ve made a career of using ten-dollar words with my five-dollar brain; what could I possibly say about what is perhaps today’s least-loved asset class: venture capital? After all, a witty intro, a hoodie and a bag of Silly Valley pixie dust can only get you so far with that crowd.

And then it hit me: the asset allocators, those exact folks who seem to be turning their backs on VC today, are the ones who bow at the altar of CAPM, the Capital Asset Pricing Model. And, as one might recall, the CAPM tells us that the portfolio that maximizes risk-adjusted return, the mythical Tangency Portfolio, is theoretically a value-weighted mix of all the assets in the world; the cool kids call this the World Wealth Portfolio (WWP).

Now here’s where it gets interesting for those of us in innovation-land: the WWP isn’t something like the S&P 500, or the MSCI All Country World Index.  It literally is ALL the assets in the world, from the biggest publicly traded company to the smallest private one.  On top of that, human capital is a vital component of the WWP.  And, indeed, small companies and human capital are specialties of the House of Venture.

But here’s the rub: notwithstanding some recent regulatory Band-Aids, the well-reported and deep-rooted dysfunction in public markets has created a great de-listing machine (thanks, Grant Thornton, for the catchy phrase), making private assets that incorporate a generous helping of human capital an even more absent (and vital) component of risk-optimized institutional investment portfolios.  In fact, the entire category of “emerging growth” companies has become an endangered species, as only the most robust or most hyped companies get to pursue IPOs nowadays. Since it takes longer for companies to become the former, they are, by definition, further along their growth trajectory to the point where their growth curves are beginning to flatten while the latter kinds of companies are doomed to disappoint, fouling the waters for everyone. Some early-stage, start-up exposure might be just what the doctor ordered for return-starved, sub-optimized portfolios. After all, bonds are priced for some grim returns, equity markets gyrate Gangnam style, and mattresses aren’t paying dividends the last time I checked.

And here’s another thought that came out of the conference: someone asked me about the effects of the supercycle of de-levering now taking place, which served as a good opportunity to remind folks that venture-backed companies tend to have little, if any debt.  Moreover, the technology companies that tend to acquire such start-ups are extremely cash-generative and relatively debt-free, making them pretty aggressive acquirers.

After all, for more than a decade, the number of start-ups acquired each year has averaged in the mid-300s, with a pretty tight standard deviation no matter the economic climate. But maybe I got too giddy in answering the question, because I said that these two factors “combined to make venture capital a goodhedge against de-levering,” engendering snickers from the audience. Well . . . using a word like “hedge” in a room of folks who spend their days trying to hedge out the most minute risks may have been ill-advised.  So maybe VC isn’t quite a hedge, but perhaps a diversifier? After all, exposure to growth octane is a pretty nifty complement to increasingly value-laden public market portfolios, no?

So maybe there is something to this crazy venture game. Of course, we feel it viscerally in the Valley; the gales of creative destruction blow continually here, except that they’re gentle eucalyptus- and redwood-scented breezes. It’s sometimes hard to explain that to the outside world, though. But walking around, one gets a palpable sense that every garage awaits its moment in the limelight.  Prototypes are being assembled and software is being written; the next great fortune seems so close that one might hardly fail to grasp it . . . all you need is a dollar and a dream.


Herodotus, Investor

It’s been a bit slow on the blogging front, but after a bit of a hiatus, I’m back. 

As you know, I’d been wandering around Silicon Valley for the past few months, meeting with people and learning about what they spend their days doing and whether I might want to do the voodoo they do.  But, of course, TS Eliot had it right when he said, “we shall not cease from exploration and the end of all our exploring will be to arrive where we started and know the place for the first time.”  And, indeed, in a sense, I’ve come full circle as I’ve joined Venture Investment Associates where I’ll be able to pursue my passion for investing in buyout, growth equity, and venture capital funds with folks who have been friends and mentors during the decade I've known them.

Of course, those of you who know VIA might cry out, “but you share a common Greek heritage with two of your partners and whenever the three of you meet, the European Central Bank will have to call an emergency meeting, as the prospect of three people of Greek lineage talking about investing will certainly unsettle financial markets!”  And, yes, I should probably apologize for the havoc that my people have wreaked.  But I actually prefer to brandish my heritage in another way. 

After all, our countryman, Herodotus, is viewed as “the father of history.”  Now, maybe it’s because I’m trying to justify my dusty history degree by saying that the subject is a great metaphor for investing, with it's emphasis on continuity and change.  After all, both history and private equity are concerned with catalysts and their effect on the status quo; at the same time, the whole process of forming investment hypotheses and testing them sounds like a Hegelian dialectic. 

And it was Herodotus who really taught us how to do history.  After all, the word history comes from the greek word historía (ἱστορία), which means “inquiry.”  And what’s really interesting is that ἱστορία in its original connotation suggested inquiry that arises from wandering around and listening while conversing with people.  Herodotus traversed the world and absorbed the stories of the locals in search of understanding.

His lessons echo in the craft of the private equity investor 2500 years later, as we travel the world, visit portfolio companies, do reference calls, and attempt to divine the motivations of our General Partners.  In moving to Silicon Valley almost four years ago, I sought to live among the people the way Herodotus did as he wandered the ancient world.  

But why is such inquiry important?  Inertia makes it easy for some to continue in tried-and-true ways, but good investors constantly cast a skeptical eye, making each new commitment as a "fresh money buy".  Indeed, Herodotus himself reminds us: "For many that were once great have become small, and those that were great in my time were small formerly. Knowing, therefore, that human prosperity never remains the same, I will investigate both alike."  

Of course, Herodotus's investigations took place during a time of great progress and burgeoning affluence for the ancient Greeks.  As the Persian Wars about which he wrote receded into memory, the Hellenes experienced a flowering of knowledge and an explosion of wealth.  And while it may seem rash to compare our era to one of the most fecund in human history, today we are enjoying similarly profound advances in the frontiers of human understanding.  Technology-enabled advances are spreading quickly across an ever-more tightly connected world portending fresh prosperity.  

And I think that's why it's a particularly exciting time to be an investor: skilled practitioners should be able to catalyze value in companies that leverage such advances.  I believe that we'll look back on this period as a golden era of investment opportunity and that's why I'm so excited about spending the rest of my career with seasoned, savvy partners whose commitment to inquiry, to ἱστορία, matches my own.

For my friend Bill . . .

My friend Bill Dietrich passed away the other day and I've been broken up ever since I heard . . . 

There's so much to say right now, but I can't quite find the words — other than to say that my life was richer for knowing him and I was always honored and humbled to be among his friends.  If you'll bear with me and read the story below, I'd be much obliged.  

I first met Bill at the Garden Court in Palo Alto in late 2001 or early 2002.  There was a riot of people over in a corner and I was drawn over by the sheer magnetism of the moment.  I don't remember exactly what everyone was talking about — it was probably some bellyaching about the then-current malaise in the business — but I remember there was this guy at the center of the clutch with a knowing smile and a sparkling eye who sported a bowtie and glasses and whenever he spoke, everyone grew quiet.  I leaned over to my buddy Du Chai and said, "who is that guy?" and he just whispered back reverently: "Dietrich."  To this day, I haven't forgotten the instant and powerful sense of recognition.  I'd never met Bill prior to that moment, but I knew him straightaway: he was a character from a Fitzgerald novel . . . not one of those main characters, flawed, vain, and imperfect, pinballing through the world.  Instead, Dietrich was someone that people talked about through the warm gauze of memories: a man of generous spirit and quick wit, a man who saw others for what they were and loved them for what they were.  A man who sheepishly and gracefully accepted their love in return:

"Do you remember that party at Deitrich's all those years ago?" Tom Buchanan asked Daisy across the vast expanse that separated them, even thought they sat but a few feet apart.  "Yes, Tom," she sighed.  A moment passed.  Then another.  And a wispy smile came across her drawn lips:  "The stars that night hung so low," she remembered, "I thought I could stretch up on my tip-toes and touch them.  And the people . . . the people.  Absolutely everyone was there and they moved so impatiently just to see all the other people who were there.  It was like watching a waltz in old Vienna-town.  And Dietrich!  Oh, dear old Dietrich!  I don't think he moved a step that night.  The party seemed to rotate around him like the planets around the sun."  Tom gazed over at Daisy and felt some of the old, forgotten feelings swelling in him again.  "That Dietrich!" he chuckled as he reached for his Gin Rickey, "Always so quick and witty . . . and, boy, did the ladies ever love him!  You should've seen him at the mixers; no girl from Bryn Mawr or Sarah Lawrence could resist his charms."  Daisy laughed now, that sweet exciting laugh that intoxicated men and infuriated women.  "Oh, Tom, let's go to Pittsburgh!  Let's go right now, this very minute!  Let's go see Dietrich and it'll be just like old times again!"  "Yes, Daisy, let's!" Tom replied, as the old excitement animated his legs and his heart and he sprang to his feet crying out to the thin wafer of a moon that winked down at them "To Dietrich's!"