Confirmation Bias

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.

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.

• 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.

The panel agreed that a holistic approach to investing in innovation is required. The maturity of a team's plan depends on moving from the art of what is possible to the science of what is most efficiently consumable.

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.

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:

1. average venture asset class returns are a nonsensical number
2. why? less than 20% of the firms drive greater than 80% of the returns
3. it is borderline impossible to get into the top venture funds
4. 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

The question then becomes what should LPs do. I see 3 possible choices

1. leave the asset class
2. be patient and wait for allocation to top tier funds
3. sponsor emerging manger funds targeting young GPs at top tier funds

The first two choices imply that an LPs allocation to venture will be materially reduced on both an absolute and relative dollar basis. Less money will enter the system and, like most maturing industries (think ORCL in software), the excess rents in the market will be captured by a diminishing number of firms. The competitive position of the top firms will compound over time as competitors drop out of the market as LPs refuse to fund them.

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%.