The Investor's Consigliere

Marc Andreessen on the Venture Capital Industry

One of my current projects is to learn about the venture capital industry.  Specifically I want to answer this question:  Can venture capital investing be practiced in accordance with value investing principles as I define them?

Marc Andreessen is a very successful entrepreneur who has recently "moved to the dark side" and raised a venture capital fund.  In this Tech Ticker interview he speaks candidly about how the industry actually works.  Novice student that I am, I tried to take good notes:

1)  On purpose, the fund is designed to invest anywhere between $50,000 and $50 million per deal, meaning it has the flexibility to invest in early stage to late stage companies.  Unstated message: most venture funds are too rigid in their mandates.

2)  The data say that in any given year there are only about 15 funded companies that will ultimately reach $100mm in annual revenues.   These companies end up accounting for something like 97% of venture capital returns (!).  Unstated message:  If a VC fund can't get into these 15 deals, it has very little chance of delivering strong returns for the above-average risks it takes. 

(As an aside, consider these political economy thought questions:  It's often said, by people like Tom Friedman, that the United States' large venture capital industry is one of its greatest competitive strengths, since it promotes the formation of the great new companies that provide the jobs of the future and raise living standards, etc.  If Andreessen's point above is true, however, is Friedman's argument true?  According to the Economist, "VC funds have been investing, on average, a whopping $26 billion a year in start-ups since 2004."  From society's point of view, does investing $26 billion a year (plus billions of the best and brightest person-hours we have) to produce only 15 "successful" companies represent a good return on society's resources, the necesssary price of creating the next Googles?  Do we need to break that many eggs to make a few great omelettes?  Or, is our VC industry perhaps TOO large, which implies that the true source of America's advantages in innovation lie elsewhere.  Note to self: read this book and reread this book to learn more.)

3)  The job of the VC investor must be to be able to invest in one or more of those 15 companies.    That's the point of having the flexibility to invest across all stages.

4)  To call venture capital an "asset class" is a misnomer, because only about 10 to 20 VC firms earn very good returns, and the rest of the 780 or so don't beat the S&P.  The dividing line is who is able to identify AND get into the best deals, the magic 15.  Andreessen thinks his firm can be one of those firms.

5)  Many VC firms will go under--most likely hundreds.  But the top 10 or 20 firms will do well and deliver pretty good returns.

6)  Ideally the founder of a VC investee goes onto become an effective CEO.  That's how you get the big wins.

7)  Much less ideally is when the founder doesn't want to be the CEO, because that introduces a gigantic element of risk--hiring a CEO is an extremely dangerous proposition and usually fails.

Here is my question:  If you were a "venture capitalist in venture capitalist firms," how would you go about determining which of the 800 VC firms in the country have the ability to be among the top 20 that justify their existences?  My sense is that the strongest determinant of the ability to get access to the best deals of tomorrow is the ability to have gotten into the best deals of recent years.  There is a "rich get richer" effect in VC that makes the top firms very good businesses.  Which begs the next question?  Why does this effect exist?  I'll save my speculations for another post.

It also begs another question:  If incumbent VC firms have such an advantage, why does Andreessen believe his upstart firm has a shot at breaking into the club?

Lots to learn . . .

Addendum: I recently had lunch with a person in the VC industry who made another point that furthered my education.  He believes that a necessary element of a good VC fund, an element that is difficult for large institutional investors to stomach, is the ability to tolerate and even encourage great flexibility in the evolution of startup companies.  Just as no battle plan survives the first contact with the enemy, no startup business model survives first contact with commercial reality.  It's almost a rule rather than an exception that a startup will radically alter its original business model early on in its life, maybe more than once.

Now that I'm involved in a startup project of my own, I think about this stuff often these days . . .

Vornado's New Private Equity Fund

The WSJ reports that Vornado Realty Trust is seeking to raise a $1bn distressed real estate fund to use as its "exclusive vehicle for real-estate and real-estate-related investments." 

The article wonders why a publicly-traded REIT like Vornado would choose to raise money from private investors rather than in the public market.  To do the former, the article argues, "risks dismaying shareholders who hoped Vornado would use its investing expertise to do deals on its own balance sheet," and quotes Mike Kirby of Green Street Advisors as follows:

Most smart observers feel like the cheapest capital for the next few years is going to be in the public market, not the private market.

I guess the real question is: cheapest capital for whom?  For companies themselves--ie existing investors--or for new investors?

As a publicly traded entity, Vornado's management has a duty to its existing shareholders, which includes the duty not to dilute them.  As a REIT, even in good times it is capital-constrained, because by law it must distribute at least 90% of its taxable income as dividends.  To do deals and grow it must constantly raise money, both debt and equity, and if you read Vornado's annual letter, chairman Steven Roth often praises Wendy Silverstein (Executive VP-Capital Markets) for her ability to do that.  If a company has a duty not to dilute existing shareholders, yet must also constantly raise new money, with every new capital raise it must ask itself "Does this new capital create value for existing shareholders?"  In its long history, Vornado has shown that its answer to this question has mostly been "yes."

In times of distress/opportunity a company like Vornado is even more capital-constrained.  It sees many more deals it wants to do than it has capital to do them with.  The "traditional" solution, to just raise new equity, is unattractive because Vornado's stock is down.  My strong guess is that Vornado has concluded that any equity raise at current prices would be too dilutive to current shareholders--it would allow new shareholders to buy into Vornado's existing portfolio of assets at a bargain price, and at the expense of existing shareholders.  So it has opted for an untraditional solution, raising private money in a PE fund structure, maybe even at 2 and 20, to give it the capital it needs to do all the deals it will want to do. 

How can raising money in the private market at 2 and 20--where investors literally pay up front for the privilege of being able to invest alongside Vornado's management team--be more expensive than raising new public equity, with the stock down over 50% from its highs and where Vornado would itself have to pay almost 9% in dividends as an inducement?

I think Vornado is simply doing its job here, and doing it well.  If I were a Vornado shareholder I would not be "dismayed," I would be happy.  If I were an institutional investor being pitched Vornado's new PE fund, the smart thing to do might be to say no to the fund and simply invest in the stock.  Most institutional investors are not set up this way though--they decide in advance "We're going to allocate X to 'distressed real estate opportunity funds'" and don't have the flexibility to invest in a potentially superior mousetrap that targets the identical asset class.  You might say Vornado is making an institutional rigidity arbitrage bet here.

Disclosure: No Position (yet)

My Hiatus

I apologize for the many weeks without posting.  I have two good excuses:

1)  The thyroid gland (or the organ formerly known as my thyroid gland) is a cruel mistress.

2)  I've been working on a new project, a commercialized brand extension of the blog.  Commercialized means I'm going to try to make money off of it.  Stay tuned.

Shout out to the doctors and nurses at Mt. Sinai Hospital in NYC, especially KW, DA, RH, MD, that nurse who chased me down to say they were ready for me in the OR, and the other nurse who let me use the phone. 

Dolly Parton 60 Minutes Profile

Harvard Business School won't do a case study on her, nor will academic psychologists of success and successful entrepreneurship, and if you live in New York or have an MBA she may be something of a joke to you.  But Dolly Parton is the best businesswoman/entrepreneur/entertainer in America--better than Martha Stewart, better than Oprah, better than anyone in Corporate America. 

This 60 Minutes profile barely scratches the surface. 

Update: A profile from FT Weekend

Bill Gross vs. the Harvard/Yale Endowment Model

William Gross of PIMCO says they may need to reduce their famously high allocations to illiquid asset classes.

Upcoming Natural Experiment in the Beer Industry

Long-time readers (Hi Mommy!) know I've written about the beer industry a few times in the past.  The idea is that in order to evaluate investors, you have to be able to evaluate their investments, which means you have to know a little about business.  One business that's fun to know about is the beer business.  Check out the oeuvre so far, there's no quiz at the end:

Thai Bev

Beer and Mongolia

BUD and Economies of Scale

More on Beer

Jim Koch Interview

Now check out this NYT article about Beer Lao, which enjoys 99% market share in its home market of Laos.  Beer is not indigenous to Laos, so I don't think it's the main source of liquid nourishment, nor does the country have a history of German immigrants who started their own breweries (like Argentina for instance).  It's basically for the tourists (the ones in the photo look Australian but my physiognomy is a little rusty).  Nor, the claims of Mr. Cheung notwithstanding, does it taste any different than the many other rice-based lagers sold in hot countries--trust your consigliere on this.

Nonetheless, Beer Lao is embarking on an ambitious project to expand abroad, based mostly on its cool factor.  As the above posts demonstrate, the beer market in any country tends towards dominance by a very few players.  That does not mean that an upstart cannot make huge inroads, or even topple the leader--it happend in Thailand.  I suspect that's not what Beer Lao is trying to do here though--I think it's going for a guerrilla strategy (is that a horribly insenstive pun given the country's history?) of stealing little bits of market share in those countries with huge beer markets (US, Germany, Britain, Japan) or countries whose citizens have, or are starting to have, an ethic of travel abroad (Israel, China).  Even that's hard though--Ambev tried and failed to take Brahma beer from Brazil to the rest of the world.  And Brazil, in my humble opinion, is even cooler than Laos (or if you prefer, Exhibit B.  There is an Exhibit C but this is a professional blog . . .).

Anyway, it's an interesting natural experiment.  Keep an eye on Beer Lao's progress, and also watch how its competitors react.

The Hedge Fund 100

In the WSJ.

Great Seth Klarman Interview with TIFF

Thanks to the Manual of Ideas for finding this one.

Michael Lewis Reviews The Snowball (and Warren Buffett)

In the New Republic.

I don't want to write a long review of a very long review of a very, very long review of Buffett's life-that's too much reviewing.  I will say two things though:

1)  Lewis and Buffett have a weird history.

2)  Lewis is a genius at narrative storytelling.  This genius works best in fiction because in fiction you get to make up the facts, and you get to make it "life with the dull bits cut out" as Hitchcock said.  In business non-fiction, however, you don't have those two luxuries.  You have to get your facts straight, and you can't completely discard the dull bits--the counterarguments, the caveats, the things that are sort of true but not 100% true--just to burnish the luster of the story, the way a diamond cutter discards much of a rough diamond to create the perfect polished stone.

For instance, in his attempt to draw a distinction between Ben Graham and Buffett, and to make a larger point about the Great Depression, which produced Graham's worldview, and the post-WWII era, which produced Buffett's, Lewis writes the following:

Benjamin Graham was in many ways very different from what Warren Buffett was destined to become. Graham's experience of the Great Depression had instilled him with pessimism. He eschewed judgments about the future prospects of a company or an industry, and instead looked for bargains in the here and now--companies that were trading below the value at which they might be liquidated. Graham was "looking at businesses based on what they were worth dead, not alive," as Schroeder puts it. Cigar butts, he called these.

Cigar butts obviously appealed to Buffett, but Buffett's investment career was destined to coincide with a very different period in American financial history. There never was a better time and place to make money from optimism than in the American stock market since World War II. Had Buffett confined himself to the gloomy business of plucking wet smelly cigar butts off the ground, he would never have become Warren Buffett. And Buffett was built differently than Graham. He had emerged from his childhood both a pleaser and an optimist. Dale Carnegie's How To Win Friends And Influence People apparently made a deep impression on him. When he looked at a company, he saw not just its asset value but also its possibilities.

Buffett's first big bet was on a then obscure insurance company called GEICO. GEICO was not, by Graham standards, a bargain: it traded at a price above the value of its assets. But Buffett dug down into the business, saw how fast the company was growing, and, as Schroeder writes, "felt confident of being able to predict what it would be worth in a few years. ... A less Graham-like analysis could hardly be imagined. Graham's 1920s bubble and Depression experiences had made him suspicious of earnings projections. But Warren was betting three-quarters of his patiently acquired money on the numbers he had calculated."

None of the above excerpt is false, but there is one hole in it:  When Buffett bought GEICO, which to Lewis represents the mythical break of the student from the master, its chairman and largest shareholder was . . . Ben Graham.

One more example:  Trying to cast the present financial crisis as a kind of final commeuppance for Buffett in his old age, Lewis writes:

Which brings us, oddly, to our present financial crisis. There has never really been a bad time in the last fifty years to be Warren Buffett, but just now would seem to be less favorable than most. If Buffett still measures his life by the book value per share of Berkshire Hathaway, then for the first time in forty years he must feel like a wasting asset. His share price is still off more than 40 percent from its highs, underperforming even the S&P 500. He railed against derivatives as weapons of mass destruction, and now turns out to have been sitting on a $68 billion pile of credit default swaps and exotic put options on various stock market indexes. And having vowed never again to become entangled in a big Wall Street investment bank, he has gone and sunk $10 billion into Goldman Sachs, a virtual re-enactment of his investment in Salomon Brothers--cash for reputation. The difference this time is that he has gotten himself a sweeter deal than not merely ordinary shareholders, but also the U.S. Treasury . . .

Thus she leaves open the possibility that Buffett might have gone a bit soft in old age. "Basically, when you get to my age," she quotes him telling a group of business school students, "you'll really measure your success in life by how many of the people you want to have love you actually do love you. I know people who have a lot of money, and they get testimonial dinners and they get hospital wings named after them. But the truth is that nobody in the world loves them." Where there was once only the time value of money, there is now also the time value of love. My God, he's even given his fortune away!

In short, there has never been a better time to bet against Warren Buffett.

First of all, the excerpt is misleading and wrong on the facts: 

1. When you write that Buffett measures his life by the book value of Berkshire's shares, and in the next sentence state that the stock is off 40% from its highs, you create the impression in the jury/reader's mind that the metric by which Buffett measures his life is down a whopping 40%.  Not true: Berkshire's book value declined by only 9.6% in 2008 vs. a decline of 37% in the S&P.  This 27.4% outperformance, you can read on the first page of Berskhire's annual report, has been bettered only six times in Berkshire's history with Buffett in charge.
2. How is Berkshire "sitting on a $68 billion pile of credit default swaps and exotic put options on   various stock market indexes"?  I don't know where that number comes from.  And if it's the      notional value, Lewis should know that overstates the liability to Berkshire.
3. Buffett has not "sunk $10 billion" into Goldman Sachs.  He has sunk $5 billion into Goldman        Sachs and received warrants to purchase an additional $5 billion.

Secondly, I don't know how anyone can agree with the impression Lewis wants to create, that the financial crisis plus Buffett's age means "there has never been a better time to bet against Warren Buffett."  If you're the world's greatest value investor, and asset prices are way down all over the world, and you have bilions in cash and borrowing capacity to deploy, and Berkshire's stock is down, maybe it's actually a pretty good time to bet on Buffett.

Neil Barsky of Alson New York Times Interview

He's closing his hedge fund.

Update:  Here's a web Q&A Barsky did with the Freakonomics blog.