Venture Populist

The availability of risk capital for early-stage ventures has proven itself to be remarkably resilient. It has overcome the cycles and uncertainties of our economy, as well as, the myopic tax policies perpetuated by our partisan politics. But I foresee a fresh challenge to the startup ecosystem on the horizon—and it is the direct result of bad brokers, disingenuous dealers, unprincipled promoters and iniquitous issuers.

The “bad actors” (to incite regulatory jargon) that I am referring to are the fraudsters who make confidence a career by peddling perilous product to unwitting investors of all sizes and sophistication. More often than not, they camouflage their chicanery under the cover of Regulation D.

Reg D provides for some companies to offer and sell their securities without having to register the securities with the SEC enabling access to the capital markets for small companies that could not otherwise bear the costs of SEC registration as would be otherwise mandated under the Securities Act of 1933.

Reg D is a success story that began when the SEC created the exemption in 1982 with the intent of simplifying capital-raising for small business owners to launch or expand their ventures. Subsequently, the provision has enabled literally hundreds of thousands of new ventures. Businesses ranging from neighborhood taverns in urban alleys to nascent technologies in Silicon Valley have relied upon Reg D to quickly, cheaply and efficiently secure financing.

But, private placements offered under Reg D have likewise endured a checkered history beginning with the Prudential Securites Inc. offering that devoured $1.4 billion from 100,000 investors back in the late 1980s. That was only the beginning as more recent abuses include;

• Stanford International Bank–for running a “massive Ponzi scheme” and offering phony CD’s via private placement deals totaling $2.7 billion.
• Provident Royalties, LLC—fraud and Ponzi scheme related to $485 million in oil and gas limited partnerships.
• Medical Capital Holdings Inc.—fraud accounting for an estimated $1.2 billion in investor losses from the sale of private securities in the form of notes on medical receivables.
• DBSI Inc—charged this past December with promoting a $600 million Ponzi scheme related to the sale of fraudulent tenants-in-common real estate exchange products.

Each of these private placement pilferings were conducted under the cover of Reg D in the virtual absence of gatekeeper protection or regulatory oversight. Regulators and lawmakers are rightly concerned, particularly with the private placements of limited partnerships that have been capitalized by offerings to “accredited” individual investors through independent broker-dealers that reap commissions as high 10%.

Though initially intended to enable entrepreneurship and small business financings—the legitimate users of Reg D have been eclipsed by the scamsters. The deals have become gateways to multi-million paydays for issuers, dealers and brokers.

“Fraudsters are primordial creatures who live in their own lawless existence,” says Neal H. Levin of Freeborn & Peters in Chicago, whose practice is committed exclusively to busting fraudsters and recovering assets.  “To a fraudster, it’s kill or be killed and they will use whatever tools are available to them in order to conquer.  Reg D has certainly proven to be one such tool.”

Considering the responsibility of lawmakers to protect unwary investors form unscrupulous promoters and the readiness for regulators to expand their regimes—private investments that claim to be exempt from SEC registration are a torrid topic these days.

There were 11,000 Reg D deals filed in 1996, but that number has swelled to a reported 26,485 in 2009 when estimated offerings exceeded $609 billion. Regulators are ill-equipped and lacking the proper resources to evaluate the thousands of oil and gas ventures and real estate partnerships that file under Reg D each year.

“Investors have been exposed to far more risk in private placement offerings than Congress could have imagined”, according to Denise Crawford, president of the North American Securities Administrators Association, adding “Reg D offerings receive virtually no regulatory pre-screening at any level of government.” Not surprisingly, Crawford and many others have been lobbying for a rollback of the federal statues in an effort to return the pre-empted authority back into the hands of the state regulators. In turn, they hope to close the oversight gap that Ponzi scheme operators tend to gravitate towards to engage in their duplicitous dealings.

Good luck with that. Investors certainly deserve better protection from fraudsters, but whether or not our budget, brain matter and bandwidth-strapped regulators have the resources to capably clean out the commode is a topic for another column.

The Investment News Fraud Charge Tracker presently lists 60 securities and ponzi frauds which account for $9.4 billion in bilkings, most of which were executed as private placements under Reg D. Of these 60 frauds, 20 of them (one-third) resulted in investor losses which exceed $50 million, yet these larger frauds accounted for $8.9 billion (95%) of the total losses tracked.

Clearly, more effective oversight is desperately needed to protect investors from the multi-million dollar private placement scams—so why not start at $50M?

My fear is that the sincere interest and obvious need to protect investors from these menacing mountebanks will give rise to regulatory overreach…that the earnest interest to reduce the oversight gaps that fraudsters freely operate in will inadvertently impair the ability of small businesses to finance their ventures. It almost occurred last year when former Senator and Banking Committee Chair Chris Dodd’s discriminatory dealings nearly gutted Reg D—which would have most certainly produced the unintended baby-bathwater consequence of stymieing the startups that depend upon the provision to provide efficient access to risk capital.

There is no evidence to suggest that the typical $1-10 million startup or small business financing facilitated by Reg D is a forum for fraud. In a letter to Dodd last March, the Angel Capital Association noted “The angel investment arena has been virtually complaint-free in terms of fraud. Accredited angel investors make their own decisions to invest directly into small businesses, without securities dealers or investment advisors.” That point needs to resonate with our lawmakers who tend to be notoriously nescient with respect to nuance—particularly when there are headlines to be made.

My proposal is simple. Any fund, limited partnership or series of funds that solicit investments from individual investors and subsequently collect north of $50 million from investors should be required to register as private fund advisors. Such a requirement would reduce oversight gaps and provide regulators at the state and federal level with the transparency required to identify potential pockets of individual investor’s capital at risk.

If there is a compelling case as to why limited partnerships that solicit hundreds of millions of dollars from individual investors should be exempt from oversight—I have certainly never heard it.

But, leave Reg D alone with respect to early-stage ventures. Private investment is the sine qua non of startups and small businesses. In light of current economic and employment woes, our politicians need to stop paying lipservice to the needs of small business and by avoiding unnecessary regulations that restrict capital to entrepreneurs.

Debut Album:   Them Crooked Vultures, Them Crooked Vultures, 2009

Popularity: 6% [?]

In the State of the Union address earlier this year, President Obama acknowledged that “the true engine of job creation in this country will always be America’s businesses” and, that to spur the economy and job creation “we should start where most new jobs do – in small businesses” prior to declaring that we should “eliminate all capital gains taxes on small business investment”.

The result of this effervescent yet evanescent evangelism? Our lawmakers deliberated and subsequently concocted a legislative scheme to incentive private investment and job creation—that lasted all of 100 days!

That’s right. On September 27, of this year Obama signed into law the Small Business Jobs Act (H.R. 5297), which included among other provisions, a 100% exemption (subject to certain issuer limitations) of income from capital gains derived from investments in “qualified small business stock”. The 100% exclusion is an attempt to encourage investment in startups, early-stage companies and small businesses.

Blink and you would have missed it. The exemption expires on January 1, 2011, coincident with the expiration of the “Bush Tax Cuts” which raises capital gains tax rates at the highest bracket from 15% to 20%.

A critical (albeit secondary) purpose of tax policy is to encourage behavior that is deemed to be beneficial to the public interest. In this instance, our politicians pandered policy to promote employment and private investment. But, such that most private investors take at least 100 days to evaluate an opportunity, there was no way that this important revision in tax policy had the sufficient runway to effect any material changes in investor behavior. It was not actionable tax policy.

Few angel investors that I have spoken with were even aware of the exemption…and not a single offering out of a couple of dozen that I evaluated during this period pointed out the perk.  I wouldn’t be surprised if the legislative costs of negotiating and implementing this fleeting folly far exceeded any illusory benefits.

Policy penchants and partisan politics aside, politicians have extolled upon the virtues of no taxes on capital gains for the past 50 years. Prior to his tax cuts, President John Kennedy accurately asserted that “the tax on capital gains directly affects investment decisions, the mobility and the flow of risk capital…the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy.”

Most of our pols know intuitively that small business is the primary and most reliable engine of job creation. Irrefutably, two-thirds of net new jobs are created by companies with fewer than 500 employees.

This past August, a research study entitled, “Who Creates Jobs? Small vs. Large vs. Young” further clarified that there is more to the equation than merely size. “Business startups contribute substantially to both gross and net job creation,” says John Haltiwanger, who co-authored the study along with the two economist from the Census Bureau, but, “it’s all age – startups are where the job creation really occurs.” Most job creation occurs in the early years of new companies.

Yet, government “stimulus” programs spend more resources attempting to promote bank lending (more of a benefit to existing business) than spurring private investment in risk-taking and entrepreneurialism.

Tactically, our tax policies need to do more today (and certainly beyond this coming January 1^st) to incentivize angels investors to fund early-stage ventures than presently contemplated by our legislative class. Strategically, our restrictive tax policies put us at distinct disadvantages to industrialized countries such as Austria, Belgium, Germany, Mexico, New Zealand and others than have no taxes on capital gains, as well as, countries that do not impose capital gains on stocks such as Israel, Spain, China, Hong Kong, Singapore and most of the other Asian countries.

To its credit, Obama’s Small Business Jobs Act provided investors considering a qualifying venture investment with a significant opportunity as the result of the full 100% capital gains tax moratorium which also excluded 100% of the capital gains from alternative minimum tax (AMT) considerations.

Alas, the three-month window was unconscionable. Moreover, the act included such archaic prescriptions as; a five-year minimum required holding period, requirements that the business be a C-corporation, a greater of 10X or $10M cap, and, unnecessarily excluded certain labor-needy business categories such as hotels and restaurants.

In short, thos disappearing Jobs Act mirrored the myriad of misinformed, ill-conceived and insincere tax policy prescriptions of prior administrations.

But it may get even worse. Last week Obama’s bipartisan deficit commission released draft recommendations on a host of third-rail political issues including entitlement, discretionary and defense spending cuts and a variety of comprehensive tax simplifications and reforms. With lack of respect to capital gains, they would be taxed as ordinary income under each of the Bowles-Simpson reform scenarios. Since the rate is currently at 15 percent, that implies a doubling depending on the plan.

I have never angst over the notion of politicians breeding due to their inability to bifurcate the baby and the bathwater.

Tax policy must be designed to promote private investment in startups, stimulate job creation and the economy in a manner that is meaningful and immutable to the estimated 225,000 angel investors. I would concur with New York Times columnist Thomas Friedman’s recent proclamation that “we need three things: start-ups, start-ups and more start-ups,” and, that tax policy should incentivize “our best minds to be able to make a killing from starting new companies rather than going to Wall Street and making a killing by betting against existing companies.”

During the economic downturn in the mid-1990s entrepreneurs created 3.8 million new jobs. If the genuine intent of tax policy is promote entrepreneurship and to encourage more risk-taking by private investors there should be a bipartisan consensus among politicians to eschew slippery slope suspicions and disingenuous diatribes that such targeted capital gains tax reform only reward the “wealthy”.

It is time to get down to small business. Venture Populist proposes specific and targeted tax reform such that;

• There would be no capital gains taxes on investments in startup or pre-revenue companies – to encourage more early-stage private investment.

• Shares of common stock issued to founders and key employees of early-stage companies should be exempt from capital gains taxation – to reward entrepreneurs for their risk-taking and create the currency (stock options) that would encourage entrepreneurial activity.

• Investors that contribute the first $5 million of equity financing to any new company should get a dollar-for-dollar tax deduction for the year the investment was made – that critical first $5 million is the hardest for any new company to raise. Risk-taking, venture-enabling job-creators should be encouraged and rewarded at the point of investment as opposed to a tax break many years down the road if the company monetizes.

• Assuming appropriate disclosure of all of the risks entailed, any investor regardless of their income should be eligible to invest in private ventures – yet our current  securities laws are about to become more restrictive as a result of former Senator Chris Dodd’s discriminatory deal. The asymmetric investment return opportunities of private venture investment and these preferential tax incentives should not be available exclusively to “accredited investors”.

And finally, it is time for both parties to refrain from further legislative lipservice. For these policies to be effective in stimulating sustainable job creation they need to be enacted permanently so that entrepreneurship is embraced by the best and the brightest and that private investment and risk-taking is rewarded without threat of uncertainty or reversal.

Album:   Lipservice, Gotthard, 2005

Popularity: 7% [?]

Since 2002, I have been writing a monthly column on the alternative investments for Investment Advisor magazine. A couple of years ago we renamed the column Venture Populist and focused exclusively on issues the issues confronting family offices and angel investors that make direct investments in startups and early-stage private ventures.

The column generates frequent inquiries from wealth managers as to what alternative asset classes or investment strategies may provide portfolios with risk-return characteristics that are comparable to the attractive asymmetric return profile of private venture investment (PVI). The queries acknowledge that PVI is a compelling asset class, as well as, game-changing value-proposition and differentiator for their advisory firm. Yet, despite their interest, these advisors lack the access to deal flow, due diligence skills, regulatory latitude, HNW client base, or, simply the compulsory cojones to actually allocate their client capital to private ventures.

Often these advisors have embraced the progressive precepts of Hybrid Portfolio Theory yet require more accessible investment products than direct investments in private ventures to populate Portfolio B—the 15-30% of the alpha-producing portion of the portfolio that seeks positive asymmetric investment outcomes.

So, for a number of practical reasons, some wealth managers and investors searching for a substitute asset class with the same positively skewed return characteristics of PVI, but with greater accessibility and liquidity. Many investors simply do not have the investment horizon required to successfully harvest venture investments. These investors seek liquidity—not lockups.

I have always maintained that specialized managed futures, distressed, deep-value securities and out-of-the-money option strategies have the asymmetric return profiles that are required to fulfill Portfolio B’s mandate. But for many investors and advisors, these aforementioned strategies are as arcane, elusive and illiquid as investing in PVI.

Fortunately, there appears to be more accessible alternative to PVI for investors lacking leptokurtosis in their portfolios—the universe of less liquid and smaller cap publicly-traded U.S stocks.

Recent relevant research and return data indicate that there is a seemingly significant semblance between the returns of venture capital and those of less liquid, publicly-traded, small company stocks.

In 2004, John Cochrane, finance professor at Chicago Booth School of Business published The Risk and Return of Venture Capital which examined whether individual investments in venture capital projects “behave the same way as publicly-traded securities”, and which kind of securities they may resemble.

Compiling data from the 16,613 financing rounds of 7765 private companies over a 13-year period Cochrane observed similar volatilities and alphas between venture capital returns and the smallest Nasdaq stocks and concluded that “thinly-traded Nasdaq…small stock portfolios are natural candidates for a performance attribution of venture capital investments.”

More recently, the pioneering investment industry academic Roger Ibbotson got a little more granular by re-introducing his working paper Liquidity as an Investment Style which he initially co-authored with Zhiwu Chen in 2007. The work is important to adopters of Hybrid Portfolio Theory as it more narrowly defines a potential substitute for private venture investments by articulating the phenomenon of the “Illiquidity Premium”.

From 1972 to 2009, Ibbotson studied the returns of 3500 publicly-traded U.S. stocks in the context of their relative liquidity (defined by annual trading volume divided by total shares outstanding). The surprising results were that liquidity (as an investment style) was a far more effective predictor of returns than the conventional Fama-French factors. Specifically, the equities that produced the best returns during the period were the less liquid small-caps that attract distinctively less trading interest. These companies generated a remarkable 17.87% annual return over the four decades studied.

In contrast, the most liquid (and most widely held) growth stocks performed miserably at 3.3% — below the risk-free rate. The apparent performance attribution is due to the premium that most market participants are willing to pay for the most liquid securities—which, in turn, has the unintended but discernable consequences of reducing their returns.

So, the relative liquidity of a security, according to Ibbotson’s research, actually reduces its return.

Venture investors have always acknowledged the existence of an illiquidity premium and concede that they are swapping liquidity for the potential of significantly greater upside. The historical returns of the venture capital asset class prove this out. But this quantification of the role of illiquidity as a risk factor, with a risk premium, is most illuminating.

“There is a clear pattern of decreasing returns as the liquidity of stocks increase”, cites Ibbotson. There is indeed an excess return attributable to less liquid stocks and “the less liquid stocks are not necessarily more risky. Measured by standard deviation, risk seems to increase with liquidity.”

Ibbotson himself likens liquidity as an investment style to private investment such as venture capital, commenting that private securities are most appropriate for investor’s seeking even higher returns that have the luxury of longer investment horizons.

But the illustrated fact that “the illiquidity premium is positive and substantial with publicly-traded securities” offers an “Ah-Hah” moment for advisors seeking a complimentary asset class or substitute for allocations to private venture investment.

Food for thought.

Album:   Food for Thought Substitute, Heaven’s Cry, 1997

Popularity: 9% [?]

Last month I spoke on a venture capital panel at an alternative investment conference in Chicago. As the former head of alternative strategies for a well known investment management firm, I saw many old friends and familiar faces among the family offices, wealth managers and investment firms that were attendees and exhibitors.

I also picked up on a chilling consensus that was apparent among the conference attendees…that the individual investor that has been fleeing from the public equities markets for months now, is not expected to return anytime soon. They are frozen…stunned, like the “ex-parrot” in the Monty Python sketch.

Beyond this sallow assessment, these investment pros were not particularly optimistic about the near-term. Wealth managers and investment advisors are hardly the beneficiary of todays investor’s prevailing distrust of Wall Street. Among all investor types, from retirees to HNW, money is rapidly flowing out of equities in favor of bonds and cash.

Today, the key asset management industry metric of AUM (assets under management) more aptly refers to assets under mattresses. Investors have lost faith in the integrity, as well as, the opportunity of the public equities market.

The advisors I spoke with were not prescient…merely perceptive. The evidence is hard to ignore. A recent CNBC/AP poll cited widespread investor distrust of the stock market with 61% of investors declaring that the market’s recent volatility has made them skeptical about participating in the market.

The radical shift in stock market investor confidence has resulted in a net $250 billion outflow from stock mutual funds since January 2008, according to the ICI, $48 billion in the past four months alone. Perhaps under different a different economic scenario the recent 21 consecutive weeks of persistent equity outflows would be a contrarian indicator, but Citibank’s own Robert Buckland cites these menacing metrics as support for his theses foreseeing trillions of additional dollars in outflows to follow and summarily declaring the “Equity Cult” to be DOA.

Some of these credible voices are even stronger. For example, sports mogul, billionaire investor and modesty magnate Mark Cuban initially declared that the “Stock Market is for Suckers” back in January 2006. He has frequently revisited and reiterated his meme on his Blog Maverick site since. Cuban recently called out the conventional wish-dom of Buy & Hold to be “the second most misleading marketing slogan ever, after the brilliant rinse and repeat message on every shampoo bottle”.

I guess that’s why the mutual fund company swag has been such slim pickings at investment conferences lately. There probably is not a lot of interest in those tired old laminated Ibbotson “Stocks, Bonds, Bills” charts anymore.

The stock market has become inhospitable to the individual investor. It has gone absolutely nowhere in the past ten years and investors have no returns (rather, for the most part…losses) to point to for the risk that they have assumed.

Nothing seems to work. Forget about investing in an individual company’s security based upon its specific fundamentals and outlook. The price movements of individual securities are now dictated by larger global macro themes such as the economy, interest rates, currencies, commodities and geopolitical considerations. Individual stocks are no longer priced on their own fundamentals. Hedge funds, index funds and speculators drive price action.

Adding to the investor’s frustration is the fallibility and futility of popular, traditional and even alternative approaches to extracting returns from the stock market. Buy-and-hold, day-trading, Modern Portfolio Theory, diversification, sector rotation and even the majority of alternative and absolute return strategies have come up short.

After 10 years of high volatility but no net return, two 50% bear markets and the May 6th flash crash (apparently was the result of one massive computer-triggered sell order)…they majority of investors have it figured out. Mass exodus time. They are pulling out of the equity markets in droves.

But, I did not get the sense that the majority of wealth managers and investment advisors have caught on. Most are still approaching their asset-allocations as usual.

A couple of years ago I introduced and advocated Hybrid Portfolio Theory as an alternative asset-allocation approach for the progressive advisor that held preservation of client’s capital as the primary objective while simultaneously pursuing the opportunity to achieve double-digit annual returns at the portfolio level.

Hybrid Portfolio Theory is unique as it eschews equity exposure in favor of allocating the majority (75-80%) of the assets into fixed income such as Treasurys, munis and TIPS (portfolio A). A second portfolio (B) holding the balance of the assets is mandated to pursue investing opportunities that have a positive asymmetric return profile such as investment into private early-stage private companies or small businesses, public emerging growth companies, real estate, or, specialized trading strategies that employ options or managed futures.

Of course I am biased. Venture Populist advocates that wealth managers and investors more frequently embrace allocations to direct private investment as a means of increasing portfolio returns in a manner that does not increase portfolio-level risk.

But recent numbers from Cambridge Associates underscore this conviction as the venture asset class has continued to provide compelling returns over the long term. Over the past fifteen years the U.S. Venture Capital Index has returned 38% annually against 7.4% for the Nasdaq and 7.8% for the S&P. Over the past twenty years 24% for VC against 9% for both the Nasdaq and S&P.

Exposure to private enterprise has historically been this countries greatest single wealth producer. Progressive wealth managers would be well-advised to adapt their core competencies to embrace more diverse and opportunistic investment opportunities outside of the public equities markets.

Some of their client’s certainly are…as Mark Cuban recently posted, “The stocks I own for the most part I have owned for a long, long time and I have more in gains than I want to pay taxes on. But in total, I have been a net seller of stocks for more than a year. The only investments I am making are small buys into private companies.”

Entourage fans, for the record, those “small buys” do not actually include an investment in “Turtle’s tequilla“…but considering the past decade of stock market performance, and the forward prospects, a spirits investment may not be a such a bad alternative.

 Album:   Exodus, Bob Marley and the Wailers, 1977

Popularity: 8% [?]

Private venture investors consciously embrace the notion of swapping liquidity and safety of principal in the pursuit of positive asymmetrical outcomes and the higher risk premium associated with venture capital. Against the certainty of uncertain outcomes, the venture investor accepts liquidity and principal risks as the apropos quid pro quo towards achieving high double-digit and triple-digit IRRs on investment.

But, venture investors too willingly accept the notion that their investments outcomes will be the result of a binary set of events—characterized either by loss of capital or an attractive multiple on exit as the result of an IPO, sale, merger or other change of control transaction.

These investors can become more effective fiduciaries of their capital by demanding investment terms that broaden the variety of each investment’s potential returns. I refer to this as increasing an investment’s “optionality” beyond a binary set of boom or bust outcomes.

Among the most frustrating venture investment experience is the non-outcome outcome. In an earlier post (Hits & Exit Wounds) we described this sort of venture purgatory as “My Grandkids Company”—a private company that is successful but there is no exit in sight. (Perhaps your grandchildren’s inheritance?). You were prescient enough to back an early-stage venture that is now successful yet all you have to show for it is an annual K-1. This is where investment term sheet mechanisms that enhance the investor’s optionality really come in handy.

I have become a strong proponent of requiring that venture investors demand a “put right” (or, put option) as a contingency to committing venture capital to an angel round or early-stage equity financing. A well-conceived put option may reduce unintended gifting to your grandchildren by giving you one way out of a private investment without an exit in near sight.

Typically, a venture investor’s exercise of a “put” would require the company to repurchase their equity securities at fair market value. Investor put rights have been around venture transactions for years for the express purpose of providing a way out of an investment with no liquidity event in near site. But, because of the terms by which they have generally been structured, they have been rarely exercised.

That’s because if the company appears to be on the right track, investor’s are more likely to let their fortunes play out. On the other hand, if the company is not performing to plan it is not likely to be able to afford to honor the investor’s put—rendering the option worthless.

With investors rarely exercising these puts and with companies generally apprehensive of the uncertain implications of any non-budgeted hit to their balance sheet, issuers are less willing to draft investor put rights into their offerings…but you should insist.

It works like this…upon completing due diligence and deeming a venture to be worthy of a capital commitment the investor reviews the company’s anticipated revenue projections to identify a period in the future (beginning at 30 or 36 months out) at which the company’s cash flow model and pro forma balance sheet suggests that it would be able to return the investor’s initial capital contribution along with any accrued dividend. As a contingency to financing the venture, the investor requires the company to grant a put option for that future point in the company’s growth trajectory.

If the investor exercises the put, the investor is entitled to redeem all or a portion of their equity interests in exchange for the initial capital contribution value plus a nominal return above the risk-free rate. In addition to the return of investment, the put right allows the investor to maintain a reduced equity position in the company…perhaps, somewhere between 50% to 75%. (This would imply an increase two to four times higher than the company’s initial valuation)

Essentially, the exercise of the put allows the investor the ability to take “risk off the table” (the initial contribution) while still maintaining a material amount of “skin in the game”.

To prevent the investor from exercising the put at a moment when the company’s financial stability or expansion plans could be jeopardized, the company can require that in addition to a prescribed time period restriction, certain revenue and/or R&D milestones must be achieved and set as “triggers” before the put may be exercised.

The put option must be constructed in a manner that enhances the investor’s optionality, without putting the company at balance sheet risk. It is possible to achieve that balance. The company that achieves the predetermined revenue milestones would likely savor the opportunity to buy back its stock to the pro-rata benefit of the remaining stakeholders, and of course the investor benefits from the possibility of a wider variety of liquidity events and exit outcomes…which, in turn, enhances the ultimate appeal of venture capital as an asset class.

Album:    One Way Out, The Allman Brothers Band, 2004

Popularity: 7% [?]

One of the few commonalities among the thousands of VCs and angel investors is the consensus that the process of identifying an attractive private venture investment is “part art, part science”. The art part speaks to the inherent absence of certainty with respect to any venture’s viability. There are no absolute truths…no bankable checklist to follow that ensures a successful outcome for a private venture investor.

The science part? That’s simply hindsight, which of course is an exact science. Of the ways that I have derived knowledge as a private venture investor, hindsight is the most expensive, the least merciful and the most valuable.

When it comes to separating the wheat from the chaff, my primary screen is simple. For a private venture investment (PVI) to be worthy of the costly, time-consuming, bandwidth-bogarting process of evaluation, consideration, due diligence and deal term negotiation, it must initially meet these four criteria;

1.  There is a large market for the firm’s products or services

The size of the market must be material for a PVI to potentially achieve a high cash flow or high-multiple (positive asymmetric) outcome. The success of category-killer app, product or service in a small market lacks the potential of an exponential payoff and does not proportionately offset the risk of a loss.

Ideally, the market should not be merely mature—it should be a growing market. The market can be newly-emerging (alternative energy, for example) or non-existent (Twitter) at the point of the venture’s introduction of its product or service, but it’s potential must be measurable and meaningful.

The values set forth in the modern business classic Blue Ocean Strategy often come to mind. Blue oceans denote industries untainted by competition. In blue oceans, demand is created rather than fought over…competition is irrelevant because the rules of the game are waiting to be set.

I am predisposed to the notion that the initially contemplated product, service or business model rarely succeeds, and consequently ventures are frequently forced to adapt to new data points. This requires the room to maneuver that a large market provides.

2.  The firm has a sustainable competitive advantage

The venture must have a sustainable edge to attract and retain its market share. The location or lease of a real estate development can be an edge. The celebrity chef to a restaurant, the IP portfolio of a technology or medical device company or a strong distribution channel relationship can be a critical edge to a consumer product.

The more tangible, unique, defensible and proprietary the edge (such as patents)…the better. The competitive advantage should discourage competition and create a barrier to entry. The edge will vary according to the venture’s industry. First-mover status is often meaningless (like many others I prefer second-mover) and certainly not sustainable in a market of compelling size.

A sustainable edge to compete in a large market is critical to potential acquirers or public markets and the objective of realizing compelling multiples on an exit.

3.  The management team has compelling expertise in the contemplated market

You must have a great execution team. Visionary founders may be inspiring but they alone cannot bring a great idea home. Get an experienced and accomplished operator in early.

In a couple of my early investments I failed to hone this rule to its proper endpoint. Naively, I believed that the serial entrepreneur with prior liquidity events was a proven winner and worthy of the wager. The first time that formula fell short I failed to make the proper connection, the second time I learned the lesson. There will not be a third time.

Successful entrepreneurs too often become deal junkies fueled by the fumes of their prior triumph. Some become self-anointed business “generalist” experts (contradictory, eh?) that no longer feel restricted by the limitations of their actual core competencies.

The founding partners and management team must include an accomplished C-level executive or highly accomplished operator with a track record of proven experience with the specific business model and target market. Moreover, the operator must have the authority and discretion to execute the business plan. Serial entrepreneurial ego in the absence of domain expertise is a formula for failure.

4.  The deal terms are no less than fair, and ideally—favorable

Valuation, investor rights, board representation, management discretion and transparency with respect to material events, protective provisions, anti-dilution protection, liquidation preferences and optionality issues must incentivize and respect the source of the capital. The investor’s capital is the great enabler… the sine qua non for any venture.

Few things are as humbling as the successful venture that does not translate into a successful investment. I respect the often repeated axiom that a fair deal is one where both parties feel that they got a bad deal, but the end game should always be to negotiate favorable deal terms.

The probability of an attractive outcome is diminished if a private venture investment cannot meet these initial thresholds. In VC-speak you are nursing a newborn “zombie”…a walking dead venture…the ship is already sinking and it has not even left the port.

Album:   We Were Dead Before the Ship Even Sank, Modest Mouse, 2007

Popularity: 9% [?]

As my career has been largely devoted to the intersection of money management and venture finance, I am no stranger to the independent RIA universe.

I have worked with dozens of wealth managers and family offices that regularly evaluate and allocate to private venture investments. Although they represent a fraction of the RIA universe, they are invariably among the most successful of their peers. These progressive wealth managers represent the primary audience of this blog.

I regularly advocate that RIAs that possess the requisite mandate, the means and the mindset should embrace private venture investments–for the benefit of their client’s portfolios, as well as, their practices. Yet, the majority of independent wealth managers should best leave this sandbox to VCs and angel investors.

Does your advisory practice possess the rationale and the resources to advise clients in start-up, early-stage and other private venture investments?

Your advisory practice may be uniquely qualified, if you consider:

• (To begin by stating the obvious…) You are in the business of wealth preservation and wealth creation.  Without question, the primary source of family wealth in America is the result of private enterprise and private venture investments characterized by their potential for positive asymmetric outcomes.

• You embrace Modern Portfolio Theory.  Despite its flaws, MPT advocates diversification into non-correlated asset classes. One-off investments in private ventures are distinctly non-correlated to broader asset classes and major market indices and have exhibited less correlation during negative black swan events.

• You possess the proper due diligence skills.  In addition to those skills you also posess the doubting disposition that is critical in evaluating private investments. The skills that advisors have developed in the course of investment manager evaluation are relevant and applicable to the private equity universe. Moreover, your experiences have taught you to be cynical and skeptical of assumptions regarding future performance.

• You are an entrepreneur.  As an independent wealth manager have chosen to compete in a highly-competitive, low margin industry. Your personal experiences should render you more prone to recognize the prerequisite personality traits of a successful entrepreneur…de rigueur in the executive team due dilly process. You also recognize the mission-critical elements beyond the strengths of the management team that determine the probability of successful enterprise.

• You understand finance.  As a stock, sector and industry analyst you know your way around balance sheets, cash flow, valuation issues and income statements. I am frequently surprised at the number of professional private venture investors that have little understanding of business and finance.

• You possess both an awareness of regulatory issues and a fiduciary responsibility that is consistent with the best practices of seasoned angel investors and VCs.

• You are networked. Beyond your practice, you have access to an expansive network of tools, resources and expertise that are essential to evaluating new technologies, industry sectors, new business models, intellectual property and other elements of private investment. Your industry colleagues offer incomparable access to the analysts, research, legal and domain expertise that is required in the course of successful private investing.

• You have access to the critical resources.  As an independent wealth manager you have enviable access to the two most important resources of private investment….investor capital and deal flow. Your HNW clients most likely became HNW clients as a result of their own ventures in private investment. Serial entrepreneurs and HNW investors are an excellent ongoing source of deal flow.

Advisors that affirmatively identify which each of these traits may have the mandate and the means to expose their client’s portfolios to the asset class that has historically created the vast majority of our nation’s private wealth and can dramatically differentiate your practice from its peers.

More advisors should explore asset allocation beyond the lame limitations of highly-correlated asset classes, stale style boxes and pointless pie charts.

Album:    Playing the Angel, Depeche Mode, 2005

Popularity: 12% [?]

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% [?]

Do you wish you had a yuan for every time you heard the inaccurate reference that the Chinese symbol for “crisis” is the same as for “opportunity”?

How often will we have to hear this nonsense from pontificating pundits, investment advisors and portfolio managers out ballyhooing the pending stock buying opportunity of a lifetime?

The equation above is only applicable when something is actually learned from the chaos and behavior is changed. The common definition of insanity–the behavior of people who keep doing the same thing, yet expect different results–is likely more relevant.

So far, I see little evidence that investment advisors have learned anything from their vanishing assets-under-management, despite irrefutable evidence that:

• Stocks have plummeted more than 60% in real terms since the market peak in 2000. They have performed no better than 20-year Treasuries for the past 40 years and certainly have not delivered their risk premium.
• Bonds may be the next bubble (according to Warren Buffett) as unprecedented spending, ballooning deficits, risk of a devalued dollar, and inflation could prompt foreign investors to dump Treasuries.
• Modern Portfolio Theory, traditional asset-allocation and diversification models, and buy-and-hold investing have been materially discredited over the past 80 years.

Will investment advisors revisit their mantras or continue to tout the same traditional asset-allocation models that have so dutifully devastated their investment portfolios?

Empirically, investor returns on private investments constitute the single largest source of private wealth in America. All stages of private venture investment (early/seed through mezzanine and later) have dramatically outperformed traditional equity indexes over the past five, 10 and 20 years.

Investment advisors should educate themselves to become more familiar with best practices in evaluating and ultimately embracing private investment opportunities for investors. Prudently implemented, private investments can materially benefit your client’s portfolios, and, in turn, your investment advisory practice.

By “private investments” we are referring primarily to investments in private enterprise. (But Venture Populist will address the wider range of private investment strategies, including angel investing, private equity, venture capital, venture debt financing, private placement offerings, and private investment in public equity (PIPEs).

Walk the Walk

True, sustainable wealth is rarely generated through traditional investment or employment. It is the consequence of inheritance, windfall (lottery), illegal activity, or private enterprise. Contrary to the widespread, pedestrian misconception, inheritance is not the major source of private wealth in America. Rather, it is entrepreneurial success or investment in private enterprise.

According to Drs. Thomas Stanley and William Danko’s research published in their book The Millionaire Next Door: The Surprising Secrets of America’s Wealthy–80% of today’s American millionaires are first-generation rich. More than half never received as much as $1 in inheritance, and 91% never received as much as $1 from their previous generation’s ownership of a family business.

The same was true a century ago per Stanley and Dankos’s citation of a 1892 study of the 4,047 American millionaires…”84% were nouveau rich, having reached the top without the benefit of inherited wealth.”

The highly-coveted high-net-worth and ultra-HNW investor knows this better than anyone, because, as probability has it, they very likely accumulated their own private wealth through entrepreneurial activity or investment in private venture. When investment advisors are speaking with HNW investors about private investment opportunities in start-up ventures or emerging companies they have their attention, and do not show that glazed look of disinterest that a lecture on the Efficient Frontier evokes. The HNW may not be familiar with the specific product, service, or technology that the venture you may be discussing is engaged in, but they do understand business, private enterprise, and their potential for wealth creation.

Advisors should become more receptive to learning to speak the language of their desired target market, rather than continuing to subscribe to the defiled dogmas and outmoded portfolio fallacies (like Modern Portfolio Theory) that have so wantonly wasted wealth and invalidated their perceived value proposition.

Album:   Crisis, Mike Oldfield, 1978

Popularity: 32% [?]