March 24, 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.”

March 11, 2010

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
vice-versa?

 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.

February 26, 2010

[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.)

February 7, 2010

Careening with Smeed

So there I was, thinking about how I was going to start this blog post; I'd been meaning to compare investing to Smeed's Law — a behavioral theory that predicts the rate of traffic fatalities — for a while.  Determined to come up with something vaguely witty and quasi-relevant to kick off this post, I sat in my car for a moment before going into the 7-Eleven for my morning Double-Gulp when — WHAM! — it hit me!

I mean, really, it hit me … some cat driving an Audi A4 ran into me in the parking lot.  Seriously, dude?!?  Who runs into a parked car?!?  Oh well, as Old Man O'Malley used to say through the fog of cigar smoke encircling his head: "some days youse da dog and odders youse da hydrant."  Today was shaping up to be a hydrant day, for sure . . .

Anyhow, back to traffic.  There was this great retrospective by physicist Freeman Dyson a while back in Tech Review.  In it, he talks a bit about the things he learned from his old friend, RJ Smeed.  Among many other contributions, Smeed had postulated that deaths on the roads had little to do with speed limits, car safety features, quality of the roads, etc.  Instead, motorway mortality was a function of psychology.  Dyson said it best:

"The number of deaths is determined mainly by psychological factors that
are independent of material circumstances. People will drive recklessly
until the number of deaths reaches the maximum they can tolerate. When
the number exceeds that limit, they drive more carefully. Smeed's Law
merely defines the number of deaths that we find psychologically
tolerable."

And it seems to me that we're running a great test case of Smeed's Law: cell phones in cars.  Now, the nervous Nellies would tell us that gabbing while driving distracts people to a dangerous degree; I've now lived in three states where one can't use a handheld phone (and I've been a good boy … most of the time … or at least occasionally).  And indeed, while the number of cell subscriptions has exploded to over 250 million from a base of about zero 15 years ago, the total number of police-reported accidents has fluctuated in a pretty tight band during that time.  The average number of accidents over those 15 years has been about 6.3 million, with a high of about 6.8 million in 1996 and a low of 5.8 million in 2008; the standard deviation is about 4.15% around the mean.  I'd bet dollars to donuts that if you overlaid miles driven on the data, the rate of accidents per mile would be darn near constant.  [Now, I'll be the first to admit that texting/emailing is a whole different story . . . anyone with a Blackberry behind the wheel is a menace to souls and property!]

And that's what makes Smeed an unwitting market philosopher.  Markets are all about calibration of risk, and his insight was that as people feel safer, they get more reckless.  Comfort breeds complacency.  You can fiddle with speed limits, pave roads, install air bags, ticket people for manner of infractions, but folks just end up stretching their envelopes of comfort until they undo the putative progress; they calibrate to the risk.  And the same is true for the markets: just think about the banks that kept stretching (in every way) and the hedge funds that kept getting pushed to add risk because their volatility was too low.  Maybe now that memories of a crack-up are fresh in people's minds, they'll be a little more cautious, but that caution will be thrown to the wind as soon as we all get comfortable again. 

Inevitably, we'll have some regulations and rules thrown at the markets.  But what real effect will that have?  Remember when the "circuit breakers" were established after Black Monday?  Traders joked that trading curbs would give people a couple of hours to write out their trade tickets while the markets were "cooling off."  But no matter the safeguards we put in place, regardless of who we call systemically important, it's darn-near impossible to save us from our reckless selves. 

But maybe it's New Hampshire that has it right: it's the only state in the Union that doesn't have a universal seat belt law.  For those of you who've never seen it, New Hampshire's roadside seat belt signs say: "BUCKLE UP UNDER 18 / COMMON SENSE FOR ALL."  Does it surprise anyone that the Live Free or Die state is number 49 in the among the 50 states in traffic fatalities?  Maybe we all could use a little more common sense and a little less regulation, on the road and in the markets?   

Let's all be careful out there.

   

December 10, 2009

DC-8s and Tigers and GPs! Oh my!

A few weeks ago, a local TV station aired a news story about a mostly-forgotten plane crash, the May, 1968 unintentional ditching of JAL Flight 2 in San Francisco Bay.  After an uneventful flight from Tokyo, the nearly-new DC-8, nicknamed "Shiga," was on final approach to an overcast SFO.  Captain Kohei Asoh, a veteran pilot, guided Shiga's descent through the low-hanging clouds.  But planning errors, equipment unfamiliarity, and miscalculations conspired against the crew.  Dropping out of the fog, Shiga was lower than expected and about to crash into the foam-flecked bay just below.  By the time the First Officer cried out, "pull up!" and Captain Asoh applied throttle, it was too late.  The landing gear had struck the brackish water and the plane lurched to a halt, the wheels coming to rest in the muck seven feet below — two and a half miles short of the threshold of Runway 28 left.

Remarkably, no one was hurt and some passengers had no idea that they had landed in the water until the evacuation began.  And even then, the de-planing was so uneventful that most folks didn't even get their feet wet.  But for me, the best part of the story was popularized by management guru, Jerry Harvey (author of the Abilene Paradox): when Captain Asoh was called before the Transportation Safety Board, the inquisitors opened by asking how an experienced pilot flying a sound airplane on a straight line to an unobstructed runway in generally benign conditions could land in the water miles short of the field?  Offering an answer that resounds across the ages in its clarity and honesty, the Captain replied, "as you Americans say, 'Asoh f@#%ed up.' "

Fast forward 40 years and compare Captain Asoh to the bellyaching finger-pointers that were in the cockpit of the Northwest flight that overflew Minneapolis.  And the public nature of Captain Asoh's taking of responsibility stands in stark contrast to the recent (ahem) screw-ups of Tiger Woods.  Look, I'm not a moralizer or a scold — I grew up in the anti-role model era heralded by Charles Barkley and Ice Cube — but Tiger, dude, you make your living by having people look at you; you get paid because people watch what you do.  I'm not sure you get to flick that switch off by pleading for privacy.  Even if you ask, "pretty please."

And what does this have to do with investing?  Recently, I was talking to a buddy who's a GP at an LBO shop (this conversation was explicitly cleared for the blog on the condition of vagueness — I should note that it's not a group in which I'm an investor).  This GP bemoaned the fact that his LPs had seemingly thrown in the towel on his troubled fund; turnout had been sparse at this year's annual meeting and some investors had stopped returning phone calls.  He insisted that they had Great Stories of Progress to tell for each of their troubled portfolio companies and that if they could just convey these stories to LPs, all would be well.  How, he asked, could he communicate the exciting stuff afoot? 

So I asked him to test drive some of the rap on me.  After a few tales larded with lament over difficult (but improving!) end markets, missteps by (recently replaced!) management teams, and (impossible to please!) crabby lenders, I asked him how many times they'd screwed up in the fund?  Now I don't mean to be harsh, but here's what I heard for the next 90 seconds: "excuse excuse excuse blah blah blah excuse excuse excuse blah blah blah."  No wonder his LPs have tuned out his firm's fund, I told him; I'd just been handed a bagful of excuses devoid of any corresponding accountability or responsibility.  It was the first time I'd heard the fund's story and I was already tired of it.

Look, LPs understand that business has been tough and even the tightest investment theses have been severely tested over the last 18 months.  We get that.  And we also know that investors are fallible.  It's OK to make mistakes sometimes.  Really it is.  Sometimes even good decisions have bad outcomes and vice-versa (more on that next week).  Sometimes people are just unlucky or in the right place at the wrong time.  But when things head south, please be honest and straightforward.  (There's no need to take things to an extreme and self-flagellate, like some GPs do.  There's no joy in that for anyone.)  As GPs and LPs, we're in a long term relationship — one that's longer than many marriages.  An open, honest, transparent dialogue pays dividends in the long term. 

So my GP buddy asked me for some advice once I climbed down off of my soap box.  The best I could come up with was, "just remember, it's not the break-in that brings down the presidency, it's the cover up."  Sometimes, like Captain Asoh, you've just gotta say, "I f@#%ed up."