Venture Populist

I have noticed that VCs tend to talk to the public and with their peers more about their home runs than their strike outs. Angel investors, on the other hand, prefer to relentlessly revisit their pain—often comparing their battle scars like veteran samurai. Probably because angels put up their own capital. Because they truly do eat their own cooking it’s harder for angels to forget their fallen soufflés.

VCs achieve their highs from the opium of OPM…so even a bad trip is still a free trip.

I recently had lunch with an inveterate venture investor (aka “angel”) whom I had co-invested with in a biotech, as well as, a med-tech company, several years back. Our conversation inevitably turned to peck at our past portfolios.

The biotech company was a true home run—a high-multiple exit realized in a 2004 IPO. (When was the last time you saw biotech, high-multiple and IPO in the same sentence?)

But, rather than relishing in a reminiscence of our raison d’être, we chose to get muddy in the mire of our miss—the medical device company that (nearly seven years later) was still trudging along with neither an exit, nor a write-off in sight.

There is the baneful scenario–five or more years in an illiquid private investment that just keeps rolling over but never plays dead, and, there is the painful scenario–a company running profitable for several years straight but no IPO, acquisition or distribution on the near horizon.

Two questions dominated our discourse. First, what would become of the med-tech investment? And secondly, what can we do differently as investors to avoid non-outcome outcomes in the future?

My most previous venture ovation opined, “There is very little that is binary about venture investing outcomes. It is not just feast or famine…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…”

That list of outcomes would be just fine if it was indeed comprehensive, but I employed some autistic license. The reality of the absence of binary outcomes in private venture investment occasionally includes the potential absence of any outcome at all.

In an amusing piece “10 Exits”, Angel Capital Association’s chairman John Huston further parses this purgatory. He evokes the venture vernacular “Zombie” as “a walking dead venture that will never become a great company, nor will it die so I can declare the loss.”

There are a number of ways to euthanize a zombie but what do you do about the investment that Huston calls, “My Grandkids’ Company…a company that is successful but there’s no exit in sight”? (“Maybe it will occur after my grandchildren inherit the portfolio.”)

That is the second question, and yes, there are methods that an investor can apply at the outset of the investment that mandate distributions from profitable private companies.

I have developed some effective term sheet and funding mechanisms that enhance the optionality of a private investment’s outcomes that avoid inadvertently gifting your grandchildren. I will share them in upcoming posts. They are the byproduct of my own experiences, and as you know, experience is what you get when you were looking for something else.

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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 investors can materiality improve their 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.

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Private investments in venture and early-stage companies are characterized by their potential for positive asymmetrical outcomes (PAO). The risk of losing the entire investment is offset against the potential for high-multiple ROIs. But asymmetric outcomes refers to more than the non-linear relationship between risk and return…it also refers to the appeal of investments where multiple liquidity and exit outcomes are possible.

This is often referred to as optionality…current knowledge of the potential for multiple future outcomes.

According to his book, In an Uncertain World, Robert Rubin, the nine-figure alumni chairman of Citi, is said to have developed his appreciation of optionality in his prior days of risk arbitrage at Goldman. While practicing risk arbitrage, Rubin developed a penchant for optionality (keeping ones options open) and avoidance of a mindset that restricted decision-making to binary and zero-sum outcomes.

It is believed that Larry Summers ultimately coined the phrase “preserving optionality” back when he was deputy secretary of the treasury under Robert Rubin in the Clinton administration. It was meant to describe a strategy of keeping options open and fluid, before all of the uncertainties have been resolved in dynamic environments where there is a high likelihood for the emergence of new and material information.

The phrase is relevant in venture circles for investors, as well as, entrepreneurs.

Preserving Optionality for Investors and Entrepreneurs

For entrepreneurs, optionality in rapidly evolving scenarios (such as a start-up) means leveraging real-time data and experience before making important decisions that are either resource intensive or cannot be easily reverse…such as pursuing a market vertical, developing a new technology or application, embarking on a joint venture or contemplating multiple exit strategies.

In most instances these options were not conceivable at the outset of the venture because, at best, a start-up’s business plan is to an entrepreneur what a treatment is to a script writer…it’s simply a first draft. It is the actual, real-time development of the story line and its characters that ultimately determines the final draft of a movie script…or the path to monetization for a new business venture.

Investors and experienced entrepreneurs know this. I have rarely seen a startup that successfully monetized itself based upon the mission, objectives and milestones envisioned in its original business plan. That’s because time in the market is often more valuable than time to market with respect to improving the quality of the critical decisions that are of material consequence.

Technology consultant Sean Hull of the Heavyweight Internet Group notes this nuance…“preserving optionality is a philosophy that takes some getting used to. It involves having a sense of humor, and realizing our own human limitations.”

Author-epistemologist-investor Nassim Taleb gets it as well. In Fooled by Randomness he characteristically opines “people overestimate their knowledge and underestimate the probability of their being wrong“. He suggests that by being ever aware of our limitations of prescience, and keeping our eyes and our options open, we can make better, more educated, and lower risk decisions. He is correct.

This implications and realities of preserving optionality, often positions entrepreneurs at odds with investors. The interests of optionality must be balanced.

For the entrepreneur, preserving optionality is an interest that frequently requires a balancing act against intrusive, non-strategic, no-value-add investors who view accountability and measurability as metrics preeminent to the benefits of prudent executive flexibility and strategic discretion.

On the other hand, the investor’s needs for optionality is particularly relevant today in light of the macro market malaise and minimal marquis exits. With venture-backed IPOs now more an exception, venture investors need to stipulate optionality with respect to cash-flow and exit rights as a contingency to their investment commitment.

Investors need to see visibility to alternative liquidity events such as dividend distributions or return of initial capital beyond the sale or merger of the company or its assets, or a less than likely IPO.

It is of no surprise that investors have a preference for positively-skewed outcomes and hold an aversion to negatively-skewed outcomes despite the fact that linear or variance-based risk measures generally weigh the outcomes equally.

Yet, investors seeking the potential for multiple and positive asymmetric outcomes on their commitments must also apply the measures of asymmetry and optionality to their deal diligence and terms. More than ever, investors should require visibility on multiple paths to liquidity. The investor has the responsibility to appropriately balance their interest in ROI with the survival or expansion cash-flow needs of the portfolio company.

Why so many “professional” investors are so passive on this issue is puzzling.

Investors and entrepreneurs alike both benefit from preserving optionality and having the pre-negotiated discretion to pursue a prudent Plan B.

We will discuss those some of those options in upcoming posts.

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Our recent proclamations that “MPT failed” have elicited a distinctively binary response from wealth managers and investment advisors. I have both the commendatory and the castigating emails and comment board posts that prove it.

While many IAs responded enthusiastically, a seemingly larger pool of advisors continue to cling desperately to their discredited diversification dogmas hoping that investors may not have noticed the failure of their advisor’s mantras and models even as last week’s front page WSJ article (“Failure of Fail-Safe Strategy Sends Investors Scrambling”) cited more examples of prominent institutions who who likewise believe that prevailing “asset-allocation strategies are fundamentally flawed”.

Last month in this column I introduced Hybrid Portfolio Theory (HPT) as an alternative to Modern Portfolio Theory. HPT is comprised of two distinct (hybrid) sub-portfolios; the larger (say, 75%) with the primary objectives of insuring safety of principal, liquidity and income by way of allocations to money markets, CDs, municipal and government bonds, while the smaller (25%) portfolio is opportunistically allocated to make investments that have a positive asymmetric outcome (PAO) profile.

In a recent Investment Advisor Magazine-sponsored webinar I defined PAO opportunities as those characterized by 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.

This definition implies a potentially broad constituent universe that allows the investor considerable discretion in identifying PAO opportunities in the HPT sub-portfolio mandated to pursue capital appreciation. Advisor practitioners seeking to implement HPT should exercise such discretion based upon a number of factors, such as their access, due diligence skills and core beliefs with respect to the viability of certain PAO asset-classes, strategies or products. As the moniker Venture Populist implies, my PAO allocations favor private investment in private venture due to the decisive historical performance of venture capital and private equity as an asset class and its proven role of being the greatest and most sustainable source of private wealth.

But the beauty of HPT lies in its adaptability as each investor will define their PAO universe according to their own beliefs, biases, professional skills, access to product  and deal flow…as long as those investments are truly characterized by an empirical and quantifiable positively-skewed risk/reward ratio.

Private investments in venture and early-stage companies are unmistakable asymmetric upside candidates as they are often vulnerable to a 100% loss but may also return three to twenty times on capital. Publicly-traded emerging growth companies are occasionally capable of delivering outsized (Lynch’s “10-bagger”) returns, as well.

But, what about managed futures and market-timers? The manufacturers, marketers and distributers of these so-called “absolute return” products clearly position them as effective portfolio diversifiers, citing their low correlation to long-only assets during Gaussian good times, but does anyone still fall for that line in light of correlations invariably coalescing amidst ever more frequent black swan drills?

Fact is, quantitative diligence reveals most managed futures and market-timers employ zero-sum game strategies with distinctively binary and symmetrical outcomes. They can lose or gain the same amount on each trade. Even if their quantitative models impose disciplined (per trade) stop-loss provisions the aggregate sum of losing trades can equal (or exceed) the aggregate of the winners….hardly asymmetric.

MPT would not have failed so miserably if the concept of diversification was not diluted and polluted by product pushers and manipulative mutual fund marketers. Achieving true diversification requires a higher standard. Amidst the new normal and an elusive equity premium, capital appreciation should be pursued via diversified portfolios defined by their breadth of investments with the potential for positive asymmetrical outcomes.

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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.

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