Sean Park Portrait
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Articles tagged 'Zopa'

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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Improving financial literacy

Metro reports this morning that 6% of adults in the UK – a million people – regularly use their credit cards to make their mortgage payments:

More than 1million people use high-interest credit cards to cover their mortgage or rent payments, debt experts say. Six per cent of householders have turned to plastic to pay for the roof over their heads during the past year, according to housing charity Shelter.

Young people struggling to stay on the property ladder are most likely to use the ‘rob Peter to pay Paul tactics’, despite risking long-term ruin. Many credit card companies charge interest between 15 and 18 per cent – up to three times higher than typical mortgage rates.

Clearly – and I would expect all my readers to understand this – borrowing at 15% to pay off debt contracted at 6 to 8% is financial lunacy. (It’s called negative carry and you have to have a damn good reason to hold a position like that for any length of time.) There may be an argument to do so occasionally for one or two months if you are facing an exceptional and short term liquidity shortfall as the ease and convenience (ie opportunity cost) of using an existing committed line of credit (ie a credit card) offsets the extra interest cost. Indeed this may be the case for some of these people. However for most I suspect it reflects two failures that should be addressable: firstly it reflects a basic lack of financial (mathematical?) literacy among a substantial proportion of the population, secondly it reflects a lack of appropriate basic banking (lending) products, or awareness of those that do exist.

A cynic would say that it is easier for a lender to price (and thus provide) ‘credit card’ debt and so this is what is offered. It is true that credit card risks – being very granular, and widely distributed, and having a relatively long history (through various economic cycles) – are more easily modeled using statistical techniques. Indeed this is why you haven’t seen distress in the market for credit-card backed securities as opposed to mortgage-backed securities: they tend to behave as modeled and so the stress tests used to structure these securities tend to reasonably accurately represent real life losses under economic stress. Indeed, the high interest rates reflect the probability of high expected losses. Looked at from a portfolio point of view, credit card receivables are less ‘lumpy’ and losses more normally correlated and distributed than most other kinds of lending. Of course one of the reasons that mortgage loans cost less and are typically seen as ‘safe’ (or at least safer) assets is that they are secured on real property (and in the case of a primary residence, seen as the first in the queue for repayment as people are loathe to lose their homes.) The problem with this (as is being brought home in spades by events in the US) is that the lender faces two residual risks – one the value of the underlying real property can change (go down) and the transaction costs involved in ‘realizing’ (ie foreclosing: taking ownership and liquidating the property to repay a delinquent loan) are typically very high (it depends on the legal regime and labor costs but these can often be as much as 20-30% of the value of the property, especially for lower value homes.)

So what can be done? Schools, but also financial institutions, need to do a better job of educating their citizens/customers. You need a driver’s licence to drive a car. Perhaps you should have a borrower’s licence to take out a loan? Ok perhaps not – I’d much rather see a market solution, and I suspect there must be a long term commercial benefit to financial institutions who take this responsibility seriously (and not just as a box-ticking exercise under regulatory duress.) Perhaps new innovative start-ups like Kublax will start making a difference in this area.

Next, financial institutions need to pro-actively offer better overall financial solutions to their customers. For most high-street banks however there may be a inherent conflict of interest in promoting more intelligent solutions to credit cards. (Don’t misunderstand me, credit cards are a fantastic product when used appropriately – ie for 20-40 day ‘working capital’ rolling credit, but they should always be paid off in full, or at worst used for very short term cashflow smoothing as per above.) Ideas like the various ‘One’ accounts, which automatically offset deposits with mortgage debts should be extended to consolidate all assets and liabilities. An idea I’ve been thinking about for several years is to create a company that would help individuals manage their personal balance sheet in a professional way. I suspect that the vast majority of people don’t really know what a balance sheet is, and amongst those that do, few think of their own finances in this way, other than perhaps momentarily when applying for a mortgage or writing a will. Perhaps I am naive but I believe the concept of a balance sheet – stripped of jargon and intellectual snobbery – is one that the vast majority of people could grasp if presented in a friendly and clear manner.

Finally, if banks won’t help their customers contract more appropriate debt, I hope more people will make recourse to markets like Zopa for unsecured financing. Aside from getting better rates, participating in a market like Zopa forces people to spend a little time thinking about their balance sheet and how credit markets work (even if they probably wouldn’t articulate in this way.) Zopa is user friendly and welcoming in a way that banks – despite I’ll admit some efforts to improve their public perception – just aren’t.

Of course none of this will help anyone who is bound and determined to spend more than they earn (or more accurately will earn), but I suspect that many of those struggling with managing their finances would welcome a helping hand in having a better understanding of their financial situation and the options available to them.

Next up: taking option theory to the masses. ;)

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Edge finance

Great post the other day on ‘You’ve been noticed’ highlighting how the traditional (centralized) banking paradigm is facing a real alternative for the first time in the modern era (notwithstanding the historical success of credit unions, especially in rural locales; of course these depended on a wholly Web 2.0 concept ;) – community!)

How long before the price of this debt is reduced due to better “Social Ranking”, ie on Rapleaf, or eBay? I think we may be seeing the world of Micro-lending re-engineering the world of traditional lending. Instead of just “Bad Debt”, perhaps people will respond to “Bad Rep”, and pay on time? I mean who wants to look bad in the eyes of friends and colleagues?

Banking has used technology to great effect in terms of making their processes more robust and massively more efficient over the past 2 or 3 decades. Some of these gains have trickled down to the customer, but most have been absorbed by the management and the shareholders. And I’m not just talking in terms of pricing or margins. Indeed much more important in my view is the heretofore missed opportunity to pass on a truely tailored, friendly and understandable customer experience notwithstanding the fact that the technology (and business models) to do so already exist. However it is not hard to understand why such reticence (on the part of the incumbents) exists: they are making money hand over fist (ie if it ain’t broke, don’t fix it), barriers to entry are very high (but perhaps not just quite as high as they think), they have huge financial and psychological investments in the giant mass-production factories they have built (not easy admitting obsolescence) and all the usual human and behavioral impediments to change in large organisations.

Companies like Zopa and Prosper are certainly interesting and deserve to be applauded, but somehow I think they are only scratching the surface. Furthermore it becomes quickly obviously that the regulatory framework is woefully ill-adapted to allow this new paradigm to flourish. (Of course as Ms Perez so eloquently stated in her masterpiece, this is unfortunately par for the course:

…in the first decades of installation of the new industries and infrastructures, there is an increasing mismatch between the techno-economic and the socio-institutional spheres…

It is indeed intuitive when looked at from this perspective, that the (social) inertia of the existing – and previously successful – paradigm acts as the main obstacle to the diffusion of the new paradigm.)

One example (and there are far, far to many to enumerate here) is the strictly national framework imposed. To participate on Zopa, one must be a UK resident. On Prosper, a US resisdent. Whereas in many instances, trans-national communities would form much more interesting and robust markets. And wouldn’t facilitating a natural flow of capital from developed to emerging economies, leapfrogging underdeveloped financial systems to create access to millions (much as skipping fixed-line infrastructure and moving straight to mobile telephony has revolutionized access to communication for much of the developing world) be a fantastic opportunity? I’m not saying it is impossible; but the mindset and starting point of most regulatory regimes is more adapted to a 19th-century world of independent nation states than today’s reality of a massively complex global tapestry of interconnected communities.

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What would c2b financial services look like?

Malcolm Matson observes that a new business paradigm – c2b, consumer to business – is in the acendancy:

This classification of the world into “service/content providers” and “service/content users” lies at the very heart of the obsolete and flawed Cable-TV and telecoms business models. It is what gives rise to their desperate attempt to differentiate ‘bits’ from ‘bits’. Ultimately this is fruitless and doomed effort to make water run uphill, for the liberating impact of these technologies is unstoppable – as end users enjoy the impact of Moore’s Law on the ever more powerful array of “digital creative tools” and as OPLANs begin to emerge around the world, then we will see an explosion of C2B activity – not just at the internet level but locally, within neighbourhoods, cities and communities. The mind can only glimpse through a glass darkly what positive social and economic impact this may have – positive for all of us and quite the opposite for some vested interests that thought their ‘right to life’ was immutable. Bring it on …

Rebecca Blood calls it the dawning of the “age of participatory culture” and the end of the industrial age.

What does a c2b paradigm mean for other industries. Telecoms and media seem to be the focus but if this idea is real (and I think it is) it will certainly have profound implications (and create real opportunities) for other industries, including financial services.

So what might the implications be for financial services? Is it (just) the emergence of peer-to-peer business models? (zopa, intrade, etc.) Is it back to the future with mutual banking or insurance models? Or is there more? I suspect there is, although I’m not so sure that the c2b model in financial services is as intuitively as obvious as it might be in say media and entertainment. It’s certainly something I’ll be thinking about and I’d welcome any views or ideas on this front.

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Peer to peer banking

I haven’t written about these new person to person banking exchanges before, but a recent article in the Economist is as good an excuse as any.

Zopa in the UK and the new Prosper Marketplace in the US are variations on the eBay/Betfair person-to-person business model focussed on lending and borrowing. Zopa likens their business to microfinance only using the internet to create the networks of lenders and syndication of risk needed to make this a viable and attractive proposition. Interestingly on Zopa, you can only lend (I imagine borrow as well but haven’t read the terms) if you are not a “a credit broker or lend money to other persons in the course of any business. “ I can imagine where this idea came from but over time I wonder why an exchange would want to limit or restrict the types of participants on them. Indeed, institutional players can be key liquidity providers with the long tail of individuals setting the marginal price. Betfair is a lot more robust as a marketplace for instance for having a heterogeneous base of users.

Zopa do a very interesting market update however.

Prosper Marketplace has added an additional angle which is to allow customers to form groups of affiliated borrowers that can (in theory) harness their collective trust / reliability to achieve lower borrowing rates – similar to the idea of the traditional credit union or the more modern social network (a la Friendster or LinkedIn.)

It will be interesting to see how these networks develop, but weaved into the tissue of the connected web, it is possible to imagine a day when such exchanges become ubiquitous and the preferred method of dynamically managing credit for millions or billions of users – retail and wholesale – around the world. Clearly there are many many obstacles to overcome but imagine the day when a hedge fund can trade on Betfair using leverage provided by Zopa using PayPal as a payments system…all dynamically managed in real time.

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