My first blog post on May 12, 2005 reviewed Nassim Nicholas Taleb's wonderful book, Fooled by Randomness.
I am currently reading his second, The Black Swan, the Impact of the Highly Improbable.
The first book centers on the "hidden role of chance in life and in the markets." As an investor, it is particularly apropos as one tries to identify systematic methods of creating value via investing. Investors and investees like to believe that the investment world is deterministic with clearly understood cause and effect. Understanding causal drivers of value helps to create repeatable models for investment that scale both across time and individuals in the firm. Nassim challenges us to be very careful in over ascribing reason and logic to an outcome. Too often, investment outcomes are the result of randomness rather than science, ie being lucky rather than good.
The second book posits that we expect the world to operate within very narrow bands of probability and tend to discount the possibility of extreme events, or black swans. For example, Wall St uses Value At Risk models that analyze capital at risk with a 95% confidence interval - the models, based on Monte Carlo simulations, create a range of statistically probable outcomes. The savings and loan debacle, the current subprime mortgage mess, Long Term Capital, etc illustrate the fallacy of discounting the highly unlikely.
The book also introduces a key concept that with real application for venture capital - confirmation bias. He writes, "cognitive scientists have studied our natural tendency to look only for corroboration; they call this vulnerability to the corroboration error the confirmation bias." Due diligence is the process by which investors analyze and evaluate investment opportunities. Too often, however, diligence is confirmatory in nature. As Taleb notes, "...subjects supplied mostly questions for which a "yes" answer would support the hypothesis. Disconfirming instances are far more powerful in establishing truth. Yet we tend to not be aware of this property. A series of corroborative facts is not necessarily evidence. We can get closer to the truth by negative instances, not by verification."
In my experience, investors often look for corroboration at the cost of negative empiricism - ie at the cost of looking for non-confirming evidence. Such evidence in itself may not argue against the deal, it will, however, help avoid Pollyannish projections based more on hope than on truth.
Friday, November 23, 2007
Saturday, November 10, 2007
Panel on Investing in Innovation
Last night, I spoke on a SVOD panel discussing investing in innovation.
Invitations to speak always spark new ideas and new frameworks for trying to cogently boil down large and complex ideas into a few key ideas.
The topic of the panel and this post provided a framework for thinking about the issues.
For example, innovation is the science of new possibilities. Investing in innovation, however, centers on the science of consumption.
Innovation in a vacuum leads to failure and the commercialization of innovation is predicated on a ready ecosystem in place to enable the development, delivery, and sale of a product.
Consumption, in the broadest sense, demands the marriage of science with application.
A useful framework for tying technical innovation to consumption follows:
Commercial Success = Customer Need x Offering Innovation x Sales and Delivery Model x Ecosystem Development x Risk-adjusted Return
Customer Need = a clear view of the buyer's problem, identity, motivations, and resources
Offering Innovation = a material, rather than marginal improvement in the state of the art
Sales and Delivery Model = a distribution model that aligns product-market fit and, like Occam's razor, reduces any unnecessary frictions from the buying process
Ecosystem Development = no material exogenous market developments are required for the company to be successful. Rather, the ecosystem is ripe to support the innovation.
Risk-Adjusted Return = ROI alone is not sufficient to motivate customer behavior.
Invitations to speak always spark new ideas and new frameworks for trying to cogently boil down large and complex ideas into a few key ideas.
The topic of the panel and this post provided a framework for thinking about the issues.
For example, innovation is the science of new possibilities. Investing in innovation, however, centers on the science of consumption.
Innovation in a vacuum leads to failure and the commercialization of innovation is predicated on a ready ecosystem in place to enable the development, delivery, and sale of a product.
Consumption, in the broadest sense, demands the marriage of science with application.
A useful framework for tying technical innovation to consumption follows:
Commercial Success = Customer Need x Offering Innovation x Sales and Delivery Model x Ecosystem Development x Risk-adjusted Return
Customer Need = a clear view of the buyer's problem, identity, motivations, and resources
Offering Innovation = a material, rather than marginal improvement in the state of the art
Sales and Delivery Model = a distribution model that aligns product-market fit and, like Occam's razor, reduces any unnecessary frictions from the buying process
Ecosystem Development = no material exogenous market developments are required for the company to be successful. Rather, the ecosystem is ripe to support the innovation.
- For example, wimax deployments, RFID reader deployment, etc.
- Also, like Newton's "on the shoulder of giants," all start-ups require a foundation of enabling conditions to truly be successful. Understanding the cornerstones of the opportunity and how to leverage them is key to commercialization.
- Also, innovation is largely symbiotic. Bill Joy's quote, "innovation happens elsewhere" is important to keep in mind as product design should benefit from the innovation of others rather than solely on the company's employees.
Risk-Adjusted Return = ROI alone is not sufficient to motivate customer behavior.
- Like any investor, return must be analyzed with risk and customers, like investors, will seek to maximize their Sharpe Ratios, or return divided by standard deviation.
- Many start-ups fail to realize the vendor, operational, and product risks they are asking customers to take on. Selling absolute return independent of the risk ignores a major component of customers' product selection. Be conscious of inadvertently creating risk and manage risk out of the sales and deployment model.
Friday, November 02, 2007
Top Dealmaker List
AlwaysOn, in partnership with KPMG, just released their inaugural Top Dealmakers List.
The lists include the top LPs, early stage firms, late stage firms, corporate vcs, law firms, investment banks, etc...
As Letterman knows, everyone loves a list. Worth a quick read.
The lists include the top LPs, early stage firms, late stage firms, corporate vcs, law firms, investment banks, etc...
As Letterman knows, everyone loves a list. Worth a quick read.
Thursday, November 01, 2007
Venture Capital and Emerging Managers
I recently wrote a post, Portfolio Math, that examined the hit rate and return on invested capital required for the venture capital industry to be viable. The post led to excellent feedback from venture investors, entrepreneurs, and, interestingly, limited partners in various venture capital funds.
The existential question the comments begged appears to be, is it worth investing in the venture asset class?
The current LP position appears to be rather axiomatic:
The last choice is also interesting to consider. In the hedge fund industry, it has long been standard practice for LPs who cannot get into Citadel, SAC, and other top funds to lure away rising stars to start their own firms. If the axioms above continue to hold, I would not be surprised at all to see groups of sophisticated LPs lobbying younger GPs to start new funds in order to ensure allocation to talent who can drive returns in a now well-established Pareto distribution market.
Over the next few years, I expect to see more firms fail as LPs refuse to reup, the total dollar size of the industry shrink, and the birth of several new venture firms run by top-tier alums and backed by LPs committed to the asset class but denied entry by the door keepers at the top firms.
Post-script:
After posting the above, someone sent me the following news story:
California State Teachers' Retirement System may once again be reducing its target allocation to venture capital, this time in favor of debt-related investments such as distressed debt and mezzanine, according to the agenda for its Nov. 1 investment committee meeting.
The pension system is mulling changes to its investment policy that would reduce the target allocation to venture capital to 5% from 15% of its alternatives portfolio and raise the target allocation to distressed debt and mezzanine from 5% to 15%, according to the agenda. The proposal would also reduce the upper end of its venture capital target range from 25% to 15% and increase the upper end of the debt-related target range from 10% to 20%.
The existential question the comments begged appears to be, is it worth investing in the venture asset class?
The current LP position appears to be rather axiomatic:
- average venture asset class returns are a nonsensical number
- why? less than 20% of the firms drive greater than 80% of the returns
- it is borderline impossible to get into the top venture funds
- blind allocation to the asset class - ie if Sequoia says no give it to someone who will say yes, is now recognized as very flawed logic
- leave the asset class
- be patient and wait for allocation to top tier funds
- sponsor emerging manger funds targeting young GPs at top tier funds
The last choice is also interesting to consider. In the hedge fund industry, it has long been standard practice for LPs who cannot get into Citadel, SAC, and other top funds to lure away rising stars to start their own firms. If the axioms above continue to hold, I would not be surprised at all to see groups of sophisticated LPs lobbying younger GPs to start new funds in order to ensure allocation to talent who can drive returns in a now well-established Pareto distribution market.
Over the next few years, I expect to see more firms fail as LPs refuse to reup, the total dollar size of the industry shrink, and the birth of several new venture firms run by top-tier alums and backed by LPs committed to the asset class but denied entry by the door keepers at the top firms.
Post-script:
After posting the above, someone sent me the following news story:
California State Teachers' Retirement System may once again be reducing its target allocation to venture capital, this time in favor of debt-related investments such as distressed debt and mezzanine, according to the agenda for its Nov. 1 investment committee meeting.
The pension system is mulling changes to its investment policy that would reduce the target allocation to venture capital to 5% from 15% of its alternatives portfolio and raise the target allocation to distressed debt and mezzanine from 5% to 15%, according to the agenda. The proposal would also reduce the upper end of its venture capital target range from 25% to 15% and increase the upper end of the debt-related target range from 10% to 20%.
Wednesday, October 31, 2007
Rich Price
As some of you know, my brother Rich is a wonderful singer-song writer.
Embedded is one of his new songs, Change, and I love it.
Embedded is one of his new songs, Change, and I love it.
Tuesday, October 23, 2007
DuPont Models and How to Determine KPIs?
Data driven management is a popular concept and with good reason. CEOs, management teams, and board of directors gain tremendous value in defining and managing to key performance indicators (KPIs).
Why?
KPIs provide insight into the underlying mechanics of the business model that help teams manage departmental functions and focus the company on the building blocks of future success. The concept of KPIs as powerful intra-period (day, week, month, quarter) barometers of company performance is well understood.
However, traditional mechanisms for financial management, GAAP financials and the operating plan, are necessary, but not sufficient tools for data driven management.
Start-ups are exercises in prospective thinking and both GAAP financials and the operating plan generally fail to provide insight into the upstream metrics that drive financial success.
GAAP financial statements are backward looking records of the past, and they often fail to provide insights into how the company will perform in the future. Start-ups all develop operating plans, however, in my experience 3 year plans, while necessary, are often highly abstracted summaries of a hoped for future that tend to be more academic than operational. They tend to be the product of the CFO's office with little day to day value for the team.
How then should one bridge the gap between GAAP financials and the high level financial projections? As a CEO, VP, director, or individual contributor what data points matter to you? When you come in in the morning, how do you know what to focus on with some sense of certainty that your particular KPI is a key part of the broader company's goals?
In 1919, DuPont's F. Donaldson Brown was tasked with turning around GM after DuPont bought a 23% stake. In order to help drive clarity and transparency into the state of GM's finances, Brown developed a model that broke down the company's ultimate goal, high return on assets, into an easy to visualize set of critical building blocks.
The standard DuPont model follows:
Return on Equity = Net Profit Margin * Total Asset Turnover * Equity Multiplier
Each component can then be broken down into its constituent parts.
For example,
NPM = Net Income/Net Sales
TAT = Net Sales/Total Assets
EM = Total Assets/Common Equity
One can now see that higher profitability, higher asset utilization, and higher debt levels can all lead to higher ROE. Further, each child node can be further analyzed to understand the key levers that drive the parent node.
Net Profit Margin can be influenced by unit volume, unit price, fixed costs, variable costs, and so on.
Now, how does this apply to start-ups?
Well, start-ups can develop a custom version of the DuPont model that 1) transparently states the formula for value creation and 2) makes visible key value-creating levers that are themselves the "Is" in KPIs.
For example, the search business can be defined by the following formula:
Revenue is no longer an abstract concept but a goal with clearly defined indicators that departments can execute against, such as driving more queries per user, maximizing ad attach rates per query, optimizing click through rates, driving higher ecpms....
A team's ability to develop a relevant DuPont model that maps out the key components of revenue and profit is critical in developing material KPIs. To bridge the gap between Quickbooks' financials and Excel operating plans, I suggest that a team whiteboard a model that drives both revenue and costs.
As a planning exercise:
If so, take the time to develop a company specific DuPont model and agree as a team on the formula's key arguments; assign each team member a set of arguments to optimize, and come to the team meeting with weekly snapshots and trends of the arguments' execution.
In may ways, laying out a DuPont formula is a precondition to building an operating plan, ie it identifies the key business model drivers. Moreover, aligning strategy with a DuPont model allows for orchestrated execution where the component pieces, ie departmental specific activities, sum to a larger whole.
Why?
KPIs provide insight into the underlying mechanics of the business model that help teams manage departmental functions and focus the company on the building blocks of future success. The concept of KPIs as powerful intra-period (day, week, month, quarter) barometers of company performance is well understood.
However, traditional mechanisms for financial management, GAAP financials and the operating plan, are necessary, but not sufficient tools for data driven management.
Start-ups are exercises in prospective thinking and both GAAP financials and the operating plan generally fail to provide insight into the upstream metrics that drive financial success.
GAAP financial statements are backward looking records of the past, and they often fail to provide insights into how the company will perform in the future. Start-ups all develop operating plans, however, in my experience 3 year plans, while necessary, are often highly abstracted summaries of a hoped for future that tend to be more academic than operational. They tend to be the product of the CFO's office with little day to day value for the team.
How then should one bridge the gap between GAAP financials and the high level financial projections? As a CEO, VP, director, or individual contributor what data points matter to you? When you come in in the morning, how do you know what to focus on with some sense of certainty that your particular KPI is a key part of the broader company's goals?
In 1919, DuPont's F. Donaldson Brown was tasked with turning around GM after DuPont bought a 23% stake. In order to help drive clarity and transparency into the state of GM's finances, Brown developed a model that broke down the company's ultimate goal, high return on assets, into an easy to visualize set of critical building blocks.
The standard DuPont model follows:
Return on Equity = Net Profit Margin * Total Asset Turnover * Equity Multiplier
Each component can then be broken down into its constituent parts.
For example,
NPM = Net Income/Net Sales
TAT = Net Sales/Total Assets
EM = Total Assets/Common Equity
One can now see that higher profitability, higher asset utilization, and higher debt levels can all lead to higher ROE. Further, each child node can be further analyzed to understand the key levers that drive the parent node.
Net Profit Margin can be influenced by unit volume, unit price, fixed costs, variable costs, and so on.
Now, how does this apply to start-ups?
Well, start-ups can develop a custom version of the DuPont model that 1) transparently states the formula for value creation and 2) makes visible key value-creating levers that are themselves the "Is" in KPIs.
For example, the search business can be defined by the following formula:
Revenue is no longer an abstract concept but a goal with clearly defined indicators that departments can execute against, such as driving more queries per user, maximizing ad attach rates per query, optimizing click through rates, driving higher ecpms....A team's ability to develop a relevant DuPont model that maps out the key components of revenue and profit is critical in developing material KPIs. To bridge the gap between Quickbooks' financials and Excel operating plans, I suggest that a team whiteboard a model that drives both revenue and costs.
As a planning exercise:
- develop DuPont formulas relevant to the business that define the material components of revenue, costs, and profit
- drill down on each node until there is no marginal benefit of further granularity
- analyze the impact of moving each indicator, or formula argument, on the desired result and identify the most impactful indicators to manage
- assign each department indicators, arguments in the equation, they can control, effect, manage, and report against
- the formula's arguments are now the organizations KPIs
- With the KPIs extracted from the company's DuPont model, data driven management is now possible. The company, departments, and individual contributors now understand how their daily work contributes in the aggregate to the model's efficacy
If so, take the time to develop a company specific DuPont model and agree as a team on the formula's key arguments; assign each team member a set of arguments to optimize, and come to the team meeting with weekly snapshots and trends of the arguments' execution.
In may ways, laying out a DuPont formula is a precondition to building an operating plan, ie it identifies the key business model drivers. Moreover, aligning strategy with a DuPont model allows for orchestrated execution where the component pieces, ie departmental specific activities, sum to a larger whole.
Monday, October 22, 2007
Aria Systems Raises Series A - Leave the Billing to Us!
The below is a guest post written by Lars Leckie of Hummer Winblad.
HWVP’s investment in Aria is the firm’s fourteenth SaaS investment (others include Omniture, Adforce, Employease – some of which date back to 1998).
The investment in Aria is a double down on the SaaS market – Aria is not only itself a SaaS ISV, but also the company is a core component of any SaaS company trying to efficiently scale. RBC Capital Markets predicts that the SaaS market will grow at 43% CAGR to be $28bn by 2010. That’s a lot of billing.
As the SaaS market grows, the need for ISV’s to make bespoke investments in data center operations, billing infrastructure, and other core, but non-differentiated, functions is lessening by the day. Providers like Aria allow ISV’s to focus 100% of their human and financial capital on differentiated application logic, while using best-of-breed platform vendors for infrastructure services. The company puts it best when it tells customers it will help them, "get customers, get paid, get control."
Why invest in Aria? Simply put, traditional billing solutions, independent of expensive on-premise software, are not well suited to subscription and usage based billing models. New revenue models bring about the need for new billing architectures. Emerging SaaS companies who don’t use Aria can either choose to build a billing system themselves, thereby diverting engineering resources to a non-core engineering function, or they can use existing on-premise solutions with a myriad of spreadsheets and manual accounting. Aria is a solution that can scale and provide the best infrastructure through a strong focus on the billing market.
The Aria solution is a complete turnkey SaaS (single instance, multi-tenant) solution to manage recurring revenue billing. They manage the quote-to-cash system for a company including hosted customer sign-up, customer service, provisioning of service, dunning and all the other components needed for a full billing solution.
Aria is already in the market with strong customer traction and key partnerships in place. The vertical markets that Aria addresses today are SaaS, On-line Gaming and Telco. A few of their partners in these markets are Opsource and GNi but you can see the full list of over 25 partners here.
Congratulations to Ed Sullivan and the rest of the Aria team - Welcome to the Hummer Winblad family.
Friday, October 12, 2007
Burn the Boats
As a venture capitalist, I am fortunate to meet with people brimming with ideas for new products and new companies. You can feel the excitement build as ideas percolate and mature from insights quickly scribbled down in the middle of the night, to application mock ups, late night Starbucks brainstorming sessions, and early team solicitation.
Often, however, the ideas never bear fruit and the excitement subsides and the spark of creativity dies. This week, I met with several good friends who suffer from both the blessing and the curse of a surfeit of choices and options. The blessing is that talented people are always in demand and there are many avenues of opportunity available to them. The curse is that they often sit stalled at the cross-roads of choice - start-up, large company, start my own gig....
Mark Gainey, the founder of Kana, once told me that the hardest step on the road to entrepreneurship is the first one. Once committed, the iterations come fast and furious and the pressure to make it work allows for moments of genius and insight simply not possible before diving in head first.
I continue to regret that so many brilliant people that I know, full of energy and ability, sacrifice their passions on the alter of safety or indecision.
The conquistador Cortes provided a model for all intrepid souls....that is to burn the boats on the shore and ensure no way back and the stark need to make the expedition succeed or go down trying.
In facing choice in a sea of opportunity, I think that Frost's road less taken is inherent in the spirit of the Valley. However, it often requires a moment a bit like sky-diving....i.e. to willingly jump out of a perfectly good plane and make the most of the free fall.
Like Cortes, it is often necessary to burn the safety boats in order to finally realize the promise of late night ideas and the passion that gets you jumping out of bed in the morning.
Often, however, the ideas never bear fruit and the excitement subsides and the spark of creativity dies. This week, I met with several good friends who suffer from both the blessing and the curse of a surfeit of choices and options. The blessing is that talented people are always in demand and there are many avenues of opportunity available to them. The curse is that they often sit stalled at the cross-roads of choice - start-up, large company, start my own gig....
Mark Gainey, the founder of Kana, once told me that the hardest step on the road to entrepreneurship is the first one. Once committed, the iterations come fast and furious and the pressure to make it work allows for moments of genius and insight simply not possible before diving in head first.
I continue to regret that so many brilliant people that I know, full of energy and ability, sacrifice their passions on the alter of safety or indecision.
The conquistador Cortes provided a model for all intrepid souls....that is to burn the boats on the shore and ensure no way back and the stark need to make the expedition succeed or go down trying.
In facing choice in a sea of opportunity, I think that Frost's road less taken is inherent in the spirit of the Valley. However, it often requires a moment a bit like sky-diving....i.e. to willingly jump out of a perfectly good plane and make the most of the free fall.
Like Cortes, it is often necessary to burn the safety boats in order to finally realize the promise of late night ideas and the passion that gets you jumping out of bed in the morning.
Investment Models as Risk Acceptance Criteria
In many ways, investing is an exercise in decision making. In order to ensure consistent decisions, firms develop investment models with which to evaluate opportunities.
The models (both qualitative and quantitative) provide a framework for evaluating risk and return. The model defines the strike zone and helps shift investment decisions away from debating the merits of a class of investing, ie. do we want to deals like this, to the merits of a specific investment. The class of investment, what type of deals do we do, is defined by the model, the object, ie discrete investment decision, is the output of the model in action.
Another way to think of a model is as an articulation of the risks the firm is willing to take. For example, Hummer Winblad's model is to invest in Series A, enterprise software start-ups, and to back capital efficient plans at reasonable post-money valuations. Explicitly in the model is a checklist defining our focus, and inherently in the model is a level of risk acceptance, i.e. we are wiling to accept certain risks subject to appropriate pricing, capital investment, and overlap with our expertise.
If a firm's risk asset acceptance terms are well defined, ie what a strike looks like, then the firm can focus on sourcing and executing to the model. Also, to the extent an investment is outside of the model, the exceptions (ie areas of misfit with model) can easily be identified and analyzed. The investor can say, "I recognize that this deal is off our curve in the following dimension, however, the exception and added risk is worth taking for the following reasons."
Defining acceptable risks and a target profile creates consistent decision making and increased productivity. It also helps quickly flag execptions and puts the onus on the deal champion to explain the logic in swinging out of the strike zone.
Models are tools for decision making, but they also provide a logical framework with which a team of individuals can use to maintain a common cadence and definition of risk. The moral is not to never to go off the model, but to always know when you are off the model and to ask if the potential return is worth taking the extra risk.
The models (both qualitative and quantitative) provide a framework for evaluating risk and return. The model defines the strike zone and helps shift investment decisions away from debating the merits of a class of investing, ie. do we want to deals like this, to the merits of a specific investment. The class of investment, what type of deals do we do, is defined by the model, the object, ie discrete investment decision, is the output of the model in action.
Another way to think of a model is as an articulation of the risks the firm is willing to take. For example, Hummer Winblad's model is to invest in Series A, enterprise software start-ups, and to back capital efficient plans at reasonable post-money valuations. Explicitly in the model is a checklist defining our focus, and inherently in the model is a level of risk acceptance, i.e. we are wiling to accept certain risks subject to appropriate pricing, capital investment, and overlap with our expertise.
If a firm's risk asset acceptance terms are well defined, ie what a strike looks like, then the firm can focus on sourcing and executing to the model. Also, to the extent an investment is outside of the model, the exceptions (ie areas of misfit with model) can easily be identified and analyzed. The investor can say, "I recognize that this deal is off our curve in the following dimension, however, the exception and added risk is worth taking for the following reasons."
Defining acceptable risks and a target profile creates consistent decision making and increased productivity. It also helps quickly flag execptions and puts the onus on the deal champion to explain the logic in swinging out of the strike zone.
Models are tools for decision making, but they also provide a logical framework with which a team of individuals can use to maintain a common cadence and definition of risk. The moral is not to never to go off the model, but to always know when you are off the model and to ask if the potential return is worth taking the extra risk.
Wednesday, October 10, 2007
Capital Flows - The Implications of Yale's Asset Allocation
David Swensen, Yale University's Chief Investment Officer, is widely recognized as one of the world's great investors
For Fiscal 2007, Yale reported a return of 28%. Over the last decade Yale's return is 17.8% and assets have grown from $5.8bn to $22.5bn.
For 2008, Yale plans the following asset allocation:
Today's NY Times noted that pension fund managers plan to increase asset allocation to alternative investments from 14.4% to 19.4%, a 35% increase, over the next three years. The article cited a survey of 50 of the world's largest pension fund managers and found:
Current Allocation to Alternative Assets: 14.4%
What is more is that the pension fund managers' planned19.4% allocation is still only 27% of Swensen's allocation to alternative assets. Too match Yale's returns, pension fund managers would need to increase their allocation by 3.6x. If a 5% increase is equivalent to $1.2tn, a 50% increase, ie matching Yale's allocation, would represent another $12 trillion dollars of allocation.
Where will this money go?
To compound the capital flow dynamic, Morgan Stanley reports that sovereign funds (gov'ts of China, Russia, Kuwait, Singapore, etc) are sitting on $2.8 trillion and that the figure will grow to $15 trillion by 2015. $12 trillion here and $15 trillion there...now you are talking about real money:)
If the stewards of the world's capital look to Yale as a model there will be a massive flood of capital into non-traditional, alternative vehicles over the next decade. China's investment in Blackstone and Abu Dhabi's investment in Carlyle are harbingers of what is to come.
The chase for returns will continue unabated and Yale's approach suggests that relying on equity and fixed income markets will not suffice.
The recent sub-prime meltdown led many pundits to believe that institutional investors would shy away from private equity and hedge funds. The data above suggests that they will have no choice but to do much more investing with alternative managers, not much less.
For Fiscal 2007, Yale reported a return of 28%. Over the last decade Yale's return is 17.8% and assets have grown from $5.8bn to $22.5bn.
For 2008, Yale plans the following asset allocation:
- real assets (oil, timber, real estate) 28%
- absolute returns (hedge funds) 23%
- domestic equity 11%
- fixed income 4%
- foreign equity 15%
- private equity 19%
Today's NY Times noted that pension fund managers plan to increase asset allocation to alternative investments from 14.4% to 19.4%, a 35% increase, over the next three years. The article cited a survey of 50 of the world's largest pension fund managers and found:
Current Allocation to Alternative Assets: 14.4%
- 4.5% to real estate, 4.3% to hedge funds, 4% to private equity, 1.6% to other
- 6% to real estate, 4.6% to hedge funds, 6.3% to private equity, and 2.5% to other.
What is more is that the pension fund managers' planned19.4% allocation is still only 27% of Swensen's allocation to alternative assets. Too match Yale's returns, pension fund managers would need to increase their allocation by 3.6x. If a 5% increase is equivalent to $1.2tn, a 50% increase, ie matching Yale's allocation, would represent another $12 trillion dollars of allocation.
Where will this money go?
To compound the capital flow dynamic, Morgan Stanley reports that sovereign funds (gov'ts of China, Russia, Kuwait, Singapore, etc) are sitting on $2.8 trillion and that the figure will grow to $15 trillion by 2015. $12 trillion here and $15 trillion there...now you are talking about real money:)
If the stewards of the world's capital look to Yale as a model there will be a massive flood of capital into non-traditional, alternative vehicles over the next decade. China's investment in Blackstone and Abu Dhabi's investment in Carlyle are harbingers of what is to come.
The chase for returns will continue unabated and Yale's approach suggests that relying on equity and fixed income markets will not suffice.
The recent sub-prime meltdown led many pundits to believe that institutional investors would shy away from private equity and hedge funds. The data above suggests that they will have no choice but to do much more investing with alternative managers, not much less.
Tuesday, October 09, 2007
Thursday, October 04, 2007
Prescriptions For Guaranteed Misery In Life
As some of you know, I really admire Charles Munger, Warren Buffet's partner. The clarity of his thinking, personal story, and professional success are worthy of study.
I recently read Poor Charlie's Almanac, The Wit and Wisdom of Charles T. Munger. The book is a fabulous collection of his thoughts, speeches, writings, mental models, and commentary on Charlie by Warren Buffet, Bill Gates, Bill Gross (Pimco), and others.
I particularly enjoyed the speech he gave at his son's high school reunion.
The speech borrowed from an earlier commencement address by Johnny Carson. Carson told the students that he could not tell the graduating class how to be happy, but he could them from personal experience how to guarantee misery! Carson's prescriptions for sure misery included:
Following all seven prescriptions will help ensure a life of non-felicity and abject misery. "Invert, always invert."
I recently read Poor Charlie's Almanac, The Wit and Wisdom of Charles T. Munger. The book is a fabulous collection of his thoughts, speeches, writings, mental models, and commentary on Charlie by Warren Buffet, Bill Gates, Bill Gross (Pimco), and others.
I particularly enjoyed the speech he gave at his son's high school reunion.
The speech borrowed from an earlier commencement address by Johnny Carson. Carson told the students that he could not tell the graduating class how to be happy, but he could them from personal experience how to guarantee misery! Carson's prescriptions for sure misery included:
- ingesting chemicals in an effort to alter mood or perception
- envy; and
- resentment
- be unreliable
- do no faithfully do what you have engaged to do.
- if you like being distrusted and excluded from the best human contribution and company, this prescription is for you
- learn everything you possibly can from your own personal experience, minimizing what you can learn from the good and bad experience of others, living and dead
- the idea is to become as non-educated as you reasonably can
- do not stand on the shoulders of giants, who needs them
- go down and stay down when you get your first, second, and third severe reverse in the battle of life
- given the abundance of adversity in life...this will ensure that you will permanently mired in misery
- ignore disconforming evidence and remain certain in your views
- be one of those people who early achieve and later intensify a tendency to process new and disconforming information so that any original conclusion remains intact
Following all seven prescriptions will help ensure a life of non-felicity and abject misery. "Invert, always invert."
Thursday, September 20, 2007
Portfolio Math
There has been a great deal of discussion about the viability of the venture capital industry.
What types of returns are required to justify the asset class' risk? Are such returns available in today's market? How much risk does an early stage venture capitalist need to take to justify the premise of the business?
For example, in a portfolio of 10 companies:
If you hold the hit rate constant at 40%, each .5x money/success is worth $20m.
In summary, given that early stage venture capital often experiences binary outcomes, individual firms should look to ensure that deals support the possibility, if not the probability, of a 10x or better outcome.
Furthermore, LPs should diversify across multiple partnerships and look for firms that look to create large winners, not incremental winners. Conventional wisdom holds that 10x returns are required for Series A investors, however, the math exercise helps illustrate why that is the case.
Back to the original question...The early stage very capitalist appears to only be able to justify the risk involved in the asset class if they can either
What types of returns are required to justify the asset class' risk? Are such returns available in today's market? How much risk does an early stage venture capitalist need to take to justify the premise of the business?
To find out, I constructed a simple model of a portfolio with the following characteristics:
- # of companies in portfolio
- 10
- $ per company ($m)
- $10
- management fee
- $0 (to keep this simple:))
- Probability of Success
- 40%
- Probability of Failure
- 60%
- Definition of Success
- 5x money
- Definition of Failure
- 0x money
For example, in a portfolio of 10 companies:
- the probability of 4 successful outcomes is 25%
- or, 10!/4!6!*(.4)^4*(.6)^6
- the value of 4 successes is $200m, or 4x5x10
- the expected value (prob * value) of the fund, the sum of the total distribution of expected values, is also $200m
To 3x a fund, one would need:
- $300m,
- given a 40% success rate, and 7.5x your money/success
- $500m, or
- given a 40% hit rate, 12.5x your money/success
- $800m, or
- given a 40% hit rate, 20x your money/success
- $300m, and
- 15x your money/success
If you hold the hit rate constant at 40%, each .5x money/success is worth $20m.
In summary, given that early stage venture capital often experiences binary outcomes, individual firms should look to ensure that deals support the possibility, if not the probability, of a 10x or better outcome.
Furthermore, LPs should diversify across multiple partnerships and look for firms that look to create large winners, not incremental winners. Conventional wisdom holds that 10x returns are required for Series A investors, however, the math exercise helps illustrate why that is the case.
Back to the original question...The early stage very capitalist appears to only be able to justify the risk involved in the asset class if they can either
- materially increase the hit rate, ie reduce probability of failure per deal
- create deals with 10x+ returns on invested capital
Are there 10x or greater deals in the market? Of course, however, great funds will need to find quite a few in order to justify their existence.
Hitting doubles or triples, in the face of a high mortality rate, will not cut it.
Note: thank you to Hunter Hancock for his valuable feedback and help on this post.
Tuesday, September 18, 2007
Six Filters for Business Evaluation
I am currently reading, Seeking Wisdom: From Darwin to Munger. The book seeks to provide guidelines for better thinking, explain what influences our thinking, and delves into the psychology of misjudgments. All topics of real interest to investors.
The book leans heavily on the writing and speeches of Warren Buffet and Charlie Munger. It reads like a reference book - with each chapter full of terrific nuggets of wisdom and quotes to remember.
The book includes a useful checklist for business evaluation. All investors, like pilots, need to have a checklist to ensure consistent best practices in decision making. At Hummer Winblad, we put together a checklist for every deal.
The book's checklist follows. While perhaps the book's list is not perfectly suited for early stage investing....like many frameworks, the real value lies not in the specific framework itself, but in the consistent application of a mental model that ensures diligent analysis and carefully weighed decision making.
Filter 1: Can I understand the business - predictability?
Reasons for demand - how certain am I that people are likely to buy this type of product or service? why will they buy? what are the benefits?
Return characteristics - Industry and company return characteristics and change over the last five years? Is there a business model comparable that has made real money for its investors and management team and proven the operating model's economic value?
Industry structure - (a la Michael Porter), no of competitors and size? Who dictates terms in this industry? Do I know who is going to make the money in this market and why?
Real customer - who decides what to buy and what are his decision criteria?
Filter 2: Does it look the business has some kind of sustainable competitive advantage?
Competitive advantage - can I explain why the customer is likely to buy from this company as opposed to others in the market? what is the basis of the advantage - market knowledge, execution strength, or technology?
Value - how strong is this advantage, does the advantage benefit from network effects or scale that will make it stronger and more durable over the years?
Profitability - can the advantage be translated into profitability and why?
Filter 3: Able and honest management?
Is the team competent and honest? Do they understand the market and are they focused on value creation for the owners of the business?
Filter 4: Is the price right?
Can I buy at a price that provides a good rate of return with an adequate margin of safety?
Filter 5: Disprove
How can the business get killed?
Who could kill it?
If it failed, what are the likely internal and external causes?
Filter 6: What are the consequences if I am wrong?
At Hummer Winblad, we add:
Filter 7 - what disruption will aid the company is driving growth?
What wave will the company ride that rewrites the operating dynamics of the industry and drives the reallocation of capital away from old models and technologies to new players in the market?
The book is a fun read and one to have on your desk.
The book leans heavily on the writing and speeches of Warren Buffet and Charlie Munger. It reads like a reference book - with each chapter full of terrific nuggets of wisdom and quotes to remember.
The book includes a useful checklist for business evaluation. All investors, like pilots, need to have a checklist to ensure consistent best practices in decision making. At Hummer Winblad, we put together a checklist for every deal.
The book's checklist follows. While perhaps the book's list is not perfectly suited for early stage investing....like many frameworks, the real value lies not in the specific framework itself, but in the consistent application of a mental model that ensures diligent analysis and carefully weighed decision making.
Filter 1: Can I understand the business - predictability?
Reasons for demand - how certain am I that people are likely to buy this type of product or service? why will they buy? what are the benefits?
Return characteristics - Industry and company return characteristics and change over the last five years? Is there a business model comparable that has made real money for its investors and management team and proven the operating model's economic value?
Industry structure - (a la Michael Porter), no of competitors and size? Who dictates terms in this industry? Do I know who is going to make the money in this market and why?
Real customer - who decides what to buy and what are his decision criteria?
Filter 2: Does it look the business has some kind of sustainable competitive advantage?
Competitive advantage - can I explain why the customer is likely to buy from this company as opposed to others in the market? what is the basis of the advantage - market knowledge, execution strength, or technology?
Value - how strong is this advantage, does the advantage benefit from network effects or scale that will make it stronger and more durable over the years?
Profitability - can the advantage be translated into profitability and why?
Filter 3: Able and honest management?
Is the team competent and honest? Do they understand the market and are they focused on value creation for the owners of the business?
Filter 4: Is the price right?
Can I buy at a price that provides a good rate of return with an adequate margin of safety?
Filter 5: Disprove
How can the business get killed?
Who could kill it?
If it failed, what are the likely internal and external causes?
Filter 6: What are the consequences if I am wrong?
At Hummer Winblad, we add:
Filter 7 - what disruption will aid the company is driving growth?
What wave will the company ride that rewrites the operating dynamics of the industry and drives the reallocation of capital away from old models and technologies to new players in the market?
The book is a fun read and one to have on your desk.
Friday, September 14, 2007
Rich Price - Playing on Sept 25th in SF
My brother, Rich, is a wonderfully talented recording artist.
His new band, RGB, will be playing in SF on Sept 25th.
Below is a note from Rich and I hope some of you can make it!
RGB (feat. Rich Price)
Tues, Sept 25th at 8pm (sharp)
Red Devil Lounge
1695 Polk St (at Clay)
San Francisco, CA
link to purchase $10 ticket
p.s. I'll be performing in SF in late Oct with my old band. More details to follow.
His new band, RGB, will be playing in SF on Sept 25th.
Below is a note from Rich and I hope some of you can make it!
Hi Bay Area friends, I hope all's well. I'm excited to announce I'll be bringing my new trio, RGB (Rich Price/Greg Naughton/Brian Chartrand) to San Francisco a week from this coming Tuesday.
I'm thrilled to be performing with two of my favorite songwriters, and the trio has been great fun. It's like Crosby, Stills and Nash had a one night stand with Paul Simon, The Police, David Gray, Martin Sexton and that short guy from Fantasy Island and somehow managed to produce a three-headed singing beast...that's RGB.
If you're free on Sept 25th, we'd love to see you! Thanks for all the support and for helping to spread the word!! All the best, Rich
I'm thrilled to be performing with two of my favorite songwriters, and the trio has been great fun. It's like Crosby, Stills and Nash had a one night stand with Paul Simon, The Police, David Gray, Martin Sexton and that short guy from Fantasy Island and somehow managed to produce a three-headed singing beast...that's RGB.
If you're free on Sept 25th, we'd love to see you! Thanks for all the support and for helping to spread the word!! All the best, Rich
RGB (feat. Rich Price)
Tues, Sept 25th at 8pm (sharp)
Red Devil Lounge
1695 Polk St (at Clay)
San Francisco, CA
link to purchase $10 ticket
p.s. I'll be performing in SF in late Oct with my old band. More details to follow.
Friday, September 07, 2007
What is a Brand?
I recently heard a very succinct and compelling answer to the question, "how do you define the concept of a brand?"
The answer, from the CEO of E&J Gallo Winery,...
"A brand is a promise to a customer of quality, image, and differentiation."
The definition elegantly boils down a complex concept to five key elements:
The answer, from the CEO of E&J Gallo Winery,...
"A brand is a promise to a customer of quality, image, and differentiation."
The definition elegantly boils down a complex concept to five key elements:
- a promise...a commitment from the company.
- Employees across the organization need to internalize that promise and live up to the commitment that is at the heart of the company/customer relationship
- a customer
- the company needs to understand the interests, demographic profile, characteristics, motivations of the customer. What makes them tick? Who are they?
- A clear picture of the target customer helps align the product, sales and marketing strategy, and positioning with the customer's interests and needs
- quality
- a value...be it an experience, physical good, or relationship
- an image
- a set of mental associations that complement the interests and self-image of the customer
- a differentiation
- a clearly unique proposition that is effectively communicated to and understood by the customer
- what is your brand's promise?
- who is your brand's customer?
- what is your brand's quality?
- what is your brand's image, mental associations, characteristics?
- what is your brand's differentiation?
Friday, August 31, 2007
Chad Ruble, Reuters Vlogger, is Funny
Chad Ruble is funny.
(Full disclosure - Chad is one of my great friends)
Chad hosts a weekly internet video show, And Finally, on Reuters.com highlighting wild and wacky news stories from around the world.
On this week's episode, Chad visits a professional stunt school in NYC.
The show reminds me of Keith Olberman's Countdown segment "Let's Play Oddball" and it is well worth subscribing to via RSS.
(Full disclosure - Chad is one of my great friends)
Chad hosts a weekly internet video show, And Finally, on Reuters.com highlighting wild and wacky news stories from around the world.
On this week's episode, Chad visits a professional stunt school in NYC.
The show reminds me of Keith Olberman's Countdown segment "Let's Play Oddball" and it is well worth subscribing to via RSS.
Friday, August 24, 2007
The Psychology of SaaS and Web 2.0 Persuasion (and Selling)
One of the cool things about blogging is that it fosters the cross-pollination of ideas. Often, moreover, the derivative idea is much better then its source.
Bob Warfield's post, The Psychology of SaaS and Web 2.0 Persuasion (and Selling), is a great example.
He picked up on my post regarding Cialdini and the psychology of compliance and wrote a very thoughtful piece on how Cialdini's work can be applied to SaaS and Web companies.
It is well worth reading.
Bob Warfield's post, The Psychology of SaaS and Web 2.0 Persuasion (and Selling), is a great example.
He picked up on my post regarding Cialdini and the psychology of compliance and wrote a very thoughtful piece on how Cialdini's work can be applied to SaaS and Web companies.
It is well worth reading.
Beginner's Mind
"In the beginner's mind there are many possibilities, but in the expert's there are few."
-Shunryo Suzuki-Roshi
I am coming to believe that the comfort to say "I don't know" is fundamental to being a good investor. Intellectual curiosity, being open to new ideas, and the willingness to momentarily suspend disbelief in the face of unorthodox approaches are vital preconditions to being able to reward disruption.
Ideas, opinions, and expertise get in the way of knowing what we don't know. Given that venture is premised on funding innovation, refusal to admit ignorance, unwillingness to ask for clarification, to avoid learning can blind one to the clarity and creativity that exist in a beginner's mind. "Knowing" does not allow us anything new, no surprises, no insights, no discoveries.
When I worked for Art Samberg, a brilliant investor and founder of Pequot Capital, I was consistently impressed by his ability to listen and to learn. He would often ask people for their views; the chance to showcase knowledge to a billionaire investor would drive people into long monologues. When then asked what he thought, he would often say "I don't know enough about it to comment" and walk out of the room. The lesson: there is no shame in admitting you don't know, rather, the real shame lies in making your "intelligence" so much a part of your identity that you are afraid to ask or admit a lack of knowledge.
The concept of beginner's mind is not limited to Buddhism. Frank Herbert said, "“The beginning of knowledge is the discovery of something we do not understand.” While Proust wrote, "“The real voyage of discovery consists not in seeking new landscapes but in having new eyes.”
Our learnings and experiences often help us process a complex world, however, I believe that it is important that we work to maintain beginner's mind over and over again in order to not let "knowledge" trap us from seeing innovation and possibilities.
Wednesday, August 22, 2007
Oracle buys Bridgestream
Oracle's acquisition spree continued this month with the purchase of Bridgestream, the leading provider of business role automation solutions.
Role-based access to systems and information is a well understood security paradigm. Importantly, Bridgestream extended the ability of identity access management (IDAM) solutions to map to the complex, ever-changing business relationships that exist within a department, within a division and across the extended enterprise.
Role based automation enables fast, accurate and real-time information about role-based authorizations and enables organizational changes to seamlessly flow through to production IDAM solutions. Modeling complex, ever-changing enterprises via the Bridgestream solution enhances security, improves compliance, and reduces IT costs. The acquisition complements the earlier purchase of Oblix and further pushes Oracle into the security market.
Hummer Winblad's Mitchell Kertzman co-led Bridgestream's A round and congratulations to Mark Tice, CEO, the Bridgestream team, and the Board on a great outcome.
Role-based access to systems and information is a well understood security paradigm. Importantly, Bridgestream extended the ability of identity access management (IDAM) solutions to map to the complex, ever-changing business relationships that exist within a department, within a division and across the extended enterprise.
Role based automation enables fast, accurate and real-time information about role-based authorizations and enables organizational changes to seamlessly flow through to production IDAM solutions. Modeling complex, ever-changing enterprises via the Bridgestream solution enhances security, improves compliance, and reduces IT costs. The acquisition complements the earlier purchase of Oblix and further pushes Oracle into the security market.
Hummer Winblad's Mitchell Kertzman co-led Bridgestream's A round and congratulations to Mark Tice, CEO, the Bridgestream team, and the Board on a great outcome.
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