Thoughts on Public & Private Market Investing

The grand unified theory of putting money to work

While I love trying to beat the market as a theoretical challenge, you’re better off putting your money in Wealthfront. -Brad

During a recent conversation on software development and programming languages with the awesome people at Capstory, I mentioned that I was spending my free time learning more Python in order to leverage into some interesting algorithmic trading strategies.

That was when Brad, astutely pointed out that unless you are James Simons (Ph.D. mathematics by 23, former code breaker for the NSA, and head of the world’s most secretive/profitable quant hedge fund Renaissance Technologies), you are better off investing in Wealthfront, a great variant of the low cost diversified portfolio.

I want to dissect this statement a little more and the assumptions behind it for my own benefit and hopefully for that of my readers:

SP500.png

 Public Markets

 Stocks

First, what is Wealthfront? Wealthfront is an amazing Silicon Valley company that is making the equivalent of the iPod for managing your personal savings. You just load it up (with money) and it just works.

In all seriousness though, what is Wealthfront? Essentially, Wealthfront takes your savings and creates a super diversified portfolio that is both low cost and tax efficient! Wealthfront’s strategy is further explained here for the more adventurous readers. Here’s a quick taste:

We use Modern Portfolio Theory (MPT) to identify the ideal portfolio for each client. The economists who developed MPT, Harry Markowitz and William Sharpe, received the Nobel Prize in Economics in 1990 for their groundbreaking research. Today, MPT is the most widely accepted framework for managing diversified investment portfolios. -Wealthfront Methodology White Paper

 Diversify, diversify, diversify

But why diversify and what does that mean? Well an example of an un-diversified portfolio would be owning 100% of your savings as Apple (AAPL) stock, while diversified is usually meant to be something like owning the S&P500 (SPY) which is an index fund composed of a few shares of every single Fortune 500 company, of which Apple makes up around 5%.

In this scenario, full AAPL holders are subject to the whims and idiosyncrasies of Apple as a company. Does the iPhone 6 have a bigger screen and all the preorders are massively sold out? Yay! Stock went up 5% and you are richer! Oh, Apple’s suppliers are having child labour issues and the iPhone 6 Plus bends huh? I’m sorry stock just dropped like a rock, and you are poorer today. Hopefully in the long run you’ll be better off, if you didn’t buy at $700 a share and sell at $500 a share.

Meanwhile, in the last 5 years as the economy has improved the S&P500 has increased 73.49% relentlessly and relatively consistently. Why is that? Because unlike the AAPL portfolio, the SPY portfolio cancels out un-systemic risk and only leaves systemic risk. Let me explain: every stock has 2 types of risk, systemic and un-systemic. Systemic is the risk that the broader economy will tank and drag all stocks down with it, such as the case in 2008, meanwhile un-systemic risk is stock specific like in the case of Apple when Steve Jobs became ill and investors panicked about the future of Apple without the legendary visionary.

So what’s great about a diversified portfolio is that generally all the un-systemic risk of every stock tends to cancel each other out. For example, airline stocks and oil prices tend to move inversely. As oil becomes more expense, say due to a harsh winter, planes become much more expensive to operate and margins shrink, but oil companies earn more revenue per barrel. On the flip side if oil prices drop, say due to a warm winter, then airlines stocks will benefit as oil companies suffer. In this sense the wise individual investor diversifies his portfolio as to achieve a balance where he is only exposed to systemic risk, in the case of a perfectly diversified stock portfolio, its “Beta” is said to “equal 1”.

 Beta

The concept of Beta (systemic risk) is critical to understand because it determines how much money you make on your investments. See, there is a correlation with risk and return. The riskier an investment is, the higher rate of return you expect for taking that risk. However, not all risk is rewarded, only taking on systemic risk is rewarded, because as we saw in the case of a diversified portfolio, un-systemic risk can be removed. This is best captured in the famous Capital Asset Pricing Model (CAPM) in finance.

CAPM.jpg

This formula maps out into a nice linear graph, where the minimum return for taking on zero risk would be represented by a risk free asset, traditionally US Treasury Bonds. Then for every extra percentage point of Beta or systemic risk in your portfolio, you get rewarded by the risk premium of the market. The risk premium is difference between what a diversified portfolio would return and a risk free asset would return. The final answer to the equation (i.e. the y value in the graph) is the expected return of your portfolio of stocks.

CAPM Line.GIF

Thus, the market does not reward taking on un-systemic risk (it’s not even part of the equation); therefore, it does not make sense for your unsophisticated investors to take on stock or sector specific risk, unless… they have some kind of incredible expertise such as being a Ph.D. in genetics plus former FDA regulator who now trades stocks of pharmaceutical drug companies with promising drugs in clinical trials. This is the level of sophistication one needs, and even then without illegal insider information there is no guarantee that one will time the market right given the multitude of external factors that affect the broader economy and the biotech sector. Thus, for average investors its better to invest in a diversified index.

 Passive Management > Active Management

But wait you say! I know a lot of super smart professional money managers out there who are Ivy League educated and work at incredibly prestigious investment banks, mutual funds, endowment funds, even hedge funds!

The research is pretty clear. After factoring in management fees, passively managed low-cost index funds tend to far outperform actively managed funds in the long run. In fact two studies show that monkeys throwing darts (aka random selection) are better at managing money! And the most interesting research shows that those select investment funds that do outperform the market one year, tend to not be the same funds who outperform the next year. In other words, all luck, no skill, and all the fees that come with active management.

Furthermore, even if one does find a well-performing fund, you have to keep in mind that active management is a zero sum game. An index fund represents market prices which are simply aggregations of gains and losses by all traders. Thus in order for an investor to gain beyond the index, another has to lose in relation to the index. However, management fees, transactions costs, and tax inefficiency will eat even the profits of profitable traders.

zero-sum.png

Finally, the most detrimental effect of active management is innate investor behavioral bias, which affect even professional money managers. One common behavior is chasing returns (i.e. buying expensive historically well returning stocks and then panicking and selling at a discount when they underperform in order to buy another expensive stock). In fact, return-chasing mutual fund investors are losing about 2% per year relative to buy-and-hold investors.

Given all the evidence, it seems clear that passive management is the way to go. This is where Wealthfront comes in; they use a rules based system that asks you questions to understand your risk tolerance and then creates a super diversified portfolio of stocks and bonds that is 1) more diverse than S&P500 2) optimally allocated for your personal risk appetite 3) risk adjusted over time as you age 4) automatically rebalanced 5) tax efficient .

Here’s a chart of the additional return you would expect from Wealthfront compared to a comparable mutual fund:

Wealthfront.png

 The exceptions that make the rule

Be First, Be Smarter or Cheat

But wait you say! What about Warren Buffet and Berkshire Hathaway? He has far outperformed the market for almost the last 50 years. This is true. In fact, in my mind there are about 3 types of investors who actually make any real money by being smart/cunning and not just by taking extra risk (this by the way is called alpha, or “generating alpha”). Interestingly, all of these prototypical examples are represented by eccentric personalities, underscoring their rarity.

 1) James Simons of Renaissance Technologies

Financial Engineering

James Simons has a B.S. in mathematics from MIT and a Ph.D. in mathematics from the University of Berkley. He worked as a code breaker for the NSA during the Cold War, and is now worth $12.5 billion. He is a brilliant quant through and through. (Quant being a nerd in Wall Street speak). Now he runs a secretive and massively profitable $28 billion hedge fund called Renaissance Technologies which employs hundreds of world experts in mathematics, physics, signal processing and statistics in order to find hidden patterns in financial markets. Renaissance then creates mathematical models which analyze and execute trades in order to profit of these patterns, often completely autonomously and at the speed of light using self-directed computer algorithms. Since 1989, after fees, Renaissance has averaged an annual return of 35% soundly beating the S&P500’s 12.02%. This is while managing billions of dollars and taking a massive fee of 5% of assets under management and 36-44% of annual profits. Clearly Renaissance takes the engineer’s approach to financial markets and does extremely well.

This is also not the only method. There are numerous other quant strategies, one of which, a branch of High Frequency Trading (HFT) has come to public attention recently in Michael Lewis’s book Flash Boys. Essentially, when people make trades they ping multiple stock exchanges in order to find the best price, but as soon as they ping one exchange some hi-tech quants go to all the other exchanges first using ultra-fast proprietary channels and buy the stock before the original buyer and then sell it back to that buyer for a profit of a fraction of a penny, and then they do it a billion times a day, generating millions of dollars a day. This is possible because some clever signal engineers and physicists figured out that stock signals move super fast in straight fiber optic cables and even faster via microwaves instead of fiber optics. In fact in Flash Boys, one trading firm offered the owner of a fast channel $200 million just to not sell access to other firms. Here again what you are seeing is an engineering approach to finance, not really a true sustainable financial model for the rest of us to follow.

 2) Steven Cohen of SAC

Black Edge

Steven A. Cohen, the infamous manager of the hedge fund SAC Capital Advisors, employed an army of “Portfolio Managers” whose job it was to find unique trading strategies based on their personal knowledge, strengths, and networks. What this widely was thought to mean was that SAC expected mangers to find “black edge” or insider information and leverage it into extremely profitable trades. However trading on insider information is highly illegal and a great account of what happened to a SAC Portfolio Manager named Mathew Martoma who traded on insider information of a biotech company with a promising and potentially extremely lucrative Alzheimer’s drug in clinical trials can be found here. In the end, Steven Cohen has an estimated net worth of $11.1 billion, but in 2012 he was implicated in a large insider trading scandal. In 2013, the fund plead guilty to preventing insider trading and paid a fine of $1.2 billion as well as returned all out side investor money. What we can see here is that indeed some investors may be making money through cunning trades, but it may not be for the reasons one may expect and hardly a model to follow.

 3) Warren Buffet of Berkshire Hathaway

Value Investing

Finally there is Warren Buffet, the one guiding light for investors hoping to beat the market. Warren Buffet is a known student of value investing. Value investing is a somewhat nebulous concept because at its core it’s about finding under-priced securities by doing some form of fundamental analysis. However, because there are so many different assumptions, models and uncertainties about any analysis, all attempts at Value Investing are informed guesses at best. Of course some investors such as Warren Buffet clearly have a keen ability for it. This small class of investors would seem to disprove the superiority of the Passive Management Theory; however, four things to keep in mind. 1) Likelihood of finding another Warren Buffet is pretty unlikely 2) Likelihood of you being the next Warren Buffet is even less likely 3) Investing in Berkshire Hathaway exposed investors to un-systemic risk which has fortunately been made up by Buffet’s alpha 4) Warren Buffet is thought to have made his significant fortune by leveraging the incoming premiums from his insurance affiliates like GEICO and investing those into low beta Consumer Packaged Goods companies which managed to do extremely well in the growing American economy since 1960 onward. Despite all of that, it is difficult to belittle Warren Buffet’s great achievements, so perhaps this rare class of investor can be written up as genuine skill.

In the end though I think Brad would encourage your average investor to look towards some form of diversified passive management such as Wealthfront, from a risk, return, and tax efficiency perspective. In fact, Buffet has the same advice for his wife:

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit… My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund… I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers. -Warren Buffet

 Bonds

Still not convinced? Well so far we have only talked about stocks (aka equities). And equities are only one side of public market investing. In fact there’s a much larger side known as debt or bond investing. In 2011, McKinsey & Co put the size of the global stock market at $54 Trillion and the global bond market at $157 Trillion; in other words stocks only make up 25% of capital globally. Wealthfront actually exposes you to bonds in their diversified portfolio so kudos to them.

What are bonds? Bonds are essentially debt obligations which earn interest and are generally tradable. For example, when you buy a house and take out a home mortgage, you create a debt obligation between you and the bank. The bank charges you an interest rate and has specific terms based on how creditworthy you are (i.e. how likely you will pay back the debt). The bank then takes hundreds of these mortgages with varying levels of credit worthiness and sells them as a group for a profit to investment banks. Investment banks then structure thousands of these mortgages into what is called a Collateralized Debt Obligation (CDO) which are then sliced up into “tranches” or pools of credit quality. The higher quality tranches are then sold to risk-averse institutional investors like pension funds and sovereign wealth funds, while the lower tranches are sold to more risk tolerant investors like hedge funds. A great overview of CDOs can be found here at Khan Academy.

 2008 Financial Crisis

The magnitude and importance of the bond market can be seen in the events of 2007-2008 leading up to the financial crash. In the United States, a combination of federal encouragement of home ownership, interest rate environment, and perverse lending incentives led to an unprecedented rise in creation of home mortgages and a corresponding drop in credit worthiness requirements for borrowers. This resulted in an incredibly profitable era for investment banks which packaged and resold CDOs for a cut. Unfortunately as interest rates started to rise, and subprime and prime borrowers were unable to meet mortgage payments, banks and markets started to realize that a lot of these CDOs were becoming worthless.

Almost in a matter of weeks to months, the whole world watched as banks scrambled to get these toxic assets of their balance sheets at fire sale prices. Generally investment banks resold the CDOs, so their exposure to the assets were supposed to be limited; however, major losses on the few assets that they did hold far surpassed the capital requirements of most of these banks. In other words, banks were holding on to “big piles of crap” and were royally screwed.

There were, however, a few smart investment banks that knew these securities were worthless. In fact banks like Goldman Sachs were so smart that while they sold what they knew were “shitty deals” to clients, they actually went out and bought insurance against the CDOs called a Credit Default Swap (CDS) knowing that they would profit from their clients losses.

Unfortunately, one firm, AIG, was foolish enough to issue massive amounts of CDSs to banks like Goldman Sachs, suspecting that housing prices would continue to appreciate. Thus when the music stopped and all the CDOs started to fail, AIG was on the hook for insuring $441 billion worth of CDOs, when AIG’s market cap was only $100 billion. And it took the Federal Reserve bailing out AIG to the tune of $85 billion in order to stabilize markets. Curiously, it was then United States Secretary of Treasury Hank Paulson who influenced the decision of Federal Reserve Chairman Ben Bernanke to bailout AIG, which is interesting since Paulson had served as Chairman and CEO of Goldman Sachs, the very firm that stood to benefit so vastly from an AIG bailout.

Interestingly, there were a couple brilliant actors during this tumultuous time, including hedge fund manager John Alfred Paulson (no relation to Hank Paulson) who made “The Greatest Trade Ever” by betting against CDOs and making $4.9 billion in one deal. This would seem to defy our passive investment thesis, only to realize that later on Paulson went on lose his investors billions of dollars while personally profiting greatly due to his high management fees.

There were two other brilliant trades worth noting at the time: the Magnetar Trade and Dr. Michael Burry’s short.

Magnetar Capital, named after a space phenomenon where a dying star creates such an extremely powerful magnetic field that it warps and pulls everything surrounding it, was that kind of hedge fund. Magnetar is infamous for the Magnetar Trade, where it bought the riskiest and lowest quality tranches of CDOs and then used the huge interest payments it gained from these tranches to buy insurance and bet against ten times the amount of safer tranches ($30 billion worth) due to the insurance risk premium disparity between tranches. This was absolutely brilliant, because Magnetar made money either way: if the housing boom continued then it profited from the interest payments of the tranche, and when everything collapsed its short position payed handsomely.

Meanwhile, in California a whole different story unfolded, and at the center was Dr. Michael Burry a neurology resident at Stanford.

While off duty at night, he worked on his lifelong hobby, which was an interest in financial investments. On one occasion, Burry had been working so hard, studying both for medical school and also his financial interests, that during a complicated surgery he fell asleep standing up, and crashed into the oxygen tent that had been built around the patient and was then thrown out of the operating room by the lead surgeon. He quit the medical profession in 2000 and started an investment company called Scion Capital

Despite suffering from blindness in one eye, Asperger’s syndrome, and conflicts with investors, Burry saw the housing crisis coming and bet heavily against subprime mortgages in advance of the 2008 financial crisis. He ended up profiting personally $100 million and returned $700 million after fees to his investors.

In the end, the crash of 2008 created a situation where money dried up on Wall Street within a matter of weeks, interbank lending froze, so all bank lending froze, capital started drying up in commercial paper markets which Fortune 500 companies use for financing, small business lending by local banks seized, and even Venture Capital LPs started freaking out leading to startup investment drying up. In the blink of an eye, the Wall Street crash became a Main Street nightmare.

Here’s a perfect example from the movie Too Big to Fail:

If the financial system collapses, and banks go under or dry up in reserves, they will close down. People need to withdraw cash from ATMs to buy food and groceries, so they can’t buy food. Stores have to make payroll, buy inventory, and transport food to stores. Stores only have 48 hours of inventory on hand. If there is a run on banks and then a run on stores, inventory will be gone in a flash. If people can’t reliably get food, then god knows: riots, lotting, massive civil issues, potentially martial law. All in the matter of days.

This of course was the worst case scenario we know this did not happen, whether it was due to the government bailouts, or the fact that depository institutions which hold personal savings were separate from the loss making investment banking arms.

The point here is that everything is interconnected, the investment market is incomprehensibly complex starting with just stocks and bonds and moving up to insurance and derivatives, and very hard to predict, so your average individual investor should stick to index funds instead of trying to be too clever.

 Private Markets

Wait a minute you say! What if I just invest in the next Facebook then? I mean the guy who sprayed graffiti on Facebook’s walls is worth half a billion dollars.

So far we’ve discussed public markets, but what about private markets? Private markets also consist of equity and debt; however, in order to invest in private securities the SEC legally require you to be an accredited investor (i.e. rich), meaning you have an annual income over $200,000 or have assets exceeding $1 million not including your primary residence. This will rule out most Americans (about 99% actually). Interestingly, the accredited investor requirement does not apply to foreign investors.

There are 4 faces to Private Markets 1) Private Equity: Venture Capital 2) Private Equity: Growth Equity 3) Private Equity: Buyout 4) Private Debt

 Venture Capital

Venture Capital (VC) is a form of Private Equity that focuses purely on early stage, non-public companies like startups (e.g. Snapchat and Uber). Venture Capital firms acquire equity stakes in startups in return for providing a combination of money, advice and access to a network.

The interesting thing about Venture Capital, is that it does not follow the rules of traditional investing. A VC firm invests in 10 startups with the expectation that about 7 will fail with 0x return, 2 will breakeven with 1x return, and 1 will provide 10-100x return making up for and exceeding the whole portfolio (often called a homerun or even a grandslam in some cases). Here’s a graph illustrating the perceived linear value of a VC’s portfolio and the true exponential nature:

exponent.png

The reason for this phenomena is that early stage venture backed startups have very binary outcomes: 1) they fail to gain traction and close up shop or 2) they gain massive traction, experience hyper growth and eventually exit by going public (an IPO or initial public offering) or get acquired by a bigger company.

Thus the rules around early stage investing are not based on linear relationships as seen in the CAPM model, rather they are based around exponential thinking. This binary outcome model creates a lot of risk and investor uncertainty that is further compounded by the fact that most forms of fundamental analysis are not applicable on pre-revenue unprofitable early-stage startups, killing all hopes for value investing.

Due to this uncertainty, successful venture capitalists have come to rely on two heuristics/indicators: massive markets and killer teams. Precisely because most companies fail, investors need to know that rare successes will generate massive returns. Thus they prefer startups who have a 1% chance of dominating a $10 billion market vs a startup with a 50% chance in a $10 million market. The math adds up but not the way most people are geared to think. Also, since the odds are stacked up against startups, successful companies tend to have founders that either 1) started successful companies before or 2) have industry experience and 3) have worked together and known each other for a long time.

In recent years, as software has eaten the world (i.e. software has disrupted traditional non-software oriented industries e.g. Taxis) investors have seen huge returns. Correspondingly, Venture Capital has experienced a massive influx of new money and new entrants:

Mutual Funds and Hedge Funds Enter Late Stage Equity Financing

Because of the interest rate environment created by the Federal Reserve, expected returns for public stocks and bonds for the next decade have fallen dramatically. Thus return hungry investors like mutual funds and hedge funds have entered the mid to late-stage equity financing of technology startups, which in turn has inflated prices. Some examples include Fidelity (mutual fund) leading a $1.2 billion investment in Uber at a valuation of $17 billion, after only 5 years of operation and Coatue Management (hedge fund) leading a $50 million investment in Snapchat at a valuation of $3-5 billion, after only 3 years of operation.

The benchmark for mutual funds and hedge funds tend to be the S&P500 (2-12%), while VCs strive to return 20% given their risky nature. Thus, an interesting consequence of mutual and hedge funds competing with VC firms in later funding rounds, is that these funds are willing to pay higher prices for startups than VCs. Which is great for founders since they get diluted less in such arrangements; however, the down side is they forgo a couple advantages including VC advice, network, commitment to hold, and LP lock in. Advice and network are straightforward, VCs tend to be more involved in the operation aspects of a startup. VCs also hold their equity positions in startups for a long time, accepting nonperformance as acceptable given the VC portfolio dynamics of homeruns. On the other hand, hedge funds will not hesitate to dump a startup’s shares if losses mount, given the tight Value at Risk (VaR) controls at most funds. Finally, mutual and hedge funds are more liquid investments where investors can withdraw their money at any time, while VC firms tend to have contractual capital commitments from their investors (aka LPs or Limited Partners). Thus, when the broader macroeconomy slumps, investors in mutual and hedge funds may pull out their capital causing funds to liquidate, mean while VC funds are relatively unaffected besides the fact that exits for their portfolio companies become a lot harder in tough economic times (i.e. less demand for IPOs and acquisitions).

Investment funds typically found in public markets are also eager to jump in for another more structural reason. Early stage companies are waiting longer to go public; therefore, more of the value appreciation is occurring in private markets. Scott Kupor from VC firm Andreessen Horowitz explains this best:

Microsoft went public in 1986 at roughly a $500 million market cap. Today, Microsoft has a market cap of $234 billion. Thus, the public investors in Microsoft have had the opportunity to realize $233.5 billion in market cap appreciation; the private investors had only a $500 million head-start. From IPO, a single share of Microsoft stock has appreciated close to 500x.

Facebook, by contrast, went public in 2012 at roughly a $100 billion market cap. That means that, whatever public stock price appreciation Facebook has over the coming years, private investors have had a $100 billion head-start against the public investors. Even if you were prescient enough to buy Facebook at its public low of approximately a $50 billion market cap, the private investors remain way ahead. If you bought Facebook stock at its IPO, to realize a similar multiple that Microsoft’s public shareholders have earned, Facebook’s market cap would need to reach nearly $50 trillion, roughly the size of the total market capitalization of all publicly-traded companies in the world.

Creation of Secondary Markets

Finally, even wealthy individuals are trying to access late stage startup equity through secondary markets created by the sale of early employee stock options. Early employees at startups, in order to reach a personal liquidation event, will often sell their stock options before the company exits. This itself has created two consequences. First, companies like Wealthfront offer a single stock diversification program where they buyout your highly concentrated stock options and return a fully diversified portfolio of equivalent value. Second, is the advent of secondary market companies (e.g. Second Market and SharesPost), which help individual investors access these second hand shares.

This is an issue for startup founders because it creates a situation in which random strangers are acquiring shares in their companies, which maybe creating unwanted pricing signals. Additionally, secondary markets dilute the concentration of ownership, which can be a problem from a legal perspective and also because founders would prefer fewer investors who can turn these shares into a core portfolio position and add on in later rounds, including in an IPO (e.g. Fidelity for Uber).

Rise of the Early Stage Venture Fund

Another entrant in recent years, are early stage venture funds, whose sole goal is to invest much smaller amounts of capital in the very beginnings (seed stage) of lots of startups in hopes of finding 1 grandslam in a portfolio of dozens of companies. While promising, this model has yet to be proven, and seems a lot like the monkeys throwing darts then one would like to admit.

Incubators & Accelerators

Incubators and accelerators are also relatively new phenomenon pioneered by Paul Graham and Jessica Livingston at Y Combinator (YC). They take the grandslam approach by finding super cheap, young, unproven founders and giving them stellar advice, seed money, and access to a huge network in return for 7% equity. The model has been wildly successful for YC generating a $30 billion portfolio of which they are estimated to own about 3% after dilution, giving a return of $900 million on an investment of about $50 million. Unfortunately all other incubators/accelerators have not even come close to this sort of financial success, indicating that even here exponential thinking and selection effects are at play. An interesting side note is that of the over 500 companies that YC has funded, only 3 companies (Dropbox, Airbnb, and Stripe) make up the vast majority of that $30 billion valuation, talk about grandslams.

AngelList

AngelList is probably the most modern financing platform ever invented. It brings a Kickstarter like mentality to angel investing (accredited individuals building a portfolio of seed investments). This is only possible with the SEC’s recent relaxation of the ways startups are allowed to market their fundraising activities. But again, this simply makes angel-investing a digital exercise, and angel-investing follows the same VC dynamics.

The Acquihire

A phenomenon worth noting unique to technology startups is the acquihire. Due to the huge talent shortage of software engineers, and the fact that the best talent tends to strike out on its own, large companies have resorted to buying out young startups just for the talent. While extremely expensive upfront, acquihiring is fast and effective (since the startup founders and employees have proven themselves to be talented). Unfortunately, talent retention is questionable since acquihires usually have a period of golden handcuffs where there options vest, but then they are free to leave. An interesting side note here is that top VCs are more likely to be able to leverage their stellar networks, and cover potential losses from their non-performant startups’ with acquihires.

Exponential Thinking

All these funds would seem to indicate that VC is a great place to be as an investor looking to beat public market returns, but the sad fact is over the last 10 years VC as an asset class has severely underperformed the S&P500. According to Cambridge Associates the average annual venture capital return over the past 10 years has only been 8.1% as compared to 5.7% for the S&P 500. But this is where the exponential nature of VC creeps in. In fact 75% of funds have underperformed, but the top 25% generated an annual rate of return of 22.9%. It gets worse:

The top 20 firms (out of approximately 1,000 total VC firms) generate approximately 95% of the industry’s returns.

VC Asset Class.jpg

In other words, even among VC funds only the best of the best are successful. In this sense VC is actually more like a boutique investment industry, where access to true performers is privileged to the rich and connected.

 Growth Equity

This is basically late stage VC; see here for more info.

 Leveraged Buyout

Also known as just Private Equity or PE generally involves these firms managing huge multi-billion dollar funds with the goal of taking failing public companies into private management using debt in a Leveraged Buyout (LBO) and restructuring them into profitability and then having an exit event, either by going public via an IPO or acquisition. Relatively straight forward and very profitable if the turnaround is successful, which is not always guaranteed. Industry returns also trail public market returns for the average PE firm; however, exponential laws also rule here, and the best of the best have done quite well. Indeed, buyout private equity is also a boutique industry rather than an asset class.

 Private Debt

A lot of the CDO creation and handling was actually private debt, but the larger point here is that debt is a very profitable business to be in with wide spreads; unfortunately, it’s a lot of leg work and you can end up holding a bag of lemons.

 Caveat

I’m not an investor. People always tell me “you should have your money working for you.” I decided, I’ll do the work.. I’m gonna let the money relax. You know what I mean, cause you send your money out there working for you, and a lot of times it gets fired. You go back and ask what happened? My money was here and it was working for me? “Yeah.. I remember your money, showing up late, taking time off.. we had to let him go.” -Jerry Seinfeld on stocks

While we have seen that for most investors, it’s far more convenient and performant to invest in a low cost diversified index fund, we have also seen that there are certain niches where rare world-class professional investors can outperform the market after fees. And this is actually good. If everyone in the world simply invested in the S&P500, then we would have a massive over-valuation and mis-pricing in the global capital markets, not to mention that nothing would ever get done without financing available. Keeping that in mind though, it’s still patently obvious that all retail investors and more institutional investors who do not have access to the best of the best would greatly benefit in the long run to keep in mind what Brad said.

Having written all this, it would seem quite paradoxical for me to try to beat the market. However, I believe I have a financial engineering edge and can reliably beat the market in the long run producing exponentially greater returns. Only time will tell.

 
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