Venture Populist

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: 3% [?]

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: 8% [?]

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: 9% [?]

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: 34% [?]