Pretty much anyone who has been involved in financial markets for any length of time and has some success knows that these markets are not efficient. And thank goodness. Well sort of. Thank goodness from the point of view of an investor, because this creates the ability to generate excess returns. But most investors don’t, most because quite frankly – although rarely admitting it – they’re not even trying.
There are many reasons why markets are not efficient, most with roots in the fact that markets are by definition complex adaptive systems which have constantly changing dynamics and local equilibria. But one of the key drivers contributing to the dynamics of this system is the psychological biases that have been effectively embedded in the DNA of the modern “industrial” asset allocation paradigm. The natural and instinctive herding mechanism that is built into the way humans think.
For most people, there is no way to switch this off; the best one can hope to do is have high self-awareness and try to compensate for this bias. Interestingly, some people are physiologically missing these mental pathways. As an example, think of people afflicted by Asperger’s Syndrome. I’m not a doctor but some of the most (consistently) successful traders who I have had the privilege to meet or work with over the past couple decades certainly seem to have personality and behaviour traits that line up with (at least mild) versions of the Wikipedia definition of this conditions. I’m pretty sure this is not coincidence.
But generally, most people (and thus the institutions they represent) make (investment) decisions locked inside a Keynesian Beauty Contest – trying to guess what everyone else thinks is pretty, not searching for intrinsic prettiness. And this is often a reasonable strategy, ie they are not behaving irrationally. Although it will never produce consistently strong returns – certainly not on an absolute basis, it will for long periods avoid consistently poor relative returns and even if absolute returns are poor (or even catastrophic) there is significant and very real safety in having fallen (jumped?) off the cliff in a herd. People like covering their ass. Wrong together rather than successful alone. Loss aversion. It’s a rational survival strategy.
And this behavioural framework applies through the whole asset allocation food chain – LPs to Funds to Companies – which means a couple things:
the big tend to get bigger (buy IBM)
there is an extremely high energy barrier to new entrants (at every level of the food chain)
an actor’s ability to raise capital is the most important factor in their ability to raise capital (recursive)
and for asset managers their core business becomes gathering (not investing) capital (tail wags dog)
Which creates a big opportunity/risk pair (or set of fractal pairs):
(for individual actors) an opportunity: for those that can break away from this cognitive and behaviour framework to make outsized excess returns if their convictions are fundamentally sound
(for society) a risk: that intrinsically value creating investments (funds, companies) are starved of capital, while many mediocre “me-too” investments are overcapitalised
In my opinion there is no precise, fundamentally “right” optimal balance in this pair, or certainly not one that is consistent in all environments but I suspect that our current state is quite far from a potentially optimal range. It’s great for a (very small) number of actors that may have the skills and good fortune to take advantage. But collectively poor for our societies and economies. Systemically brittle. From this societal point of view, I think it is important to at least try to redress this balance. I don’t have a magic solution for doing so, but as suggested above, self-awareness can be quite effective in helping to mitigate (at least a good portion) of our systemic biases. It won’t eliminate the Keynesian Beauty Contest paradigm, but it will at least dampen it.
Lest you think I’m exaggerating the extent of this herding behaviour baked into the world’s capital allocation system, let me share some of my first-hand experience of this. For almost a decade I was a syndicate manager. For those of you not familiar with investment banking jargon, my job was to manage the process of raising capital (in an industrialised, repeatable process.) While my focus was fixed income (bonds) (meaning that each year I was involved in managing hundreds of deals – ie my data set give me a decent sample size), the capital raising process – whether you are raising a seed capital round from angels, doing an IPO or selling a bond issue – is fundamentally the same. And if I were to draw a graph of the first questions investors asked during the marketing of a new issue of securities, it would have looked something like this:
(Yes, sadly Virginia this is how too many of the traditional managers of your savings frame their decisions…)
But, for the smartest investors (defined by those who consistently delivered better returns, who – during my tenure as a syndicate manager – were mostly a small number of hedge funds) this graph was inversed. It’s not that they didn’t care at all how big the book was or who else was investing, but that these were structurally second-order, tactical questions for them. First they made up their mind whether or not they thought the investment was compelling and only then did they factor in the deal dynamics in their bidding tactics.
I was reminded of this and inspired to write this post (in the hope of contributing to increasing the systemic self-awareness alluded to above) by a couple posts that I stumbled across in my bedtime reading last night that highlighted the biases (failings?) of investors in the venture capital food chain (LPs and VCs.)
If you can make as good a case as Microsoft could have, will you convince investors? Not always. A lot of VCs would have rejected Microsoft. Certainly some rejected Google. And getting rejected will put you in a slightly awkward position, because as you’ll see when you start fundraising, the most common question you’ll get from investors will be “who else is investing?” What do you say if you’ve been fundraising for a while and no one has committed yet?
While Eghosa Omoigui of EchoVC talks about the risk/opportunity pair that arises from the “Trough of Conviction” that LPs and VCs are prone to get stuck in:
Conventional wisdom has always been incredibly seductive. Particularly as it requires little to no intellectual effort. I am slowly forming a hypothesis that pattern matching in VC is showing similar characteristics, oddly enough.
Today’s VCs are falling prey to the minefield of so-called axioms masquerading as truisms. So sticking to the â€˜x for yâ€™ or â€˜a for bâ€™ pitches is simple, believable and thus fundable. I have no issues with this framework. It helps entrepreneurs to tell a story and VCs love to fund storytellers. But it implodes when faced by disruptive innovation, which I have seen recurrently present itself as an undiscovered versus unmet need.
â€¦So all this boils down to the apparent calcification of pattern recognition (formulaic VC?), and the departure from the two-sided risk-taking marketplace (entrepreneur AND venture capitalist) that was always a key part of early stage venture. A fulltime dependency on pattern-matching when unaccompanied by thesis formation means that you will miss the big winners. As the venerable Tom Perkins declared, ‘If there’s no risk, you’ve already missed the boat.’
And he goes on to quote Elon Musk:
â€œI think itâ€™s important to reason from first principles rather than by analogyâ€¦The normal way we conduct our lives is we reason by analogyâ€¦
We are doing this because itâ€™s like something else that was done..or it is like what other people are doingâ€¦slight iterations on a themeâ€¦
â€œFirst principlesâ€ is a physics way of looking at the worldâ€¦what that really means is that you boil things down to the most fundamental truthsâ€¦and then reason up from thereâ€¦that takes a lot more mental energyâ€¦
Someone could â€“and people do â€” say battery packs are really expensive and thatâ€™s just the way they will always be because thatâ€™s the way they have been in the pastâ€¦â€
Now perhaps by endorsing this view I myself am suffering from confirmation bias, after all, the DNA of Anthemis Group is entirely thesis-driven (both in the businesses we support with capital and in how we’ve organised Anthemis and our approach.) Although it is too early for me to definitively say our thesis is proven. That said (self-awareness!), this framework is the same one that informed my biggest previous (investment) successes – Betfair, Markit, Weatherbill, Zoopla – that have vastly outweighed the ones that didn’t work out. (Interestingly, one example of a poor investment I’ve made was in a company called GnuTrade. And although GnuTrade didn’t succeed, a company formed at almost the same time with the same vision called eToro has succeeded spectacularly. Thesis confirmed, backed the wrong horse.)
So my “call to action” is that anyone reading this who has responsibility for making investment and capital allocation decisions fights harder against their biases to simply follow the path of least resistance – the crowd – and to develop and embrace real conviction, arising from a robust cognitive framework, and to act on this. Even if only at the margins. Let’s move the needle. We owe it to our children to try.
 I was somewhat surprised that I couldn’t find any research that had been published on this topic that might prove/disprove this correlationâ€¦  Some venture-backed companies can also fall into this trap…  I believe that opportunity and risk are like fundamental particles that only exist in the universe in pairs, two different sides of the same coin so to speak.  Anthemis is proud to be a small investor
A billion dollars isn’t cool, you know what’s cool? A trillion dollars.
A bit more than a year ago, my friend Fred introduced me to John Prendergast who was in the very early stages of conceptualizing a platform called Blueleaf to help people better manage their savings and investments. As Fred knew, this kind of thing is right up my alley and so I set up a call with John to learn more about his plans.
As many of you know, for over a decade – since first discovering the enabling power of the internet and Moore’s Law – I have been very excited by the prospect of revolutionising the way 99.9% of people manage their personal financial balance sheet. (With the first 80% of this revolution being simply to help people recognise that they have a personal balance sheet and that it should be considered holistically and in the context of each person’s circumstances, constraints and aspirations.) I called this PALM – personal asset-liability management (but am not so naive as to think that this is the nomenclature one would use to popularise the notion…unsurprisingly most folks aren’t super aware – or inclined to be – of the importance of robust ALM…)
Indeed of all the various innovative ideas and companies I’ve looked at and invested in over the past decade, this concept of PALM is the one that actually lies in the Paul Graham vector of solving problems you encounter yourself. Indeed, I cannot wait to have a robust, networked, intelligent asset-liability management dashboard to help me manage my family’s increasingly complex balance sheet. And for once, I am also in fact part of the key or core demographic for this type of product (which is not often true!)
Although I would argue that people should start managing their personal balance sheet from the time they enter higher education or the workforce, the reality is that it isn’t until the 30s and 40s that real complexity typically starts to creep into the balance sheet: mortgage(s), other secured and unsecured loans, multiple savings and investment accounts including pension plans and other tax-driven structures, more complex compensation mixes (including equity and options), children, and the awakening realisation that they can’t count on the state or their employers to secure their financial future.
Adding to this complexity is the fact that financial products are almost always sold (and bought) in isolation – with at best limited regard to the consumer’s overall balance sheet – and choices are often driven by non-financial considerations (changing jobs, marriage, divorce, etc.) You might expect me at this point to go off on a rant about how awful this is and that our financial institutions are failing us by cynically selling us individual financial products rather than holistic financial solutions and that this needs to change. Surprise! I don’t have a problem with financial institutions selling products. That’s what they do. Worrying about that is like wishing the sky was a different colour than blue. Misdirected energy.
Ironically, most financial institutions actually spend a lot of time, money and energy pretending to and trying to convince you that they are looking at you “holistically”, that they are looking at the big picture but in order to do so, they need to control more or ideally all of your balance sheet. In other words, sell you more products. Well I don’t know about you, but whether your balance sheet is $50,000 or $500,000,000 – I think it is pretty intuitive that (a) it’s pretty much impossible to do all your financial business with just one institution and (b) even if it were possible, it is highly undesirable to do so. Pre-2008 this was obvious to me (as an ex-banker and someone with high financial literacy); post-2008 I think this is increasingly obvious to everyone.
The solution in my mind was an intelligent (online) wealth management / ALM platform that would allow individuals (and families or other self-determined groups) to aggregate all of their financial commitments – assets, liabilities, cashflows – and then allow them to risk manage (scenario analysis, simulations, rebalancing, etc.) and optimize their personal balance sheets according to their changing needs and circumstances. Mixing a high level of automation in terms of the basic record-keeping, data management and transaction processing with an intelligent user-interface allowing the user and/or their advisor(s) to make well-informed, contextual decisions. In essence, a meta wealth management intelligence layer that put the information advantage squarely with the individual, where it belongs.
I dreamed about building this…
So I remember when John started to describe his vision for Blueleaf to me on that first call, he had me at hello. The vision, the product, the approach all aligned with my vision of using 21st century technologies to bring institutional strength risk management tools to individuals. A few months of refining, learning, due diligence and progress later, and I was convinced that John and his team could deliver on their vision and I was delighted for Anthemis to become the lead seed investor in Blueleaf just in time for Christmas 2010. (And the cherry on the icing on the cake is that now I have a good reason to visit the great city of Boston every 2-3 months or so.) As you might imagine, building the technology to deliver this vision is not trivial and it’s been impressive to see them bring Blueleaf to life.
In closed beta since last fall, and by focusing on providing financial advisors with an amazing platform to help them help their customers, Blueleaf has (very quietly) already gathered over $1 billion (yes, billion…) of assets on the platform, including a significant number of multi-million dollar accounts. Often when people hear this, they are surprised – why would advisors trust a new start-up like Blueleaf with all the details of their clients net worth? I think it is relatively simple. First and foremost, because by doing so, they can derive real – measurable and material – value for their customers by using their platform, and secondly because it makes much much more sense for individuals and independent financial advisors to share a complete view of someone’s finances with an independent 3rd-party platform provider like Blueleaf than with any individual financial institution. Â In other words, it makes advisors look like rock stars and gives individuals a quantum upgrade from the still all-to-common wealth management user interface of a kitchen table covered in account statements… And the wealthier and more sophisticated (and older!) you are, the more you are likely to realise this is true. There are very good reasons to have multiple banking, insurance and broking relationships. The problem is that today, to gain the advantages of multiple relationships one has to pay a real cost in increased complexity that arises from having to manually manage and aggregate these accounts.
And just in case there are any private bankers reading, I think you will agree – if you are honest with yourselves – that almost none of your clients have given you all of their assets to manage. Is it because they don’t trust you? Well yes sort of, but (hopefully!) not in a toxic way. Let me explain: they know (and know that you know, that they know, etc.) that you need to sell them products. Perhaps you can take a long term view of this (which is good) but sooner or later, you need to book some revenue against each of your client relationships. Like scorpions, this is your nature. They also know that having all your eggs in one basket is generally not an optimal strategy. And they know that you might not be at that institution forever and – in a bit of good news for you – their relationship is almost certainly more with you as an individual than with the institution (despite the enormous sums your firm spends on brand marketing.) Hell that’s one of the reasons they have assets spread amongst 4 different banks: some of those assets followed you with your previous career moves…
In fact, I am convinced that the most enlightened private bankers, insurance brokers, financial advisors will embrace and celebrate a platform like Blueleaf as it will make their customers more intelligent, better informed and less paranoid and allow them to do their jobs better and build even stronger relationships with their customers. Of course the weak ones – who really add no value other than shuffling reports around and hoarding information – will hate it. But the clock is ticking on them in any event…
John’s vision for Blueleaf is to have $1 trillion of assets on the platform in the next 5-7 years. Yes TRILLION. Think that’s crazy?Think again:
That’s 1 million accounts of $1 million each (c. 34% of US HNWIs, 10% of Global HNWIs)
or c. 9% of US HNWI’s investable assets of $10.7 trillion (or 2.5% of global HNWI investable assets)
or 10 million accounts of $100,000 each (c. 25% of US mass affluent households)
Don’t mistake ambition and vision for hubris: it will take a lot of hard work and an amazing product and value proposition to get there, but the size of the market opportunity is clear. Equally importantly, I think the time is right to introduce a Blueleaf approach to the market: a combination of shifting demographics, increasing familiarity and comfort with web-based financial management products and the fundamental shift in private investor mindsets in the wake of the global financial crisis are all aligning to drive an increasingly holistic, transparent approach to investing and wealth management. Some of the key learnings from the 2010 World Wealth Report back this up:
Post financial crisis, HNW investors are now much more engaged in their financial affairs. HNW clients are re-evaluating their current wealth management provider relationships and moving assets to firms that can clearly demonstrate a more integrated approach to meeting their needs.
Three unequivocal demands HNWIs are making of their wealth management firms today are:
ÂƒSPECIALIZED ADVICE: As clients become more educated about their own investment choices, they increasingly expect â€˜Specializedâ€™ or â€˜Independentâ€™ÂƒinvestmentÂƒadvice, and are re-validating advice from their Advisors/Firms through other sources, including peers, the Internet, and other research alternatives. They also expect the advice to be aligned with realistic and appropriate goal-setting, based on their actual risk profile.
ÂƒTRANSPARENCY AND SIMPLICITY: HNW clients want increased â€˜Transparency ÂƒandÂƒ Simplicityâ€™ and â€˜Improved ÂƒClientÂƒ Reportingâ€™ so they can better understand products, valuations, risks, performance, and fee structures. HNWIs are reviewing product disclosure statements and investment risks before even conferring with their Advisors. They also value better reporting and more frequent updates after being blind-sided during the crisis, when they lacked a real-time view of what was happening to the value of their investments. And increasingly, the type of products they seek out are the ones they can understand.
ÂƒEFFECTIVE PORTFOLIO AND RISK MANAGEMENT: The vast majority of clients see â€˜Effective ÂƒPortfolioÂƒ Managementâ€™ and â€˜Effective ÂƒRisk ÂƒManagementâ€™ as important after the crisis. As a result, they increasingly want and expect scenario analysis on proposed allocations and products that is aligned to their individual goals and expectations, and in-depth research around all types of products so they can better understand the risks. For instance, many wealthy clients are very concerned about their exposure to markets and want to limit their downside risk. At the same time, they know they need to diversify and have global exposure, particularly to fast-growing markets. As a result, they want evidence through risk-scenario analysis to facilitate investment decisions that meet their goals while remaining aligned with broader volatility and risk-appetite limits.
These are a pretty darn good articulation of Blueleaf’s mission statement; it’s great to see this kind of independent confirmation. Now enough talking and back to work. Lots to do and $999 billion more assets to bring on to the platform. (And if you’re reading this from the US and are an early adopter type person or financial advisor, please request an invite. I think you’ll like it.)
I do have one complaint however: Â I just wish they’d hurry up and launch in Europe too!
Betterment ticks the box on so many of our investment themes and fits so well into our vision of digitally native 21st century financial services that they had us at ‘hello’â€¦but the clincher was the amazing team and impressive execution to date.
When asked, I often tell people that we invest in the “emerging Apple’s of financial services”,Â ie that we look for companies who use technology to create powerful, intuitive, user-friendly customer experiences by essentially abstracting complexity away from the user (not ignoring it, but managing it – with skill and dexterity – behind the scenes) rather than exposing it in all its glory to customers with the implicit goal of profiting from then managing (exploiting?) their confusion and disengagement. Â Of course the Apple analogy is not perfect but probably can’t be beat in terms of a pithy soundbite summary of our approach.
So with this in mind, think of Betterment as having a Jobsian approach to savings and investment:Â combining a intuitive and powerful user interface with a robust back-end execution platform, Betterment allows anyone to quickly, easily and without mystery manage asset allocation and risk budgeting using a simple, multi-asset class portfolio.Â No hassle, no time wasted, no blizzard of trade confirmations.Â The first time I saw it, I immediately wanted to be able to manage all my cash balances using their platform.Â (Unfortunately they are currently only operating in the US so not super-practical for me personally but you can bet we’re keen to help them expand their horizonsâ€¦) Say goodbye to the money market account.Â Indeed, if you are based in the US and have a bunch of your savings tied up in money market accounts or CDs, you should definitely take a very serious look at replacing these with a Betterment account.Â Have a look at their product tour:
But the most exciting thing about Betterment is that they have only just got started and it’s scary (good) to think what Jon, Eli, Kiran and Anthony, can and will do over the next couple years.Â And it’s a great fit with our nascent but growing ecosystem and we look forward to helping them work with other great digitally native financial firms like BankSimple, Blueleaf, FX Capital Group and others as they grow their business in the months and years to come. Â And the icing on the cake is getting the opportunity to invest alongside guys like Rob and Eric at BVP who bring a lot more to the table than just capital. Â Congratulations guys and thanks for inviting us along for the ride.
And was just thinking this might be the right track for their inaugural global marketing campaign…
Buttonwood has posted an excellent analysis of why financial markets are unlike other markets for goods and services:
This apparent contradiction can be resolved. Financial markets do not operate in the same way as those for other goods and services. When the price of a television set or software package goes up, demand for it generally falls. When the price of a financial asset rises, demand generally increases.
Which explains why bubbles develop and burst and why ‘market fundamentalism’ does not generally serve us well when thinking about financial markets (as opposed to other markets.) Â Buttonwood also alludes to the fact that bubbles often develop at times of great change (has he read Perez???):
Why not just let the markets rip? Some would say that bubbles tend to coincide with periods of great economic change, such as the development of the railways or the internet. Individual speculators may lose from the resulting busts but society gains from their overoptimistic investments. However, this argument is harder to sustain after the recent bubble in which society â€œgainedâ€ some empty condos in Miami and holiday homes in Spain.
His conclusion is that because of these structural characteristics of financial markets, central banks (and possibly regulators and/or governments) have a natural, pro-active role to play in trying to mitigate or counter these problems.
Of course a few investors – the most high profile being Warren Buffet – have successfully arbitraged this weakness in capital markets buy being countercyclical, being “greedy when others are fearful, and fearful when others are greedy”; but as most people know this is bloody hard to pull off and exposes the investor to significant liquidity/solvency risks if they get the timing wrong. Â As Keynes said, “the markets can stay irrational, longer than you can stay solvent…” Â If you have an edge, even a small one, doubling down will usually work as long as you have an infinite bankroll. Ooops, small fly in the ointment. Â (Besides, if you have an infinite bankroll, what the hell do you need to bother about worrying about returns!)
Well I have neither an infinite bankroll nor the skills (and/or luck) to adopt a Buffet-esque investment strategy. Â But I do have some skills. Â And some experience. Â And I can recognise patterns reasonably well. Â And I have conviction. Â And a reasonable track record for building new markets and adopting and executing novel business models. Â So a few years ago I figured out that by focusing these modest talents and skills on investing in and helping to build new businesses, with a lot of hard work and days and months of research and reading I could generate pretty decent financial returns that were (almost) completely uncorrelated with the massive tides that buffet the world’s financial markets. Â And most importantly, this lack of correlation is structural – ie it doesn’t disappear in violent bear markets when almost all mainstream asset classes discontinuously jump to near perfect correlation (much to the chagrin of the VaR boys.)
It’s not hard to understand why. Â In fact it’s pretty obvious. Â For a new business, the ups and downs of the market, GDP, etc. have at best a second or third order effect on the company’s value. Â These factors are overwhelmed by the single most important factor driving value creation which is of course, can the company successfully sell it’s products or services to paying customers (or be more and more clearly on that path.) Â As someone wise once said: Â a “start-up is not GM” Â ie They are not correlated to GDP.
Now don’t get me wrong, I’m not suggesting that investing in new companies is without risk. Â In fact as most people would glibly observe, investing in start-ups is ‘very risky’. Â Well yes, but the risk is almost entirely idiosyncratic and manageable – much much less dependent on vast, uncontrollable, macro-economic trends and forces. Â And just because the risks are easier to identify and name, doesn’t mean it is easy to manage them, just that they are potentially (more) manageable.
So if this is true, why have venture capital returns generally been so poor (at least in the last decade or so) and why don’t more smart people try their hand at this (rather than trading/managing other types of assets)? Â Answering the second question first, I suspect this is because failing together is much nicer than failing alone, and so if the global financial crisis wipes out your hedge fund or investment bank or savings, well that sucks but, you know, shit happens. Â If however you pour your own (or worse your investors’) capital into a couple of dozen new companies that crash and burn, well that’s just a very lonely place to be. Â The answer to the first is not simple and you could probably write a book on this (perhaps Paul Kedrosky will?) but with the disclaimer that I don’t pretend to really know, my short and dirty take would be that there are two related factors at the heart of this failure. Â First, investing in new companies is hard to scale – at least compared to many/most other asset classes and secondly, the traditional structure of the industry is poorly adapted to this reality. Â Private equity legal and economic structures (which is how most venture partnerships are structured) doesn’t really fit the risk/reward/resource profile needed to invest successfully in new companies. Â Of course their are exceptions – both temporal and human – but just because their are some investors clever and/or lucky enough to make it work doesn’t make it right.
I could of course be wrong. Â And I could fairly be accused of hubris, especially as at this point I don’t have a long enough track record and/or enough exits to prove without doubt that my approach is correct. Â And while I am confident in my own abilities and have backed that up with a lot of “skin in the game”, Â I am even more confident in my larger analysis that while the venture capital industry might be broken / poorly organized, the risk-adjusted returns available to those who chose to invest – methodically and with a well-calibrated capital and incentive structure Â – in new companies, are excellent and, for the VaR-boys out there, truly uncorrelated to mainstream asset classes. Â The challenge is of course to find these investors and not to swamp them with too much capital. Â This problem isn’t solved but it looks a hell of a lot like the problem facing hedge fund investors (in most strategies that also do not scale beyond certain amounts of capital) and the asset allocation community would do well to try some of their more successful solution there on finding and seeding managers in this asset class.
And if you ask me, the rise of the ‘super-angel’ much talked about in venture circles these past months, is a step in the right direction and perhaps an indication that asset allocators are (finally) waking up to this opportunity.
Today I had the opportunity to be on the other side. Presenting our CiRX idea at mini-seedcamp London; attending as a ‘founder’ and not an ‘investor’ or ‘mentor’ for the very first time. And it was totally worth it. Not only was it valuable in the normal / traditional ways that seedcamp can help a founder but interestingly – although not altogether surprisingly – as an investor, it was very enlightening to sit on the other side of the table for once. I learned a lot. About CiRX of course but also about how a founder perceives the world (as opposed to an investor.) The only regret I have is that I don’t think I did a very good job of being mentored, especially with some groups and wish I could have another go. (Basically I talked too much. I know. Shocking.) Partly because well, I unfortunately do that sometimes, sorry. Partly because at almost a subconscious level, while I was supposed to be the mentee, my default tuning in this context is to be the mentor so sometimes I perhaps did both! And partly because I haven’t yet nailed the best way to succinctly articulate the value we see in the CiRX proposition.)
This last bit was a great takeaway because even though I probably knew that before, I definitely know it now and having muddled through a half-dozen live sessions has already now given me some ideas of how to better describe and deliver the value proposition of CiRX. Indeed it was funny to fall into the exact same trap I’ve (patronizingly? hope not!) warned so many founders about myself: ie to remember that 99% of the people you will speak to about your vision haven’t spent the last 6 months bathed in it and so the threshold of obviousness is much much higher than you think it is. What you take as given, is anything but to most people you will meet. In any event, I would highly recommend that anyone investing in early stage companies walk a mile in those shoes. A bit humbling, but more importantly very enlightening.
I’d like to thank all the mentors whom we met and really underline how much we appreciated their forthright opinions and incisive analysis. Farhad and I got a lot out of it and I suspect that we will tweak our plans based on some great insights and suggestions we received throughout the day. Also at the risk of sounding a bit soppy, I’d really like to publicly thank Reshma and Saul for the incredible job they have done building the seedcamp community and ecosystem. I am reminded of the summer of 2007 when I made a rash decision to invest in this new thing a guy I barely knew named Saul (who admittedly had come highly recommended) was organizing and thinking now what a terrific investment that has been. And that’s before getting any of my capital back!
Finally, I just have to say how impressed I was by the quality of the other teams that were invited. Really really impressive. Not so many in our investment space (although Subsify is a company that caught our eye and we’ll be interested to learn more about) but the two that really stood out for me were Editd and Memrise. Would be very surprised not to see these two make it through to seedcamp week in September. Eyequant too.
As for us, well we certainly have a lot to digest and a lot to work on…but that’s exactly what we hoped for.
You may have noticed, I haven’t been posting much here lately. Â It’s not that I don’t have anything to say, probably just the opposite (!) but have be full out from dawn until dusk working on a number of exciting new projects including our own development (more on that in a few weeks.) Â One project that has been front of mind the past few weeks is a new company we are developing that is directly inspired by Paul Graham‘s great advice to “solve problems that affect you directly”.
A bit of background. Â When I was in banking, one of the achievements I was most proud of was effectively using web technology to transform how (debt) capital was raised (at least in Europe*.) Â At DrKW, we built what for many years was the state of the art capital raising platform, whose core product was our eBookbuilding platform (now in Commerzbank yellow!) Â It completely revolutionised what had heretofore been a disjointed, manual, somewhat ad hoc process into a seamless, collaborative, mostly painless process. Â Initially it met with enormous resistance from other (much bigger and more successful) banks and syndicate managers, who as ‘guardians of the temple’ jealously guarded their power, derived (in their minds) from the information asymmetry they enjoyed (vs issuers and investors.) Â However – and despite being at best a middling player in the fixed income new issues market – our disruptive technology was such a big improvement on the status quo that eventually the market adopted our standards (with everyone then rushing to build their own analogous platforms.) Â In the spirit of making sure these platforms could ‘play well together’ we even published our XML-Schema for new issues and invited all our competitors to contribute to it and use it. (Which had the effect of basically freaking out our competitors. Â They thought we were crazy – like Ali – because they didn’t have the slightest idea what it means to compete in a world of information abundance and platforms, but that story is for another day…)
Anyhow, when I became seriously and then professionally active in ‘venture capital’ or more generically speaking, in investing in private companies, the lack of technology available to manage workflows surprised me; Â I was particularly puzzled because ostensibly this was a world populated with techophiles, early adopters and people who ate disruption for breakfast (quite unlike the world of institutional capital markets). Â Further, there is much talk (and consensus) around the fact that it is hard/impossible to scale venture investing. Â And while I think this holds at some level, it struck me that a significant number of the gating factors limiting the ability to scale could be vastly improved. Â Not to infinity but substantially, perhaps by an order of magnitude. Â Pulling out an example from my old career, when I started life as a bond trader 20 years ago (ack!) the number of bonds that a typical good trader could manage numbered in the dozens at best (and even then, you would find that a trader really traded 10 to 20 bonds 80% of the time and sort of went through the motions for the other bonds hoping most of the time not to trade.) Â Then came Bloomberg. Â And excel spreadsheets. Â (And later bespoke pricing and analytic tools and platforms.) Â And all of the sudden, a trader could manage a book with hundreds of securities. Â There was still a degree of 80/20 but everything was an order of magnitude bigger.
I don’t know if our new initiative will definitely achieve that degree of change in the private investment market, but we are convinced that there is a better way and having a fit-for-purpose platform to help company management, non-executive directors and investors communicate, collaborate and manage their positions and responsibilities would be a huge step forward. Â It’s not that nothing currently exists, but I would say we are at the ‘excel spreadsheet’ phase to use my bond trading analogy – with many firms and people starting to use things like Google Apps or Basecamp and the like to better manage information flows and collaboration. Â But while this (and excel for traders) is (was) a good start, the real juice comes when dedicated, purpose-built platforms emerge. Â If you have a screw that needs driving, a hammer is better than nothing (or a rock) but a screwdriver is even better! Â (A power screwdriver better still!)
So we conceived of (what has been provisionally named) CiRX – the corporate director and investor relations information exchange:
CiRX is a purpose-built platform enabling private companies, directors and investors to communicate and collaborate more efficiently saving time, money and effort.Â By streamlining processes and connecting stakeholders in an intuitive and context-rich environment, CiRX offers a tailored yet consistent solution to the challenge of managing information and documentation flows, reducing administrative burdens and creating opportunities for a richer, more dynamic and flexible approach to corporate governance and strategic management.
Over the past few months, we have been developing the concept, the business model and have done a significant amount of macro research to identify the potential size of the market opportunity and now have started to take the next step and ‘talk/think details’ as they say. Â In order to support this next stage of development, as we are poised to start ‘cutting code’, we wanted to get more direct feedback from the community – of company executives and founders, non-executives, angel and institutional investors – to better understand how their experiences and perceptions were both similar and different to our own. Â To do so we created a short(ish) survey and have sent it to a number of our contacts across all these communities, but if we missed you and you are a company founder or non-exec director or investor in one or more private companies and you are interested in contributing your views, you can find the survey by clicking here.(We’ll leave the survey open for a couple weeks probably but if you are so inclined to complete it, we are excited to be presenting CiRX at mini-seedcamp London next week so would be great to have as much feedback as possible before then.) Of course you are also welcome to share your views – good, bad and ugly – in the comments below.
* That e-bookbuilding (generic) never gained acceptance in the US (at least not while I was still in the market) is in my opinion a telling manifestation of the oligopoly of Wall Street (which gives us things like 7% IPO fees with the spooky consistency of North Korean election results) which absent the pressure of competition, allowed the dominant underwriters to resist this change tooth and nail. Â It was even more glaringly apparent when these same US firms operating in Europe adopted e-bookbuilding as strongly as everyone else once it was obvious it was an evolutionary winner…
You may have noticed that I haven’t posted much in the last couple months and given all the interesting things going on in the world it certainly wasn’t for lack of material. Breaking my arm obviously didn’t help increase my productivity (or make typing very easy) but it wasn’t the main reason for the silence. It’s much simpler than that: I was busy!
Busy investing in a whole bunch of super exciting and interesting new businesses. Busy working on the sale of ODL Group (where I was the lead independent non-executive director) to FXCM to create a true global leader in FX trading. Busy working with my partner Uday and FT Advisors on a number of interesting strategic advisory projects, in particular focused on the electronic and algorithmic trading space. Busy helping two of our portfolio companies raise follow-on financing. Busy working on our own corporate structure and capital raising where I hope to be able to communicate some exciting news in the not too distant future. Busy.
So what have we been investing in? Here is a quick rundown (in alphabetical order):
Babuki – 2008 seedcamp winner, launching soon (will update) with an innovative platform for social gaming
Blueleaf – investment information management and planning software “to help people like you see all their savings and investment accounts in one place; understand their financial information more completely, more quickly; securely share information and collaborate with spouses, family or advisors; save their data, even if they change financial institutions; and maybe most importantly, help them stay financially safe and secure.”
Timetric – builds services to make sense of time-series statistics, based on the Timetric Platform: a proprietary service for publishing, analysing, and performing calculations on very large quantities of time-varying statistical data. Have a look at this neat little demo website they have built for tracking equity portfolios.
Metamarkets – provides global, real-time media price discovery by aggregating billions of electronic media transactions in order to deliver dynamic price data, proprietary price and volume aggregations, and comprehensive analytic media market views to sell-side media principals.
[not yet closed – will update soon]
Over the next few weeks or so, I plan to do a proper write-up on each of these businesses and the reasons we think they have bright prospects. So watch this space.
This week NEA announced the close of their latest fund at $2.5 billion. That seems like a lot of money for one venture fund, although perhaps if the intention is to focus on (highly capital intensive) clean tech and/or biotech they will be able to deploy this amount effectively. Of course NEA, founded in 1978, has a long and successful track record, with I imagine many long-standing relationships with LPs and excellent ‘brand recognition’ within the universe of potential LPs, and so it is hardly surprising that they are able to raise such large funds. After all – especially with respect to institutional investors – the analog to the ‘nobody-ever-got-fired-for-buying-IBM” paradigm operates in their favor.
A couple years ago, when I first started thinking about what would become Nauiokas Park, a good friend told me that private equity was all about raising capital, not investing it. Of course I understood what he
…private equity is about raising money, not investing it.
was saying, but thought he was using hyperbole to make the point that raising capital was more important than just a means to an end (investing.)
Now I understand that however cynical it may sound, he wasn’t trying to be clever: the way the institutional marketplace for private equity (including venture capital) is structured is all about raising capital and only incidently about investing that capital.
For better or worse, the year-end is typically a time to step back and take stock, to reflect on the year that was and the year to come. And indeed I have been thinking about what we could have done better or differently last year and what we need to focus on in this new year. And the short answer is we need to spend less time thinking about the economic and industrial landscape, developing our investment framework, sourcing potential investments and nurturing our existing investments, and more time soliciting potential investors: pitching our skills, our approach and the opportunity we believe exists to people and institutions that will determine whether or not we can turn our vision into reality. And like any start-up, we are going to have to be hard-headed about how we approach this as the proverbial runway is running out. As they say, there is a fine line between tenacity and obstinacy. I want to try to stay on the right side of that line.
Of course, once the lightbulb goes on it becomes obvious that raising money would be the most important talent of any prospective private investment firm: your LP’s, shareholders, investors are your customers (and not your portfolio companies.) They are they ones that ‘pay the rent’. They consume your service which is to invest their capital. Ah but the better the service, the more customers you have and the more successful you will be, right?
Well not exactly. In investment management generally it is very hard to determine a priori the quality of service one is likely to receive, which is why so often prospective investors – be they retail or institutional – fall back on historical performance to make their judgements. This reliance on historical data is clearly imperfect. However, when considering (many types of) hedge fund or mutual fund, given the typical investment horizon and liquidity profile, a consumer of these services can at least adjust relatively dynamically if they make a mistake. The effect of this is to reduce the psychological barrier to ‘taking a risk’ on any particular investment manager in these asset classes. But given the long time horizons and relative illiquidity in private equity, investors cannot exit a decision easily and so are (even more) inclined to stick with well-established firms and are less open to considering newcomers.
Basically “track record” is the box that needs to be ticked. And is much more important than having a coherent, well-researched and plausible investment thesis. After all, if you have the money, the deals come to you. But a track record in private equity is hard to come by quickly. (And it needs to be the ‘right’ kind: the first time I was told (by a prospective investor) that having been a founding investor in two multi-billion dollar companies didn’t ‘count’ because I wasn’t “a professional investor” when I made the investments was frustrating and somewhat irritating I have to admit.)
A company active in a two-sided market provides it’s services to two distinct constituencies. Often times, they provide those services for free to one side of the market, in order to increase the value of the services they provide to the other side of the market. For example, Visa provides consumers a free payments service (and actually often pays consumers to use their service via loyalty programs, cash back, etc.); in so doing they can charge merchants to use their services which have value to the merchants because of the number of consumers who use their platform. In effect, Visa sells ‘access to consumers’ to merchants. In a different context but the same vein, Google sells access to consumers to advertisers.
Successful private equity and venture capital firms “sell” access to dealflow to their investors and limited partners. It is a two-sided market. And so it is natural that network effects apply and rational for investors to be pre-disposed to the biggest, most established players. It is reasonable to think that NEA (and KPCB, Index, etc.) or Blackstone (and KKR, Carlyle, etc.) will see a high proportion of the best deals. So far, so true. But unlike electronic payments or algorithmic online advertising, investing (in private companies) does not scale and so unlike these markets, the law of diminishing returns kicks in much, much earlier. The industry (well, much of it) admits as much: I suspect if you offered the GPs of NEA a $10 billion fund, they would probably demur. Indeed I suspect if you offered USV a $500mn fund, they would probably turn it down. The key point is that for any given private investment strategy (sector, stage, etc.) there is clearly a maximum optimal fund size. For a company like Visa or Google, this is not the case – more customers, more merchants, more searches, more advertisers – it’s all good.
Jeff Bussgang recently estimated that the (US?) population of active VC partners was approximately 1000. I don’t know how many mutual and hedge fund managers there are but I suspect it is at least an order of magnitude higher than this. This seems intuitively wrong: investing in a private company is more work and there are more of them. You have a thousand investors looking at a universe of tens of thousands (or more) of investable private companies and tens of thousands of investors looking at investing in a universe of thousands of public companies…
Paul Kedrosky (and others) have written extensively and intelligently on how the venture capital industry needs to shrink. How too much money, chasing too few opportunities has destroyed returns. The logic is compelling. However I would posit that the problem is not too much money per se, but too much money with too few and homogeneous investors.
Let’s look at these two constraints sequentially (although they are co-dependent to a large extent.) If you double the number of GPs but provide ten times more investment capital, on average the valuations of the investments they make will go up five times (thus significantly compromising their future returns.) Ah but this logic assumes a closed system – ie that both the number and types of investments are held constant, and so increasing the ‘money supply’ drives inflation (and lower real returns.)
And we uncover the Achilles Heel of the (otherwise extremely successful) ‘Silicon Valley’ model: the relative homogeneity of the environment leads inevitably to a collective narrowing of the universe of potential investments that is considered and amongst these, an additional narrowing in the way they are evaluated and considered. ie Everyone sees the same deals and runs the same slide rule over them. And so more capital simply means valuation inflation and ultimately, lower returns.
But what if we were able to disrupt this state of affairs? Having spent the past two years intensively researching the markets we are interested in, I simply don’t accept that the ‘problem with venture capital’ is a bounded set of investment opportunities. I’m sure there is some limit to the number of good entrepreneurs, viable business models and attractive market opportunities but we are nowhere close to reaching it. In fact, it is so far away we can’t even see it yet.
No, the problem is a failure of market design. (The irony being of course if this market design failure were in any other industry, venture capitalists would be aggressively investing in companies and business models designed to correct and take advantage of this failure.) The problem simply stated is too small a number of too many similar venture capital and private equity investors. The solution is more, and more diversity. The question is how?
I’m sure you won’t be surprised to hear that I have a few ideas on the subject, and for my first (and only) New Year’s resolution, I will endeavor to articulate these in a multi-part series I will call ‘Saving Private Equity’. Some earlier thoughts on the subject can be found here.
The more cynical amongst you might accuse me of simply ‘talking my book.’ Perhaps. Probably. A more flattering way to look at it is that I am living my convictions. And the lesson I’ve learned is that we need to focus almost exclusively on fund raising for now even if that means disappointing some of our portfolio companies or missing out on a great investment opportunity in the short term. It’s not fun or particularly interesting but like almost any other startup, without capital the rest is just theory. Time to stop thinking and start pitching!
Equity markets to go up and vol to drop:S&P is now c. 1020 (up from 890 at year end, c. 15%) but traded down to 666 first. I’ve kept my individual portfolio holdings throughout (AAPL, AIRV, RMG, EWZ) but was stopped out of a leveraged long on S&P at c. 800 and did not get the trade back on. Didn’t play on VIX which has come down to c. 25 from 40 at the end of last year.
Selective Emerging Markets will outperform (in particular Brazil, India and Sub-Saharan Africa): Brazil iShares (EWZ) has outperformed S&P by about 50%, I held my long position but didn’t add to it as my limit orders were a bit too greedy. As for India and Africa, my preference was for private plays but if public markets are a proxy, directionally these seem to have done well also, with India outperforming S&P by c. 30%, whereas Africa it’s less clear.
Buy long dated calls on Oil: really angry on this one, my size was too small so my broker didn’t want the hassle of doing the trade for me. Was looking at $65 to $75 Dec 2010 calls. Even with big brokerage costs these are up 5-6x… Note to self, get new broker.
GBP will stop going down: I am structurally very long GBP so my trade here was not to hedge. So far so good as GBP is up c. 10% against the major crosses so far this year, having been even a bit higher a few weeks ago.
So, where do we go from here? I know it’s not very exciting, but I suspect we go mainly sideways in most asset markets between now and year end. If you are holding the positions above, I would continue to run them but tighten stops and look to take profits if S&P approaches 1100, Oil gets above $85 and GBP re-tests it’s August highs vs USD or EUR. Would be more patient or less nervous with positions in corporate bonds and Brazil; although both would probably suffer in a generalized market sell-off, I’d be more inclined to add on dips. Generally, I think it’s not a bad time to be raising cash again and sitting on the sidelines waiting for a better opportunity to come in: choppy sideways – which is more or less what I expect – is a very dangerous market to trade unless you are doing it full time (in which case it can be profitable and fun.) My biggest regret? Not buying AMZN when it traded below $50 like I swore I would. Have raised to $60 but not too hopeful. Otherwise I’m pretty happy with how my portfolio weathered the financial hurricane of ’08/09. Learning? Don’t overtrade: fastest way not only to lose money, but also your sanity.
(Self-)Report card: Predictions A, Trading C+, Overall B- Trading is always harder than predicting.
When speaking to start-up investors about their track record most of the time the conversation revolves entirely around the investments they have made in the past. The winners, the losers and why. More rarely do people talk about the investments they didn’t make. This is understandable for a number of reasons, one of the most important being there is usually no obvious record to fall back on and there is no way to short bad start-ups. So one relies on the investor keeping track of the investment opportunities they looked at and passed on, and further keeping tabs on how these companies did. Not many investors do this – at least not publicly, one (great) exception being Bessemer who with great humor points out their heroic misses – opportunities they declined that turned out to be home runs – in what they term their ‘anti-portfolio.’ But it would also be interesting to see a record of the deals an investor didn’t do that failed. But this is even harder (if one is to avoid noise) – even a small, relatively new investor like us sees hundreds of proposals and even this depends on what one considers as having ‘seen’. Is it an email in passing saying XYZ is raising money, would you like to look? Is it spending a few hours going through an executive summary / pitch book / website finding out more? And it is also important (if this information is to be meaningful) to qualify why the investment wasn’t made. Is it because it didn’t fit a certain sectoral or geographic investment criterea? ie Good prospect but not for us. Is it because of a conflict with an existing portfolio company? ie Good idea but we like these guys better or they were first in the door and now we’re stuck. Is it because of apathy or lack of resources (time, money)? ie Good idea but just can’t focus and isn’t top of the list? Or is it because, well it’s just not a very good opportunity? ie Mediocre or downright bad idea.
In order to have the discussion, an investor needs to keep a record of all of this. How many do? We are trying to – or at least have plans to do so – but I’ll admit it’s harder than it sounds. It’s not something that generally gets anywhere near the top of a priority list, when the days are filled with making and managing the investments you do make. (And when you are trying to raise capital and/or keep existing investors happy or informed if you are a professional.) Don’t get me wrong, it’s not rocket science and I think it probably comes down to spending a bit of time and energy upfront to put a workflow in place to be able to capture and manage this information efficiently. And to be truly useful, this record needs to be ‘timestamped’ and auditable: we all suffer from hindsight bias. ie We definitely would have invested in Google given the chance, and obviously we passed on Webvan….
OK, fair enough, but why is this important? It’s because I think knowing which investments (and why) an investor didn’t make, and comparing these to the ones they did make, is a much better way to analyze their skills and approach. I think this is true in any asset class, only in most (all?) others it is practically impossible to do the kind of analysis I describe above if they are a long only investor (private equity perhaps being the exception.) Of course for long/short hedge funds this type of thinking is embedded in their performance.
Nauiokas Park is too new for this kind of analysis to be relevant but I was thinking about it in the context of my prior angel investing experience. I didn’t keep a complete record but there are a few deals that come to mind, two of which I was fortunate enough to blog about before the outcome was known, one after (discount appropriately) and so are public record. Hopefully you’ll trust me on the other two.
The first example is a company called SpiralFrog which is now the poster child for the second wave of bad ‘internet’ investments. I was approached in early 2006, through my Wall Street/City network to look at this, as people new I was interested/knowledgeable about “tech” start-ups and had had some success as an angel investor. When I saw the prospectus (and yes it was a prospectus) and looked at who else was involved as investors, I was immediately suspicious: this wasn’t a nimble start-up, it was packaged like a Wall Street deal – the scale and approach were way too heavy. Looking into the plan and the projected financials it just got worse. I passed and when they launched to considerable fanfare, I wrote this in September 2006 and followed up with this a year later.
The third is Powerset. What attracted me was the great team they pulled together and my conviction that semantic technologies were going to become increasingly important and valuable. I didn’t directly have the opportunity to invest but was one degree away and think I could have if I had agressively pursued.
Zopa is the fourth. I was approached by a friend when they were raising their initial outside round. I loved the idea but didn’t think it could get traction – at least not enough, fast enough to disrupt the market it was targeting, especially given how free and easy it was to get credit (something I new about…) I think I was right then. But I still love the concept and would be open to taking a closer look again in the future should the opportunity present itself. My focus would again be on understanding whether or not they can scale and whether or not the business model is optimal.
The final example is Skype. I didn’t directly have the chance to invest, but again at one degree of separation I could have tried. That said, I’m pretty sure had I been given the opportunity I would have passed: I didn’t see (until everyone had figured it out) how it could be a good investment despite loving the product. I’ve changed my mind and if I were running a big private equity fund, I’d definitely be trying to run my slide rule over them to see if I could make eBay a better offer than the public market.
Good investing is about managing your failures, your losing trades. The best way I know of doing this – whatever the asset class – is working hard to figure out what could go wrong before putting on the trade. (I guess it’s the bond trader in me…) There is always something that can go wrong. If it is big or likely enough you should pass. If not, by having a clear understanding and focus on these risk factors, you give yourself the chance to adapt and/or mitigate before its too late. This is especially true in venture investing as many risk factors in these companies tend to be endogenous; obviously if your basic premise turns out to be wrong that’s tough (but not impossible) to mitigate and sometimes it doesn’t work out. But by actively knowing what is going wrong and why at least you can avoid throwing good money after bad while also knowing when the odds are in your favor and you should double down.