Venture Populist

Senator Chris Dodd looks determined to leave his last term in office with a dubious legacy – his sponsorship of the Restoring American Financial Stability Act of 2010  which passed the Senate Banking Committee on a party-line vote  on its way to the House floor.

Dodd’s 1,336-page reform bill seeks to address the timely and substantive need to police abusive and unfair terms for mortgages and other financial products, the “systemic risks” inherent in derivatives such as credit default swaps, as well as, the use of leverage by tackling the “too big to fail” issue. Of course this comes after the barn door has been open and all the horses have fled, and many will argue that The Street will inevitably develop new instruments to challenge the new regulations and oversight…but that’s another problem.

In the over-reaching spirit of not letting a good crisis go to waste, Dodd’s bill also seeks to fix what’s not broken with provisions that asphyxiate investment in startup ventures and subsequently stifles what has historically been the most sustainable source of new job creation during a period of hopelessly high unemployment.

Dodd proposes adjusting for inflation the income and net worth requirements for a person to be considered an “accredited investor” by the SEC under the 1933 Act. If this were to occur it will materially decrease the pool of private capital that is available to finance new companies, and in turn, innovation, job creation and economic growth.

Presently, an individual must have a minimum net worth of $1 million or an annual income of $200K to be an accredited investor. Although the reform bill does not identify the proposed multiplier to adjust these numbers, it is fair to assume that an inflation adjustment approach (based on CPI) is likely which would raise the 1982 mandated $1 million dollar net worth threshold to approximately $2.25 million and the individual annual income threshold to approximately $450,000.

Applying a $450K income threshold to the latest IRS tax return data, the number of accredited investors would drop approximately 77%, from 4.5 million individuals who earned $200K or more to a little over 1 million. That’s a material decrease in the pool of available “angel” capital.

A 2008 study of accredited investors based upon data reported in the 2008 Statistical Abstract of the United States by business demographer Paul Reynolds found that only 10.5% of accredited investors had made a private venture or angel investment in the prior three years. Adjusting that data for the increased thresholds implied under the Dodd bill reduces the number of likely angel investors to between 121,000 and 174,000 individuals…devastating.

We can debate forever the wisdom behind an over-inclusive system that uses personal wealth as a proxy for investment sophistication. Yet, many others (myself included) would maintain that the accredited investor standard prevents those with adequate access to information, or experience, or due diligence skill, or sector expertise, or entrepreneurial spirit or emotional tolerance for risk to embrace the potential asymmetrical upside of private venture investment. (What would you expect from a Venture Populist?)

I agree with the recent opinion expressed on this subject by digital strategist Alex Alben in the Seattle Times…”more investors today have access to financial information and filings through electronic databases than ever before. The old notion that only wealth buys access to financial information is increasingly quaint in our digital age. The financial crisis of 2008-09 was not precipitated by millionaires losing money in private placements…the monetary amount should not be a moving target, changeable at the whim of the SEC… Both houses of Congress should pass a bill with meaningful consumer protection and bank oversight, but not harm privately funded startups in the process.”

I would also add that if the current administration is so intent on identifying the $200,000 income level as “the rich”…as those capable of taking on a greater financial burden in the form of higher taxes, shouldn’t those same individuals continue to have the right of access to private equity and venture capital transactions, the asset class that has historically delivered investors the highest returns?

Rich enough to tax should at the very least mean rich enough to invest.

Personally, I believe the accredited investor thresholds as they are applied to investments in early-stage businesses are arbitrary, under-inclusive, undemocratic, discriminatory, and unnecessarily restrict innovation, economic growth and new job creation. All individuals should be allowed to invest in new businesses. The current rules should exempt venture capital.

But the most that you can ask of a regulatory regime is too simply leave the current law alone. It’s may not be ideal, but it certainly is not broke. Dont’ fix it. Let it be.

Album:   Let It Be, The Beatles, 1970

Popularity: 3% [?]

Contrary to conventional cliché, there is very little that is binary about venture investing outcomes. It is not just feast or famine. Rather, outcomes are diverse and asymmetric. You can lose your entire investment, just lose a portion, break even, receive periodic distributions producing double-digit IRRs or achieve exits at 5X, 10X, 20X multiples or greater on your initial investment.

What does appear to be binary is the manner in which prospective investors in private ventures perceive the asymmetric return profile of venture investment outcomes….most either adore it or abhor it.

On one hand, an investor like Jim Rogers is attracted to what he no doubt views as a positive asymmetric profile of venture investment outcomes. His venture acumen began developing at the age of five by selling peanuts and by picking up empty bottles that fans left behind at baseball games. In 1970, he co-founded the Quantum Fund. During the following 10 years the portfolio gained 4200% while the S&P advanced about 47%. Nice.

In a recent rant Rogers opined not only that “diversification was garbage”, but also went on to say that “you only need four or five good ideas in your life to get really rich”.

(Note that Rogers says “really” rich…which seems a bit elitist seeing as how only one or two good ideas can make one simply rich.)

Nevertheless, 90X returns over the S&P implies that he had very little fear of placing losing bets.

But what about those less adventurous souls that eschew positive asymmetric return scenarios in favor of more traditional investments with binary and symmetrical outcomes? Why are there so few angel and venture investors despite the compelling data of the asset class’ returns and the proven history of private enterprise as the single greatest creator of family wealth?

Economics psychologist Daniel Kahneman explained this behavior with his 1979 nobel-winning, Prospect Theory which describes decisions between alternatives with uncertain outcomes where the probabilities are known. In prospect theory, Kahneman identified Loss Aversion–people’s tendency to strongly prefer avoiding losses to acquiring gains. In fact, studies suggest that losses are twice as powerful, psychologically, as gains.

In their perpetual pursuit to mirror the risk-free rate of return, some investment advisors are factoring prospect theory and loss aversion into their asset-allocation schemes. But loss aversion studies opposing symmetrical outcomes…such as either winning $100 or losing $100. It provides little insight with respect to investor’s fear of positive asymmetric return profiles.

I prefer the wisdom in David Gal’s 2006 study, A Psychological Law of Inertia and the Illusion of Loss Aversion, which discounted loss aversion as “superfluous” and found instead that risk/return tradeoff decisions were decidedly “influenced by a tradeoff between the status-quo and change”. Gal calls it inertia, noting that that people will tend to remain at the status-quo when they have no clear preference between the status quo and an alternative option.

The rigid portfolio allocation to the same traditional asset classes within the same stale strategic asset allocation model is the status quo that Gal is referring to. The results have been far from compelling yet most investors, and their advisors, keep doing the same thing while expecting different results.

In a recent WSJ article, Jason Zwieg accounts for this “mental lazziness” that prevents  investors and advisors from challenging their status quo approach to investing (and consequently, not embracing alternative asset classes and strategies). “In short, your own mind acts like a compulsive yes-man who echoes whatever you want to believe. Psychologists call this mental gremlin the confirmation bias…people are twice as likely to seek information that confirms what they already believe as they are to consider evidence that would challenge those beliefs.”

Try Harder. Properly allocated, private equity and venture investments can materiality improve a portfolio’s risk/return tradeoffs and benefit from the proven superior performance of the asset class. But, expanding your repertoire by opening your portfolio to private investment opportunities requires commitment and effort to educate yourself on the rules of the engagement and evaluation.

Achieving superior returns by embracing private investment requires initiative…not inertia.

Album: Underachievers Please Try Harder, Camera Obscura, 2004

Popularity: 8% [?]

There is a better way to build investment portfolios than the methods presently employed by most investors and advisors.

Perhaps that is hard to imagine seeing as how well we have been served by Modern Portfolio Fallacies and the Efficient Market Hypocrisies, but if you have an open mind, there is a strong chance that these portfolio construction principles will resonate with you…particularly on the heels of what we have learned from the half dozen market meltdowns experienced since ‘87.

I know that the idea of a new asset-allocation model is intuitively tiresome…but if there was ever a time to revisit the prevailing conventional wisdom, it is now. This smarter portfolio approach places heavy emphasis on safety of principal, liquidity and income, yet simultaneously provides investors with compelling potential for capital appreciation.

I refer to it  as Hybrid Portfolio Theory (HPT) and could safely say that less than one percent of advisors have contemplated, let alone implemented such a methodology in their practice…despite its proven efficacy and how well it resonates with high-net-worth investors.

In HPT the investor allocates 100% of the assets into two distinct (hybrid) portfolios. The larger portfolio (A) represents 75-90% of the assets and is invested with the primary objective of liquidity, safety of principal and income. This portfolio is benchmarked against a blend of risk-free and short-term yield rates and invests predominantly in money markets, CDs, short-term muni’s and Treasuries.

The challenge of portfolio A is to maximize yield in bps and increase yield to the point that does not threaten the overall liquidity and safety of principal. With liquidity and safely of principal as primary objectives, that effectively eliminates allocations to high-yield corporate and junk bonds, REITs, MLPs, closed-end and utility stocks by the literal-minded HPT practitioner.

Why Bother with Stocks?

So, what is the source of return for capital appreciation in HPT? Not traditional equities. Stocks go up and stocks go down. That’s a symmetrical outcome that we now know empirically to be a bad bet unless you have a multi-decade investment horizon. Rob Arnott’s recent article “Bonds: Why Bother?” in the Journal of Indices emphatically settled the score.

Arnott proved that the 5% risk premium promoted by the financial services industry is at best unreliable and is probably little more than an urban legend. Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009. Going back 40 years to 1969, the 20-year bond investor still outperforms by a marginal amount, even with the Carter-era inflation and traumatic bond market in the seventies.

It is not debatable. Equities have not delivered their risk premium and are simply not worthy of their risk. Rather than pursing the laughably unreliable risk premium of equities, Portfolio B is exclusively seeking higher risk–higher return positive asymmetric outcomes (PAO). The Portfolio B benchmark is in the 10-20% range.

A PAO is defined by its ability to generate high double-digit or multiples of return on investment, as can be achieved by successful investments in venture capital, private equity, direct (angel) private investment in start-ups, small business, private manufacturing business, private real-estate, private debt, franchises, operating cash-flow businesses, as well as, publicly-traded emerging growth companies and leveraged option strategies or highly-specialized investment strategies such as managed futures.

The PAO mandate is broad but should ultimately be defined by a positively skewed risk-reward ratio, as well as, the practitioner’s sector expertise and due diligence resources.

The investor’s overall hybrid portfolio benefits by assuring that the vast majority of assets are not exposed to a downright bad wager relative to risk-free or short-term assets, as well as, unpredictable (yet, frequent) black swan events that decimate investor portfolios.

HPT should be engaged and implemented as a theory, not as an absolute rigid asset-allocation model. If the portfolio manager, advisor or investor accepts that; 1) current asset-allocation frameworks cannot successfully mitigate significant market exposure and do little to protect investors from unpredictable negative black swans, 2) investors are generally over-exposed to equities in light of the proven absence of any sustainable risk premium, and, 3) investors benefit from limited but diversified exposure to investments and strategies characterized by the possibility of positive asymmetric outcomes…this is a portfolio theory that you can adapt into your other core asset-allocation principles and values.

When adapting HRT to your own biases, the allocator can exercise discretion with respect to;

1. The A:B Portfolio ratio
2. The constituent opportunity set for Portfolio A–from short-term high liquidity, lower-yielding, shorter-term instruments to Treasurys, TIPS and munis
3. The consitutent opportunity set for Portfolio B–from private venture investments to publicly-traded emerging growth companies to specialized trading and option strategies
4. The benchmarks applied to the A and B Portfolios

Today, investors more than ever appreciate and welcome the notions of safety and liquidity. They no longer believe in the buy-and-hope asset-allocation models and “stocks for the long run” mantras peddled by talking heads. Moreover, the coveted HNW-investor demographic that you either aspire to, or presently serve understands and accepts the risk and liquidity realities of private investment in venture and enterprise. In fact, in most cases, such investment or employment is how they generated their private wealth.

Assuming the proper resources, advisors that embrace Hybrid Portfolio Theory (for appropriate investor portfolios) your advisory practice would benefit by;

• Delivering the services, results and sensibility that desirable HNW investment clients are actually seeking from advisors,
• Protecting your client’s assets and portfolios from incurring significant losses from exposure to unpredictable black swan events,
• Strengthening advisory-client relationships by developing a unique and connected client community within your practice, and,
• Competitively distancing your practice from the vast majority of investment advisory firms that can provide no evidence of a discernible value proposition.

I understand that this sounds provocative considering what investors and advisors have come to believe in after years of over-attentive care and feeding by the financial services industry. Yet, if you acknowledge the historical data,  the frequent and unpredictable impact of negative black swans and the notion of investing for positive asymmetric outcomes ,you should not be questioning the virtues of HPT as much as the critical issues of; access to the opportunity sets, due diligence, implementation and execution of the strategy.

Stick with us as we intend to tackle those issues in coming posts.

A more detailed Powerpoint presentation and audio webinar on HPT is available here.

Album:    Hybrid Theory, Linkin Park, 2001

Popularity: 100% [?]

The Black Swan by Nicholas Nassim Taleb holds its own among the most important investment books ever written. In it, Taleb argues persuasively that any sensible long-term strategy in a world dominated by extreme and unpredictable (black swan) events has to accept, and even embrace, that very unpredictability. It is poignant and timely advice for any investor and a must-read for investment professionals.

I met Taleb for lunch at Bice in NYC one afternoon about three years ago while I was heading Alternative Strategies for an investment management firm. I was interested in exploring the idea to engage Taleb as a sub-advisor for an investment fund that we were contemplating. I found him to be personable, enthusiastic, engaging and surprisingly modest.

I had read and re-read Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life before our meeting and I was looking forward to discussing his contempt for investment managers that sell themselves on their track record…a cynicism that I shared. But Taleb had just finished his final draft manuscript of The Black Swan and directed our discussion towards his treatise on asymmetric outcomes-the central theme of the unpublished tome that he brought along with him and referenced throughout our visit.

The notion of asymmetric outcomes, “I will never know the unknown since by definition it is unknown. However, I can always guess how it may affect me, and I should base my decisions around that”, causes Taleb to advise to seek out (investment) situations “where favorable consequences are much larger than unfavorable ones.”

That is a central tenet of Venture Populism and my advocacy of committing a portion of an investor’s portfolio to private venture-oriented investments. Like Taleb, I believe that effective investment portfolios should contain meaningful (and appropriate) exposure to positive Black Swans-such as private equity investments in emerging ventures and distressed companies.

In posts to come I will expand on this premise and propose a provocative new model for portfolio construction that balances the investor’s need to mitigate the asset-depleting impact of negative black swan events with simultaneous allocations that benefit from the potential of positive Black Swans and asymmetrical outcomes.

Many advisors now concede that Modern Portfolio Theory, traditional asset-allocation and buy-and-hold investing models have failed and investors are looking for improved approaches that preserve capital and manage unexpected risks more effectively without giving up on the prospects for capital appreciation.

The Black Swan is indeed a brilliant and provocative work. As the New York Times review summed, “It concerns the occurrence of the improbable, the power of rare events and the author’s lament that in spite of the empirical record we continue to project into the future as if we were good at it.”

We expect all swans to be white and are shocked when a black swan swims by…the same way that we were lulled into complacency with flawed risk management models and were then shocked when the market fell 50% and erased away trillions of wealth.

Investors and their advisors can build better portfolios that are for the most part insulated from the impact of negative black swan events, yet have simultaneous exposure to asymmetrical risk/return opportunities.

Album:   The Black Swan, Story of The Year, 2008

Popularity: 60% [?]

An opinion poll that is currently posted on Investment News asks advisors, “Do you think the market downturn has created a lost generation of investors?”

It is a thought-provoking question as investors of all ages (and ironically, of all risk tolerances) have seen portfolios reduced by as much as one half of their peak value. Have these investors lost a generation of opportunity that they can never recover?

The answers tallied thus far are as provocative as the question and may suggest a lost consciousness among many advisors. Surprisingly, approximately half of the respondents thus far disagreed with the notion of a lost generation of investors despite the fact that some of their own clients have incurred substantial losses that are not likely to be made up prior to retirement.

These advisors are naively optimistic, in denial or merely oblivious. Either way they are doing a disservice to their clients and their practice. By ignoring the mistakes of their recent past they are destined to repeat them. In the past dozen years they have seen several black swans with their own eyes yet they still manage assets as if all swans were white.

A slight majority of advisors are indeed aware of the irrevocable nature of some investor’s losses. As one advisor posted on the opinion poll’s comment boards with respect to a hypothetical 68 year-old investor losing half of their portfolio’s value;

“Based on the annualized returns of a 60/40 portfolio over the past 15 years (5.44%) it will take your client ~13 years to recover what he/she had 18 months ago, IF the annual average return was to resume at 5.44% tomorrow. IMHO it’s quite likely that John or Jane will NOT return. And if you use the 0.19% annualized that a 60/40 has returned over the past 10 years, try explaining to your former client that it will take more than 365 YEARS to get back to where he/she was.”

Advisors whose practices will prosper going forward are those (50%) that are revisiting the buy-and-hold, asset allocation and diversification models that have failed so miserably. Same old, same old will simply produce the same results.

Album:   The Sly, Slick and Wicked, The Lost Generation, 1970

Popularity: 41% [?]

A March 6th Bloomberg story, “Bonds Beat Stocks in ‘Earth-Shattering’ Reversal“, danced on the freshly dug grave of my prior post that rhetorically questioned the Death of Equities. In fact, as the chart illustrates, the patient passed away back in October of 2007 which was the peak for global stocks.

Album:   The Best of Gary U.S. Bonds, Gary U.S. Bonds, 1990

Popularity: 35% [?]

 That’s the prediction from Bill Gross.

Recently, from his perch atop $700 billion in bonds at PIMCO, in addition to advising the U.S. on its $500 billion fund to buy mortgage-backed securities and $250 billion commercial paper program, Gross sounded the death knell for common stock.

Yes, according to venture capitalist Peter Cohen of Peter S. Cohen & Associates, who cornered the bond king for the exclusive interview, “the current economic contraction is killing the animal spirits that drive risk taking and that’s contributing to the death of equity capitalism as we’ve come to know it.”

The Gross outlook is very grim for those who expect stocks to ultimately regain their historical performance advantage over bonds. “Things will never be the same. Risk taking has been destroyed…asset classes will be readjusted for that outlook. That is — stocks will be more of a subordinated income vehicle as opposed to a ’stocks for the long run’ growth vehicle.”

Common shareholders are seeing their values eroding because of their subordinated position relative to debt in the liquidation hierarchy, because when a company files for bankruptcy, all of the other stakeholders — such as bondholders, lenders, and preferred stock holders — get their money before the common shareholders see a dime.

That may be the case for some time to come, but as sure as Truman defeated Dewey, common stock returns will eventually trump bonds. But in the indiscernible interim lies the rub…inflation, interest rate and default risk has not been greater in years. Bonds are about as unattractive as stocks for the intermediate-term.

So where will growth-minded investors find compelling asymmetric return opportunities amidst the new world disorder?

Gold is probably the next bubble. Commodities are too correlated to the economic cycle. Managed Futures quant models are a black swan breeding pond, and Hedge funds? Well, that brain is drained for now.

Private Investment in Private Ventures

That’s right. This may not be intuitive to the remaining fossils that still subscribe to dogmatic asset allocation models or efficient market hypocrisies, but prudent and appropriate allocations to private investments in; your own business, start-up and early-stage ventures, mezzanine opportunities, distressed real estate and other forms of private equity are about the only remaining viable and proven means of wealth that is truly non-correlated to the whatever remains of your investment portfolio.
Every credible study into the origins of wealth has verified that the vast majority of family fortune has been generated through business ownership or investment in private enterprise. Affluent investors already know this…because that’s how they became affluent.

The counter-cyclicality of venture investing is counter-intuitive to most investment professionals. Yet, the VCs that have experienced the salad days and the soup lines will tell you that many of the most disruptive and most profitable new companies have emerged from the ruble of past downturns (Exxon, Microsoft, Google, Ebay and Skype, to name a few).

Pending breakthroughs in alternative energy, power distribution, privatized education, medical devices, non-invasive healthcare, genetic disease prediction, processors, nanotech, wireless communication, cloud computing, and so on, are agnostic to the vicissitudes of investor psyche and economic cycles.

Ultimately, the job and wealth creation that will restore our economy will emerge from the confluence of investment capital, entrepreneurship an innovation.

This is our debut post. Though Venture Populist is an unabashed advocate of private venture investing, we intend to bring you the good, the bad and the ugly of private investment. From the agonies of angel investors to the victories of VCs, we will examine the sourcing, diligence, deal terms, risks, returns, liquidity and exits associated with the various stages, structures and sectors of private investment.

Album:    For the Whole World to See, Death, 1975

Popularity: 32% [?]

 Venture Populist is the online resource for investors and investment professional to explore portfolio allocations to investments characterized by their probability of positve asymmetrical outcomes; positively-skewed risk/reward ratios that can be achieved via investments such as venture capital, private equity, direct (angel) private investment in start-ups and emerging private and operating cash-flow businesses, private real estate, private debt, franchises, as well as, publicly-traded emerging growth companies, (long volatility) option strategies and other highly-specialized investment strategies perhaps employed by some hedge funds, managed futures and market-timers. 

Venture Populist was created for investors and their advisors that seek to enhance their portfolio’s investment returns through allocations to private investments.

The Venture Populist Manifesto maintains that;

• Modern Portfolio Theory, traditional asset-allocation models and buy-and-hold investing have been materially discredited over the past 80 years.
• Black swans do exist and most portfolios are unprepared for them.
• Asset class correlations are not static.
• Stocks have not delivered their anticipated risk premium.
• Liquidity, safety of principal, income and positive asymmetric outcomes are the most important criteria in building better investment portfolios

Moreover, private investment is the single largest creator of private wealth. With proper dedication, individual investors and their advisors can educate themselves to become more familiar with best practices in evaluating and allocating to private investment opportunities.

Venture Populist advocates investor education and the legislation of regulatory and tax policies that maintain a marketplace which enables individual investors to pursue the creation of private wealth through private investment.

Album:   Welcome, Santana, 1973

Popularity: 32% [?]