Sean Park Portrait
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As industries become digital industries they become free.
- Chris Anderson, Editor, Wired Magazine

Articles tagged 'Private equity'

An alternative approach (to financing innovation)

When we set out to create Anthemis Group, we thought long and hard about how it should be structured.

We wanted a structure that would:

  • optimally support our core mission to build the leading “digitally native” diversified financial services group of the 21st century
  • fundamentally and structurally align our key stakeholders: investors, management, employees and our portfolio companies and their founders
  • create transparent economics that are clearly driven by long term wealth creation through capital growth
  • be as simple as possible while remaining operationally and tax efficient

We wanted a structure that would avoid:

  • misaligned economics – in particular any structure which would incent management to raise capital without regard to cost; we want to be in the business of investing and growing capital not collecting it
  • misaligned horizons- in particular having our investment decisions driven by tactical (time-driven) rather than fundamental considerations; the tail should not wag the dog
  • undue complexity – in particular where it might lead to reduced transparency or fundamentally drive management or investment decisions; as simple as possible but no simpler

And so we very deliberately – against the grain of many (smart) people’s advice1 – decided to set Anthemis up as a company, or more specifically as a group of companies with a simple holding company at the top of the group structure. In order to give you some insight into why we made this choice, I’ve tried to distill what we believe to be the key advantages of this structure in the context of our business model, vision and goals:

Alignment

We have one clear, measurable and transparent objective: grow the value of Anthemis shares over the medium to long term. All of our management decisions – which can essentially be distilled into allocations of human and financial capital and assessing the opportunity costs of both – are guided by our best judgement as to how these choices will affect the long term value of our shares. We get this right and everyone is happy. We win (or lose) together with our people, our shareholders and ultimately our portfolio companies and their founders.2

Simplicity

All investors are invested in the group’s parent company: Anthemis Group SA, a Luxembourg Societe Anonyme. We have only three classes of shares: preferred (with a simple 1x liquidation preference), common (essentially arising from the exercise of employee performance options) and founder shares (which are economically identical to common shares but carry certain limited governance rights and more onerous vesting and transfer provisions.) Investors and employees don’t need an advanced degree in financial modeling in order to understand the value or performance of their holdings. Beneath the parent company we have a small number of both operating and holding entities all of which are 100% owned by the Group, the corporate form and domicile of these entities has been chosen to ensure a tax efficient and compliant structure that is also cost effective to run. It is exceedingly simple to understand which we believe has its own value.

Transparency

We have an enormous opportunity in front of us, one which requires our full attention and all our energies. Opacity is a tax on efficiency and productivity. It drains your mental energy. It increases entropy. Transparency sets you free. If nothing else it means that you never have to remember what you said to whom when. More importantly it builds trust which is the currency that fuels networks and ecosystems. Of course it is much easier to be transparent when your structure is simple and aligned across stakeholders. Paraphrasing Warren Buffett, “our guideline is to tell our stakeholders the business facts that we would want to know if our positions were reversed…and we believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.”

Evergreen

Building great businesses takes time. Typically at least 7-10 years in our opinion, sometimes longer. And having invested in and built a great business, why would you want to sell it? Or more precisely it would seem crazy to have to sell it. And yet that is exactly the constraints faced by traditional GP/LP venture funds. Sure a GP can ask for an extension, but that doesn’t change the fundamental truth that irrespective of circumstances, they have an obligation to exit their investments. Aside from the misalignment of fund terms with optimal venture capital investment horizons (which, to be fair, could to a largely be remedied if fund lives were 15 or 20 years rather than 10), the other disadvantage of being structurally forced into shorter, time-limited investment processes is that one inevitably risks being seduced by the siren call of high IRRs to the detriment of building real, tangible long term wealth which ultimately arises from actual cash on cash returns.

An evergreen – ie equity – capital structure is the simplest, most elegant solution. We also believe in robust and conservative balance sheet management: to use the trader’s vernacular, we believe in running a matched book. Equity financed with equity. If we do our job successfully, the last thing investors should want is to be given their capital back before they want or need it. If we are successful, there will be any number of ways to create liquidity event(s) as and when required by our investors. If on the other hand we are unsuccessful, quite frankly the structure won’t make a damn bit of difference to our investors’ outcomes. In fact they may well be better off holding corporate equity rather than distressed fund units, but almost certainly they would be no worse off.


Broken business models are the new black

Last week, the Kauffman Foundation published a very comprehensive and well written report concluding that “the Limited Partner (LP) investment model is broken” as “too many LPs invest too much capital in underperforming VC funds and on misaligned terms.”

There are more than simply structural differences between Anthemis and a venture capital or private equity fund; the most important of these is our ambition to build a coherent yet diversified group of companies that is perennial. This means that our investments (and eventual disposals) are framed in the context of optimizing our business portfolio and overall return on invested capital and are considered through a lens of corporate development rather than simply as individual financial investments. The fact that our current investments (we currently have 20 companies in our portfolio) have been entirely concentrated on “venture” stage companies reflects quite simply our thesis that the global financial services sector is at the early stages of what we believe will be a secular transformation of the industry as “industrial age” business models are disrupted and ultimately replaced by “information age” or as we like to call them “digitally native” business models.

Over the next 10-20 years, our plan is to initiate, grow and consolidate our positions in the companies that emerge as leaders in this new economy. At the same time we plan to continue to make investments in disruptive startups emerging on the “innovation frontier” in order to maintain a vibrant pipeline of emergent technologies and business models in order to retain our immunization to the innovator’s dilemma. We believe that the optimal organizational paradigm of the information age will be predicated on networks, not hierarchies and have crafted our approach to building the leading financial services group of the 21st century to be inherently aligned with this hypothesis. Our vision is to build Anthemis into a strong but loosely-coupled network of complementary businesses focused on financial services and marketplaces; not to build a monolithic, hierarchical conglomerate. We never want to become too big to fail, our clear aim is to become too resilient to fail.

Although our investment thesis is fundamentally different, from a structural or even philosophical point of view our approach is very much inspired by Berkshire Hathaway. (Spookily, upon founding Anthemis, Uday and I happened to be very close to the same ages respectively as Warren Buffet and Charlie Munger when they “founded” Berkshire Hathaway in 1965. Here’s hoping history repeats!) As an aside, Henry Kravis once called Berkshire Hathaway “the perfect private equity model”, though why KKR didn’t or hasn’t adopted a similar structure is interesting. (One wonders if it isn’t as a result of the relative risk/reward (fee-driven) profile for the GP in a traditional private equity structure vs. the (equity-driven profile) of a founder/manager in corporate holding structure…) Other examples of thematically or industry focused groups from whom we draw inspiration are companies like LVMH or Richemont (luxury and branded goods) or Naspers and DST (media and internet) but ultimately we have the sense that what we are seeking to build is somewhat unique, something new. An evolution in corporate organizational structure which is adapted to the emerging social and economic landscape of the global information economy.

(excerpt from LVMH Group Mission:) The Group’s organizational structure is decentralized, which fosters efficiency, productivity, and creativity. This type of organization is highly motivating and dynamic. It encourages individual initiative and offers real responsibilities – sometimes early on in one’s career. It requires highly entrepreneurial executive teams in each company.

For both Anthemis investors and for the companies in which we invest, our focus and approach provides an interesting and complementary alternative to traditional venture capital funds. Although it would be naive to pretend there is no competitive overlap, our conviction (confirmed by our experience to date) is that we are in fact a positive new entrant in the venture ecosystem that complements rather than competes against more traditional venture investors. Not “either/or” but “and”. For the startups in which we invest, we know that building an investor syndicate of diverse and complementary talents which includes the networks and company building skills that the best VC partnerships bring to the table is the best way to ensure their chances of success. Our portfolio companies are much stronger for being able to combine our (sector-focused) talents and resources with those of leading VC firms such as Atlas Venture, Bessemer Venture Partners, IA Ventures and others too numerous to mention. And it is equally clear to us that Anthemis is strengthened by the continuous learning and exchanging of ideas that comes with having the privilege of working alongside so many smart and seasoned partners and associates of these VC firms.

For our investors, we offer a unique and efficient way to gain intelligent exposure to the future of financial services. And while clearly there are some similarities in our risk/return profile with that of a traditional venture fund (given that a very significant proportion of our balance sheet is invested in early and venture stage companies), we are nonetheless not strictly speaking substitutable (in the way say traditional “bluechip” generalist VCs might be.) And as we grow – just as for the startups in which we invest – our risk profile will naturally evolve. Indeed one could think of Anthemis as a financial services “meta-startup”. That said, when considering Anthemis I suspect that many of our existing and potential future investors would characterize Anthemis as a direct venture-stage investment, with any allocation coming from within their venture capital (or private equity) bucket. As such, I thought it would be interesting to examine how Anthemis might stack up in the eyes of an investor in the context of the five recommendations of the Kauffman report.

(1) Abolish VC mandates

Not sure if this is directly relevant to Anthemis. However we would agree that anything that encourages a return to substance over form in the context of LP asset allocation is a good thing. A private equity investment process that focuses more on the “what” rather than the “how” strikes us as being more sensible given the heterogeneity and illiquidity of these types of assets.

(2) Reject the Assumption of a J-curve

Traditional venture capital theory (useful it seems when justifying reporting opaqueness!) states that investments in startups (and thus portfolios of startups in a particular vintage fund) go through a cycle by which their valuations initially decline before later increasing in the goodness of time as the big winners in the portfolio emerge (and are fed more capital) and the losers fall away (with relatively limited capital having been invested.) Kauffman however found that this theory while it sounds good, isn’t borne out by reality; rather most funds experience an “n-curve” whereby valuations increase substantially in the first 2-3 years (driven by follow-on venture financings at higher and higher – but generally unrealizable and almost always unrealized – valuations), only then to deteriorate over the remaining life of the fund. (ie Big winners often don’t emerge…) Unsurprisingly, they also found that these increases in (paper) value topped out at almost exactly the same time that GPs sought to raise their next fund, producing a flattering backdrop upon which their LPs could tick the track record/historical returns box. The reader can draw their own conclusions, but Kauffman concludes that “too many fund managers focus on the front end of a fund’s performance period because that performance drives a successful fundraising outcome in subsequent funds.”

Investors in Anthemis don’t have to worry as to whether there is a J-curve, an n-curve or an “any-other-letter”-curve…as they are owners of preferred equity in Anthemis. We don’t raise subsequent funds. The Anthemis founders and management are significant shareholders whose performance compensation is largely equity-driven. Any time Anthemis raises new equity capital (our analog to raising a new fund), both our focus and the new investor’s focus is on future expected returns on this capital. Full stop. If we go to raise new capital and investors think the share price on offer is too high (or at least too high to offer them the risk-adjusted returns they expect), they won’t invest. If the Anthemis Board thinks the share price offered is unattractively low (insofar as the cost of capital exceeds the company’s expectations as to it’s projected risk-adjusted returns and/or those available from new investments), it won’t issue.

Every smart entrepreneur and venture capitalist understands the intrinsic tension between capital and dilution which acts as a powerful aligner of interests. We simply embrace this dynamic, aligning our returns to those of our investors and removing path dependency and our ability to arbitrage the structure at the expense of our investors.

(3) Eliminate the Black Box of VC Firm Economics

I must admit that before reading the Kauffman report, I didn’t realize how little information VCs provide to their LPs. It’s pretty ironic given that most VCs spend more time negotiating (and are more dogmatic about) the nuances of control and information rights in the companies in which they invest than pretty much anything else, including valuation. The report highlights that “LPs seem to lack the conviction to require the information from GPs in the same way the GPs themselves require it” and apparently don’t use the leverage that they potentially have to force the issue, according to one GP quoted in the report “LPs never walk away.” Sure. Um, that sounds like a robust and healthy investment process. Yikes. But the boxes are ticked and the forms all filled in nicely…and so everyone’s happy.

Another perceived top-tier GP agreed with our view about the importance of transparent partnership economics and he admitted “no good answer” as to why LPs couldn’t receive the same information about his fund, except that the information is “never shared.”

Ok so you can get away with it, fine, but why? Why not be transparent? It sounds like a bunch of derivatives bankers that won’t share the model because they’re afraid the client will find out just how big their margin is and “won’t understand” all the costs (systems, people, capital – immediate and contingent) that this gross margin needs to support. (Irony alert: of course these same bankers usually hold up this gross margin to their managers as profit, blithely ignoring these same items in the pursuit of a “fair bonus”…) Imagine Joe Entrepreneur saying to Jim VC: “Just write the check and trust me. It’s complicated, I don’t want to cause you any unnecessary anxiety or have you misunderstand the numbers. That would be distracting. I’ll let you know when I need more. Thanks.” Come to think of it Jack Dorsey could probably get folks signed up on those terms…

So Anthemis is not a black box. We treat our investors like any startup would treat their VC investors. We have certain information and governance rights written into our articles and in general we respect and are open with our investors, doing our best to keep them informed and making ourselves available when they have ideas or questions they would like to discuss. We have audited financial accounts, a clear remuneration policy (overseen and approved by the Board including at least one Investor director) and quite frankly a pretty transparent and straightforward approach to investor relations. We can’t imagine having a conflictual, non-trusting relationship with our investors. What we are trying to build is hard enough as it is, we need our investors to be on board: not just financially, but intellectually and emotionally.

And so I hope Warren doesn’t mind if we adopt Berkshire Hathaway’s first Owner’s Manual principle as our own:

Although our form is corporate, our attitude is partnership. Udayan, Nadeem and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for the moment and for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.

(4) Pay for Performance

Our first hand understanding of how this principle was being misapplied in much of mainstream finance and asset management was yet another proof point for our thesis that financial services business models were ripe for disruption. It is the shield the industry wraps itself in: “we may be paid well, but we are a meritocracy and our pay is justified by our performance.” This may have been true once – and in some firms in some activities it probably remains true today – but these are too often the exceptions not the rule. It’s a whole other essay as to how and why this is and how it came to be so, but I’ll spare you the details and jump straight to the punch line: too many compensation models are structurally biased to favor human over financial capital and worse, compound this bias with path-dependent outcomes that reinforce the skew, sometimes dramatically so.

The standard 2 and 20 fund compensation paradigm is one of these. There is nothing fundamentally wrong with the principal behind it – you get a management fee to cover your overheads and a performance kicker if you generate returns (even better if there is a hurdle rate which should be based on the risk-free return plus possibly some margin for the extra risk or illiquidity depending on the strategy.) And frankly, this model can and does work, especially when the managers have a substantial stake in the fund (both in absolute terms and in terms of a % of their net worth) and when the fund has performance high-water marks and/or hurdle rates. Good examples of this model working are often found in the hedge fund world, where principals often own much or even most of the fund and their holdings represent a very substantial proportion of their total net worth.

In cases where these conditions aren’t met it often doesn’t work out so well. The fixed percentage management fee acts as an opiate, driving managers over time to focus their energies on asset gathering (not management.) The temptation to increase AUM to the largest (credible) size is strong as doing so essentially gives the managers a free upside performance option as the management fee alone becomes enough to pay themselves handsomely. Heads I win, tails you lose.3 This pathology is bad in any asset management context, but is particularly toxic with respect to venture capital given that it is an strategy that involves investing in a limited number of essentially illiquid securities.

If you are a macro hedge fund investing in FX and interest rates, the fact that you are managing $100mn or $100bn possibly doesn’t matter (especially if a big chunk of the capital is your own.) If you are investing in venture – or for that matter small cap public equities – a strategy that is highly successful with $100mn of capital can be a struggle to execute when you have $1bn or more to play with…) Unsurprisingly you often see some of the best VCs (who have easy access to capital) drift towards growth/private equity strategies where they can intelligently deploy larger sums. Done well this can be a good strategy (for all) but still we wonder why LPs aren’t more flexible and proactive in negotiating more tailored fee structures, either on a per fund and/or per firm basis.

In this context, our relatively simple, transparent “corporate” approach to compensation is an interesting alternative – it aligns management (who are also significant investors) with outside investors under all circumstances. First, not only is there no incentive for management to raise capital (grow assets) for the sake of it, there is actually a strong disincentive to do so: more capital means dilution. It has a cost. Raising capital is only interesting at a price that allows Anthemis to improve the risk adjusted returns of its existing and potential future portfolio of businesses. If the cost of raising equity is too high (ie the price of our shares is too low), it is financially more attractive for Anthemis (and our existing shareholders) not to raise more funds and to simply manage our existing portfolio of assets. To be clear – especially given the nature of our assets – I’m not suggesting that it is possible to create a spreadsheet that will spit out a definitive share price at which we should issue or not – there are too many subjective and uncertain inputs and pricing the opportunity cost of capital (which is essentially what I’m talking about) is as much art as science, especially at this stage of our development.

But what is clear – and structurally friendly to shareholders – is that there is symmetric risk and reward for management when raising capital. Just as there is for the founders of companies that VCs invest in everyday. You don’t see Jane Entrepreneur raising $100mn on a $1mn pre-money because she could then afford (to pay herself) a big salary; rather she is going to look first at what is the minimum amount (including a margin of safety) of capital needed to achieve her key value-creating milestones (while paying herself a reasonable salary.) If the price offered is unattractive, she’ll probably err on the side of raising less capital; if the price offered is generous, she’ll probably err on the side of raising a bit more. Simple. Valuation matters. Dilution matters. And most importantly, what is good for Jane in this context is (almost) always good for her existing investors. Alignment.

So how do the management and employees at Anthemis get paid? Basically there are three components, all of which are easy to understand and ultimately transparent to our investors:

  • Baseline: We pay our people competitive salaries and annual bonuses based on their experience and market value; this gives us some flexibility and resilience with respect to managing operating cash-flow while allowing us to attract excellent people who don’t have to be independently wealthy to finance their employment with us. Note that a very significant part of our overhead costs including salaries and bonuses are actually financed by our successful advisory businesses which are profitable on a stand-alone basis. These businesses then give a decent return on capital to the group while more importantly enabling significant operating leverage vis-a-vis our investing activities. Under a traditional GP/LP structure, given the size of our balance sheet, we would currently only be able to align a small fraction of our professional resources to support our principal investment activities. (And we would not be able to leverage the extremely valuable strategic and informational advantage arising.)
  • Performance bonuses (cash): With respect to our advisory businesses, insofar as our operating revenues permit, we accrue a performance bonus pool. The size of this pool depends on achieving a certain net operating margin target as set and is agreed by the board.
  • Long term incentive plan (equity): Each time we raise new equity capital, we create an option pool equivalent to 20% of the amount raised; these are options on common shares and have an exercise price equal to the price paid by investors in that round and are subject to standard vesting provisions. The options are then allocated to staff over the expected deployment period of the capital raised, based on a number of criteria (skewed towards their respective contributions to the development and performance of our portfolio participations) – again all agreed by the board. Some are also held back in reserve for new hires and exceptional performance rewards. In our opinion, this option structure offers a competitive performance incentive to Anthemis management and employees with a payout profile that does a much better job (than traditional GP carry structures) of aligning the interests of management and investors. Unless we increase their value and create liquidity in our shares, we don’t get paid.

(5) Measure VC Fund Performance Using a Public Market Equivalent (PME)

Earlier I mentioned that we were inspired by Berkshire Hathaway; one of the elements of their approach that we most admire is their very simple but obviously relevant approach to creating value4:

Our long-term economic goal is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.

Intrinsic value is formed by three components: the value of investments, the value and growth of operating earnings and a third, more subjective element Buffett calls the “what-will-they-do-with-the-money” factor. In other words the efficiency with which management deploys cash (from retained earnings and new capital raised) in the future. This last factor unfortunately for those who love algorithms is extremely important to the determination of intrinsic value and yet unmeasurable, it’s a judgement call. As an imperfect proxy to intrinsic value, Berkshire Hathaway tracks the per share book value and it’s performance vs both the S&P500 and the S&P Property & Casualty Insurance indices, believing that over the long term this measure at least gives a reasonable indication (although understates) the change in intrinsic value of the business.

Obviously we are not Berkshire Hathaway and so it would not (yet) be meaningful for us to simply take an identical approach to reporting, but we are adopting the same intrinsic value-based approach to evaluating and analyzing our performance and valuation. And once we have enough data to be meaningful, we will certainly look to track and publish (at least to our investors) a similar proxy metric that will allow our investors to compare our performance to the relevant benchmark(s).

The Kauffman Foundation in their report suggests that the Russell 2000 is an appropriate benchmark against which to measure generic US venture capital returns. Given that we invest globally and predominately in financial services and related businesses, I suspect we will need to look at other potential benchmarks and/or perhaps a mix of 3 or 4 different indices. In the past two years since creating Anthemis, the S&P500 is up c. 11% and the MSCI World Financials index is down c. 10%, I’m happy to report that so far we’re doing better than both… As an aside, if there are any index geeks out there reading this who have suggestions as to which index or indices would be the most appropriate benchmark for Anthemis, I’d be happy to hear your thoughts.


Hacking finance

For most of my career I worked in capital markets and investment banking and mostly found it to be an incredibly stimulating environment and felt privileged to work every day alongside so many smart and ambitious people. I was particularly fortunate to have worked in fixed income at Paribas for most of the 90′s where I serendipitously found myself at the heart of the birth of the Euro bond markets, with the opportunity to participate directly in building new markets, products and businesses. And once the Euro came in to being, I naturally looked for the next big thing to build, the next big innovation, only to realize (slowly, over the course of several years) that the Euro project truly was exceptional in every sense of the word and that – like most big successful industries – there was actually very little interest in change or disruptive innovation. That “if it ain’t broke, don’t fix it” was the overriding philosophy. (Actually it turns out to be worse, “even if it is broke, don’t fix it”…)

It is difficult to get a man to understand something, when his salary depends upon his not understanding it. – Upton Sinclair

And so I left. And when I immersed myself in the world of startups and venture capital, I was very excited to be leaving this mentality behind – after all venture was all about the new new thing, right? And although I found this to be true of the founders and companies financed by venture capital, and just as in investment banking was thrilled to find myself amongst another group of incredibly smart, ambitious and (new!) passionate people, I was surprised to find this didn’t extend to how VC partners thought about their own business and business models. In this respect, they were collectively just like the bankers I had left behind. (And given the context, this was even more cognitively unsettling…)

Uday and I (and our newest partner Nadeem) set up Anthemis because we were convinced that a very big opportunity exists to do things differently in finance. And while it wasn’t at the core of our mission, if you think about it venture capital itself is part of the financial services pantheon and without having set out deliberately to do so, perhaps we will play a small role in catalyzing disruptive change here as well if our model proves to be successful. Meta-disruption anyone?

Thinking about it, I suspect our model could work for other industries and sectors – especially for those where there are strong network effects and where companies and businesses form an interdependent ecosystem and/or value chain. For example an Anthemis for retailing? health? energy? As an investor, I would certainly be interested in building a portfolio of these. Think of it as the the equivalent of sector-focused ETFs but for disruptive, emerging growth companies. Until/unless they were listed, it would be hard to short these companies so it would be impossible to run a balanced long/short strategy in both directions. But a more adventurous or aggressive investor could at least express an even more aggressive view on industry disruption by shorting an index of the incumbents in each sector (against a long position in the innovation holdcos.)5

What is clear is that change is coming to the world of private capital markets, whether it is sector-focused holding companies like Anthemis, platforms like AngelList, CapLinked or even Kickstarter and others, private company exchanges like Second Market and SharesPost, new approaches to the VC model like A16ZY Combinator, 500 Startups and many other ideas I’m sure that will emerge. Given our nature, I guess it’s not too surprising to find ourselves disrupting on this dimension too! Interesting times indeed. Stay hungry. Stay foolish.


1 The consensus advice was not to “rock the boat” by doing anything that might be perceived by potential investors as innovative or different. It’s not that we didn’t believe the advice – indeed we were certain that in the case of the vast majority of traditional private equity LPs, this was going to be true. (And has been confirmed by the Kauffman report who note that “GPs indicated that they and their partners had discussed offering alternative structures and received very negative reactions.”) So are we stupid? Well I hope not. Our decision to ignore the advice to pursue a traditional venture capital LP/GP structure was based essentially on four points, in order of importance:

  1. conviction: a fund structure fundamentally did not correspond to our vision, objectives and business model and would have forced us to make material comprises in all three which we were unwilling to do
  2. ethics: having worked in investment banking and capital markets for many years, we had a clear and deep understanding of the traditional incentive models in the asset allocation and management value chain and we believed that in many cases these were fundamentally broken, causing (mostly avoidable) misalignments of interests with often toxic outcomes; we did not want to be a party to this – we wanted Anthemis to have a fully transparent and aligned structure
  3. strategic: we wanted our shareholders to deeply understand and endorse our vision, to become truly our partners for the long term and be able to weather the good and the bad and intelligently hold us to account because they get what we are building and believe in the opportunity; it may sound crazy (for someone who wants to raise capital) but by making it harder for investors with a “box-ticking” or “herd-following” mentality to invest, we felt this would help us ensure that those that did were both smart and aligned with us as founders
  4. pragmatism (or cynicism!): we believed that even with a plain-vanilla, consensus structure, we would struggle to tick all the boxes of a traditional LP who would rather invest in the 4th fund of a serially underperforming VC fund or even the first fund of a GP with years of junior experience at an established VC, than in a team of seasoned operating professionals with a clear vision, who’s track record of success wouldn’t however fit neatly into their approval grid; we weren’t IBM and we figured they probably weren’t going to risk getting fired by investing in us


2 There are two main ways in which our performance can have a positive effect on our (minority-held) portfolio companies:

  1. if our performance is good and our share price is strong, this gives Anthemis (greater) access to (relatively) cheaper capital which will allow us greater scope to support the growth ambitions of our portfolio companies as opportunities arise; their success drives our success which in turn helps us be an even better, stronger strategic shareholder to them
  2. if our shares perform strongly, this creates an interesting currency that we can offer to the founders and executives of our portfolio companies, allowing them a mutually attractive third alternative to hold or sell if and when the day comes when they would like or need to reduce their holding in their company; we hope and expect that this will create a unique and powerful incentive that allows us to retain talented people within our ecosystem over the long term, which we consider to be the single most important driver of sustainable long term success


3 To be fair, as Kauffman points out in their report, LPs are enablers of this and if a manager can charge 2% (or more) of AUM and their customers (the LPs) are willing to pay this, there is nothing intrinsically wrong with this if it is justified by performance. I would however suggest a modification that would both allow great managers to charge whatever the market will bear and better align outcomes. For all management fees above the operating costs of the firm, the GPs could “re-invest” this surplus in the fund. Note this throws up some complications in a fund structure (in an equity structure such as ours, this would simply mean paying out surplus “management fees” as restricted equity) but I don’t think it would be impossible to come up with a decent solution. Even if not perfect, it would clearly drive a better GP/LP alignment. Indeed this is effectively what (most) of the best hedge fund managers do, essentially re-investing their surplus income back into their fund(s). Clearly this is easier with a hedge fund that will often have daily or at least monthly NAVs but again I don’t think it would be impossible to come up with a reasonable methodology to enable something similar for venture GPs.

4 (from Berkshire Hathaway’s “Owner’s Manual”):

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life. The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value…

…Inadequate though they are in telling the story, we give you Berkshire’s book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year’s change in intrinsic value. You can gain some insight into the differences between book value and intrinsic value by looking at one form of investment, a college education. Think of the education’s cost as its “book value.” If this cost is to be accurate, it should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value. First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education. Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth. In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value.”

5 Indeed, I kind of regret not having done so with Anthemis by shorting one or two of the broad public financial sector indices at the same time as going long Anthemis. Although having been very long financials in 2006 (structurally as a result of my 16 years in banking), I can’t complain too much having sold down as quickly as possible my direct holdings and implicitly – by leaving my job – my ongoing embedded exposure… As an example, Weatherbill (now Climate Corporation) where I led the angel round in 2006 is now worth upwards of 9x where I invested, whereas Allianz (where I worked via DrKW) is down c. 40%! If you use Commerzbank as a proxy for Dresdner (RIP) it’s down by c. 95%!! And yet investors still consider public stocks like these less risky than venture stage companies…go figure.

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The case for investing in new companies.

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.)  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 “gained” 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.   As Keynes said, “the markets can stay irrational, longer than you can stay solvent…”  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.  (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.  But I do have some skills.  And some experience.  And I can recognise patterns reasonably well.  And I have conviction.  And a reasonable track record for building new markets and adopting and executing novel business models.  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.  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.  In fact it’s pretty obvious.  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.  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.)  As someone wise once said:  a “start-up is not GM”  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.  In fact as most people would glibly observe, investing in start-ups is ‘very risky’.  Well yes, but the risk is almost entirely idiosyncratic and manageable – much much less dependent on vast, uncontrollable, macro-economic trends and forces.  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)?  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.  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.  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.  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.  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.  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.  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.  And while I am confident in my own abilities and have backed that up with a lot of “skin in the game”,  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  - in new companies, are excellent and, for the VaR-boys out there, truly uncorrelated to mainstream asset classes.  The challenge is of course to find these investors and not to swamp them with too much capital.  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.

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Bringing corporate governance into the digital age

You may have noticed, I haven’t been posting much here lately.  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.)  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.  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*.)  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!)  It completely revolutionised what had heretofore been a disjointed, manual, somewhat ad hoc process into a seamless, collaborative, mostly painless process.  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.)  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.)  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.  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;  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).  Further, there is much talk (and consensus) around the fact that it is hard/impossible to scale venture investing.  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.  Not to infinity but substantially, perhaps by an order of magnitude.  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.)  Then came Bloomberg.  And excel spreadsheets.  (And later bespoke pricing and analytic tools and platforms.)  And all of the sudden, a trader could manage a book with hundreds of securities.  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.  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.  But while this (and excel for traders) is (was) a good start, the real juice comes when dedicated, purpose-built platforms emerge.  If you have a screw that needs driving, a hammer is better than nothing (or a rock) but a screwdriver is even better!  (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.  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.  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.  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.  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…

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(Venture) Capitalocracy?

AMEE announced today that they had closed a new round of financing. I think this is a fascinating company and compelling opportunity. Given the chance, would I have for certain chosen to invest? Based on what I know of the company and its management, I would like to say yes. Probably. I’m forced to hedge my opinion because I just don’t know enough, especially with respect to the financials and the attractiveness of the valuation given the opportunity. But given what I do know, I would have loved to have them in our portfolio. And I’m certainly more than a little disappointed that we weren’t in a position to throw our hat in the ring, do our homework and at least make an offer…

Which brings me to an idea I’ve been toying with for the past several months. I’ve been contemplating publishing a virtual portfolio of venture and private equity investments – ie the investments we would likely have made (and would make) had we the capital available. A sort of an analogous take on Covestor or Marketocracy but for private investments.* There are however a number of reasons I have not taken the plunge. Perhaps most obviously is the issue of proprietary knowledge. After all, the heart of the value proposition we make to prospective investors is that we have a unique and robust investment thesis and that based on this foundation, we have identified (and will continue to identify) exciting young companies who are naturally adapted to grow and prosper in the coming years. If we tell everyone who these companies are, why would anyone need to pay us a fee? Why wouldn’t they just invest directly. Or more likely, why wouldn’t competing investors just ‘free-ride’ on our research and analysis, using our list as a filter or more? And what if the companies we listed failed (see below)? What benefit would there be to publishing such a list?

Further, there are a number of structural factors at work that mean that the ‘Covestor’ metaphor is imperfect at best and fundamentally inappropriate at worst. Investing in private companies involves a number of challenges that are different/additional to those faced by a public company investor. A number of these factors are interrelated but for the sake of clarity I’ll try to enumerate a few:

  • deep information deficit: for most of the companies that would appear on such a list, our information is significantly limited, especially with respect to financial aspects (budgets, sales, valuation, etc.) As a practical matter it is usually not possible to obtain this level of detailed information unless one is actively engaged with the company in view of a potential investment. Obviously it would be completely disingenuous for us to misrepresent our capacity and intentions simply in order to be able to put our slide-rule over the financial model. Further, without the potential pay-off of being able to follow through and invest in companies that pass due diligence and valuation muster, quite frankly we don’t have the luxury of doing such a deep analysis even if the company was happy to provide us the data.
  • price (valuation): while perhaps less important (within reason of course) the earlier you are in the life-cycle of a company, it is obviously a key input that is quite often unavailable. To be fair, one could possibly – at least for the purposes of such a list – assume that if respected investors participated in a given financing round that we would have been ok with the pricing too.
  • value enhancement: call it hubris if you like, but one of the key inputs in our investment process is understanding to what extent our participation as an investor can help reduce risk and accelerate success. Elements of this analysis can be done from ‘outside’ but without a deeper understanding of the business and in particular a personal relationship with the management team, it is hard to properly assess what value, if any, we can bring to the table. Some companies that look great to us from afar might just not be a good fit.
  • managing destiny: (a variation/specific case of the point above) particularly for seed and very early stage companies, one of the biggest risks they face is securing follow-on finance. In this context, a theoretical investment and a real investment are fundamentally different: there are many ways a company can fail. Failure is failure of course but I suspect there is a risk that some of the companies on our wish list might indeed fail to raise follow-on capital, whereas had we invested for real, we would be prepared to follow-on in most cases, mitigating if not eliminating this risk. Of course it’s probably impossible – even ex-post – to definitely identify companies whose failure was ultimately unavoidable (market driven) from those whose failure was only due to a financing gap.

The case for publishing such a list – assuming you can overcome some of the structural limitations outlined above – really boils down to building reputation and trust, both with potential investors and existing and aspiring entrepreneurs in particular and within the wider venture capital / private equity ecosystem in general. Part of me also likes to think that there is less risk, in terms of ‘giving away’ intellectual property, than would be the case for say a hedge fund manager focused on public equities: anyone can buy a public security, the same is not true of private companies. Wanting to invest is not sufficient to allow one to invest. Further, let’s be realistic: for better or worse, I’m not Warren Buffett or John Doerr or anyone really…will the fact that I say AMEE is a must own company really make a difference to anyone? More importantly (to me!), will it make it more or less likely that I will be able to use my skills to make a living identifying and investing in great young companies?

Basically the only potential downside to publishing a virtual or ‘wish-list’ portfolio I can see is the fact that one would have to assume that any nuance and qualifying information attached to such a list would ultimately get lost and that for better or worse, the companies would be inextricably linked to me without qualification. I was thinking that a list constructed as ‘Probables’ and ‘Possibles’ might just allow some useful qualification without diluting the impact. And yet, I hesitate. And I’m not sure why. So I thought I’d ask you.

  1. Why should I not publish such a list?
  2. What (if any) qualifications should I include, were I to publish such a list?
  3. Why don’t other investors publish lists of deals they would like to or would have liked to have done? (before outcome is known of course!) (Or if any do, please tell me who/where.)

* Is there a business idea in here somewhere? Sort of a Covestor meets seedcamp for aspiring new private equity managers? A set of tools and a community to help LPs identify new talent and spread their investments in this asset class more widely (and intelligently) without the limitations of the existing fund of funds business model…

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Another two-sided market.

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.)


Given our domain specialization and investment framework, we are very interested in understanding the dynamics of two-sided markets. Companies that successfully position themselves at the nexus of these markets are typically very, very valuable. There are many examples – credit cards, advertising, computer operating systems – and I suspect the number of such markets will continue to grow as the economy becomes increasingly digitized.


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.)

Well in a world where the number of GPs is constrained, and most of them come from similar geographic, educational and professional backgrounds, this assumption is likely to be more right than wrong. Indeed it is embedded in the initial conditions above – ten times more capital allocated to the asset class does not result in ten times the number of GPs. And yet the number of investments any GP can effectively manage is by definition bounded (at a reasonably small number.) (Which is of course why firms like Apax eventually exited venture capital and ‘graduated’ to private equity.) Perhaps an even more important gating factor however is the number of potential investments a GP can seriously analyze and consider each year (dozens? a hundred or two?)

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!

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Spotting the losers.

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.

A second is Monitor110 – great post-mortem here by Roger. This one I didn’t have a chance to invest in but I would have passed. I admit I hedged my bets a bit with this post, but was skeptical of the business model (and unsure of the product.)

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.

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Saving Iceland(?) – ICT meets Climate Change meets Markets.

Flying Around Iceland on Google Earth in iPhone
Image by cogdogblog via Flickr

A pretty interesting space I’d say. I’d love to be able to attend the Greening of the Internet conference in a couple weeks but unfortunately it would be a bit of a luxury now and logistically impossible as well so I’ll just have to follow remotely. (If anyone spots a good live blog or two on the conference please let me know in the comments…)

Over the past couple years, I’ve become increasingly interested in the potential to combine technology, energy and markets to solve multiple problems concurrently. One of the absolute best people to follow if you are interested in this space is Bill St Arnaud; I highly recommend subscribing to his RSS feed or email list.

One back-of-the-envelope idea I’ve been touting for the past few years is that Iceland should reinvent itself as (one of) the data-centers to the world. Given the complete implosion of the Icelandic economy in 2008, if my idea makes any sense, it should be pursued even more aggressively. In a nutshell…

As the world inexorably moves to computing and storage as a utility, and as energy prices and climate change (price of GHG emissions) loom ever larger in the economics of cloud computing and data-centers, and as information transmission (bandwidth) costs continue to plummet, the relative importance of (carbon-neutral) energy operating costs will continue to increase strongly. (The other main factors being: construction costs, access to bandwidth, legal jurisdiction, security, availability of skilled workforce.) Sooo…. why Iceland? Cold climate and abundant green energy (geothermal now, offshore wave and wind later.) Heck the forward stream of CER’s (depending on what happens in Copenhagen) might even fund the upfront capital cost! Also one would guess that Iceland (as opposed to say Greenland or the Canadian Arctic) would have both reasonable construction costs and access to the skilled workforce needed to both build and then run these operations. I’m not an expert on data-centers but I don’t think they generate massive amount of jobs, but if this vision were to become true, Iceland could build a whole ecosystem around Green ICT and given it’s small population, I’m sure this would have a material impact on both employment and GDP over both the short and the long term.  the= The biggest risk I can see would be natural disaster risk (ie volcanoes blowing up your data-center) and risk of damage to sub-oceanic fibre going in and out of Iceland. Both of which I think should be reasonably easy to mitigate and insure against. Plus, on the face of it, its geographic isolation and NATO membership probably make it a good choice in terms of security.

So…if I were managing a substantial Private Equity Infrastructure fund, I would (do a proper analysis of course but assuming my back of the envelope thinking holds):

  • Start talking to the Icelanding government, IMF and the World Bank/EIB about co-funding and incentive schemes (especially the required incremental undersea bandwidth
  • Encourage Iceland to join the EU asap because having data-centers in a EU jurisdiction will be a very important commercial imperative.
  • Start talking to Amazon (AWS) and Google about partnering / risk sharing as potential ‘anchor tenants’ (they could become to Iceland what Dell was to Ireland 20 years ago…)
  • Start talking to smart banks, hedge funds, etc. about innovative carbon-based financing and energy hedging structures.

Obviously this is just scratching the surface of the work that would need to be done but equally the myriad of collateral opportunities that would emerge as a part of such an ambitious project.

I’ve decribed this idea with varying degrees of detail to probably 2 or 3 dozen people over the past 2 years and no one has found a serious or obvious flaw in the logic. Then again none of them – myself included – had “done the math” nor was necessarily highly fluent in the mechanics/costs of building data-centers generally. Equally, none of them turned around and offered to raise a few million of seed finance either to do a feasability study, so you could say talk is cheap. So in the spirit of casting the net wider, I thought I’d write about it here and solicit experts to punch as many holes in the idea as it merits.

In any event, I never understood why Iceland put all its chips on banking and retail when it is so clearly at a comparative disadvantage in both domains…if nothing else my scheme at least has the semblance of logic behind it! ;)

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