The Investor's Consigliere

Soros: "Go for the Jugular"

The Atlantic recounts how the Quantum Fund forced the devaluation of the British Pound.

Moore Capital and Sticky Capital

In his annual letter to Moore Capital investors, Louis Bacon wrote about his fund's new marketing strategy:

Bacon also said it's looking to attract longer-term investors after its performance was restrained by redemptions during the financial crisis.

Moore Capital has a new marketing team, which "has had very good success in attracting what we hope is sticky capital from more institutional investors," he wrote in the letter.

Bacon is a rock star among hedge fund rock stars. His fund has returned over 20% for over two decades. My understanding is that he charges above-market fees and has a long lock-up. If even he needs stickier capital, imagine how difficult it is for everyone else. And how important.

My working hypothesis about attracting sticky capital is that it is a two-part process. The first part involves, as Bacon notes, attracting more institutional investors with a long-term capital base. This is not easy, but it is simple: everyone knows who these investors are. You might think of this as "structural stickiness": that portion of an LP's propensity to redeem capital from your fund that can be explained by the type of investor it is (pension, endowment, fund of funds, high net worth, etc). The way to increase the aggregate structural stickiness of your capital base is to attract LPs in the right categories. Simple but not easy.

The second part of the process is more amorphous and intangible. It is the effort to increase an LP's "non-structural stickiness," which can be defined as that portion of an LP's propensity to redeem capital that cannot be explained by its category. High non-structural stickiness can overcome low structural stickiness. That is, an investor in a category known for being flighty can sometimes be your most loyal investor. Consider Warren Buffett's father-in-law:

"Doc Thompson was the kind of guy, he gave me every penny he had, basically. I was his boy."

That was in 1956, and it worked out well. Non-structural stickiness is a function of persuasion, positioning, and underwriting.

I've created a new category called "The Search for Sticky Capital" in which I plan to explore these issues further, the search for both structural and non-structural sticky capital. I will explain what I mean by "persuasion, positioning, and underwriting." The presence of sticky capital is a significant source of competitive advantage for a hedge fund, so the ability to attract it and create it is crucial.

I confess I am a novice in this area, so I welcome any thoughts you may have.

P.S. On the flip-side, from the perspective of a prospective investor in a hedge fund, sticky capital is also very important. You want to spend time learning about how a fund goes about increasing the stickiness of its capital, both structural and non-structural.

Charlie Munger Slate Essay

Charles Munger of Berkshire Hathway writes a sobering parable.  This may be the main disagreement between him and Warren Buffett.

Disclosure: Long Berkshire Hathaway.

Burlington Northern (BNSF) / Buffett Interview Transcript

Matthew Rose, CEO of Burlington Northern Santa Fe Corporation, which is about to be bought by Berkshire Hathaway, conducted an in-house interview with Warren Buffett about the pending acquisition.  BNSF filed the transcript of the interview as a 425.  This excerpt in particular planted a little seed in my head:

MKR:  Okay, next question.  In 10 years, how will you evaluate the acquisition of BNSF, whether or not it's been successful?

WB:  Well, I -- I'll measure it against my own standard, which is that I have made a bet on the country doing well.  And if I'm wrong on that, that's my fault and not anybody at BNSF's fault.  But i will look at how it does compared to other railroads.  I'll look at how railroads are doing versus trucking and all of that.  But in the end, I don't really worry about that very much.  I, I've seen what's been done here.  I think I know how the country is going to develop.  I think the west is going to do well.  I'd rather be in the west than in the east.  So I really don't have much of a worry about that.

That last little part caught my attention as I stared out my window towards the east side of Manhattan.  Why does he think the west will do better than the east?  It's a multi-decade grand thematic kind of question, not the business-specific kind Buffett usually addresses.  And I'm not sure how easy it is to predict these kinds of things.  I doubt many in 1979 were predicting that New York, then near-bankrupt, would soon re-emerge as the capital of the universe.  On the other hand, as early as the late 1960s political scientists were forecasting a population shift towards the Sun Belt, and that turned out to be true.  Maybe Buffett's prediction is a continuation of that prediction.  Maybe it's a prediction about the continued rise of China, or it has something to do with being long commodities.  I don't know.

I come from a people who like to wander.  Sometimes we've chosen to wander and sometimes others have chosen for us, if you know what I mean.  I was born in a different country (Australia) than my sister (South Africa), and we were both born in different countries than our parents (Israel and France), who were themselves born in different countries than their own parents (Lithuania, Translyvania, South Africa and South Africa again).  But we arrived in the Unites States when I was about three and except for thousands of trips across the Hudson River and back, we've more or less stayed put ever since.  Until recently it never occurred to me to live anywhere else.

But if you come from a family like mine, and you're interested in how to preserve and grow wealth over long periods of time, then you know that neither money nor people can count on staying put forever. 

Disclosure: Long Berkshire Hathaway

Warren Buffett New York Times Op-Ed

The last one urged people to "buy American" stocks.  This one is a warning about the side effects to be expected from the extraordinary fiscal and monetary measures that have been taken to turn around the economy.

A little background:  Buffett's father Howard was kind of a psychopath about inflation--he thought FDR would turn the US into the Weimar Republic.  His son was never as bad, but throughout his career the specter of inflation has always guided his investment decisions.  In 1977 he wrote an essay for Fortune called "How Inflation Swindles the Equity Investor" which is the best analysis of the effect of inflation on corporations I've ever read.

Buffett almost guarantees that one day the United States will face higher inflation as a result of the actions being taken.  Yet here we sit with the 10-Year Treasury yielding 3.53%.

P.S.  Some might argue that this op-ed conflicts with the last op-ed he wrote, in which he urged Americans to buy equities.  If we're in for inflation, stocks will do poorly, like they did in the 1970s.  But read the first op-ed closely and you'll see that Buffett recommended only that Americans buy equities as an alternative to cash, which is perfectly consistent with his thinking in the second op-ed.  In fact, if you fear inflation your money may be best off in equities (public or private, in the sense of being a business owner), even more so than gold.

Disclosure: Long Berkshire Hathaway

P.P.S.  If you're a member of SumZero, you can see my write-up of a stock I think will do well in an inflationary environment.

Charlie Munger FT Profile

Read it here.

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 . . .

Double Addendum:  Check out this Fortune profile of Andreessen, perfectly timed of course.  If getting your name front and center in the press and creating a strong public persona is one of the ways an upstart VC firm can compete with the big incumbents, then Andreessen has that part of it down to razor sharpness.  The article offers some other answers to my question begged above (how can Andreessen compete with the incumbents for the extremely limited supply of good deals), namely:

• With his own money, Andreessen has been an active VC in the past few years.

• Mildly contrarian specialization:  The new fund will be net-centric.  "No clean tech, no rocket ships, no electric cars, No China or India."

• Technology and software have greatly driven down the cost of starting a tech company.  However the incumbent VC firms, which serve institutional investors, by mandate must invest large amounts.  In fact, per Andreessen, "Most VC firms don't see a high number of deals," which he defines as just five to 10 companies a day.  So Andreessen has less competition in trying to find and fund one of the magic 15 in the early stages.

• Entrepreneurs and their venture capital investors should be like the Farmer and the Cowman, but they're not.  As an enterpreneur himself, Andreessen hopes to bond better with his investees.

Triple Addendum:  Marc, please bring back the old archives of your blog.  Please . . .

Quadruple Addendum: There is another reason for someone like me to study venture capital (the first being that I'm trying to see if I can evaluate a VC fund):  In venture capital, the ability to evaluate individuals is key.  The CEO of a startup will impact its success much more than the CEO of Coca-Cola, for instance.  The same holds true for manager selection in general--a hedge fund has little competitive advantage beyond the individuals who work there.  So by studying how the best venture capitalists evaluate individuals, I hope to learn a few tricks that can be applied to the rest of what I do. 

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."

Seen in its proper light, a REIT like Vornado already contains aspects of a PE fund--call it a "public equity fund."  Existing shareholders, most notably management, are constantly raising outside money to do deals with positive expected values.  If the deals work out, some of that value goes to the new outside money, but a lot also goes to existing shareholders.  That's why the value per share of Vornado has historically increased at such a high rate, and the further you go back the better their record is.  Because the new capital they constantly raise has been invested in good deals, some of whose value has flowed to existing shareholders.

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)