Venture Capital and Rational Bubbles

This post continues my journey to explain the seemingly over priced, high risk and difficult to value venture capital market. It is well known that the empirical security market line is too flat compared to theory. This means higher risk-higher beta stocks have lower than predicted returns. Conversely, lower risk-lower beta stocks (just like the ones Warren Buffett favors) have higher than expected returns. This phenomenon is called betting against beta (BAB). Two possible reasons exist for its existence.

The first is based on leverage constraints facing institutional investors like pension and endowment funds. These investors are forced to reach for asset risk to satisfy their higher risk appetites. Furthermore, leverage constraints may impede margin and short sales ordinarily used to correct over pricing. Leverage constraints and aversion probably tightened following the great recession given the failures and near failures on many undercapitalized institutions like Lehman.

A second complementary explanation is provided by behavioral economics. The argument is as follows:

1)     Investors over weight low probability high payoff events-even those with negative expected values. A simple example is the lotto. The number of players spikes as the grand prize increases even though the winning odds fall even lower. The large unlikely payoff dominates the negative expected value. A technical explanation is players (investors?) prefer positive skew. This is especially true when the wager (investment?) is relatively small compared to investor’s overall wealth. Thus, as investor wealth tends to be pro-cyclical-so is the demand for lottery type investments like venture capital (IPOs and Private Equity as well).

2)     Two additional behavioral effects reinforce the above.

a)     Representativeness-investors focus on winners like Uber and hope their investments will be winners. They are ignoring the higher base rate failure of such investments.

b)     Overconfidence-even if investors realize “home runs” like Uber are rare they believe they possess special skill enabling them to spot “Ubers”.

Add to the above the difficult to value nature of venture investment and it is easy to see how investors can get carried away in a rational bubble.

A third more traditional factor underlying the current market is low interest rates. The Federal Reserve has keep rates artificially low following the great recessions hoping to stimulate the economy. This means projected cash flows are discounted at lower rates leading to higher values. Additionally, on the demand side, low rates forcec investors to search for higher nominal (non risk adjusted) yields by going further out on the risk curve.

Thus, the venture capital market may be experiencing a rational, albeit still dangerous, bubble.

J

Measuring the Crowdfunding Impact on Traditional Investment Banking, Including Mergers and Acquisitions

Today's guest post on Crowdfunding comes from Nate Nead, a Director at CrowdFund.co.

Measuring the Crowdfunding Impact on Traditional Investment Banking, 
Including Mergers and Acquisitions

The rise of crowdfunding has been greatly promulgated by sites like Kickstarter and Indiegogo. In what is being dubbed as the true “democratization of capital” companies with little to no financial resources can pitch an idea to receive small amounts of funding from large swaths of potential “backers.” This new form of non-dilutive financing has been working well for years now. Its sister, equity crowdfunding, is plodding along through regulatory hurdles with some success. This summer’s release of Reg A+ (an update of the long-standing Reg A regulation that expanded the offering amount from $5M to $50M) underscores the fact that regulators have not been completely closed to the idea that true crowdfunding for equity may eventually become a reality. As equity crowdfunding grows from adolescence to full maturity, casualties are sure to follow, including those in traditional finance and investment banking. Once efficient, this new form of capital formation is likely to impact everything from traditional capital raising methods to mergers and acquisitions.

Growth Capital & Alternative Finance

Alternative finance is more than just crowdfunding. The rise of many non-bank lenders over the last several years has proven an effective competitor to some of the largest banking institutions. As regulators and internal controllers have tightened the belt on lending standards for small businesses, others have swooped-in to help fill the void. In some cases, the alternatives have not played well as a good replacement for the more regulated traditional banks, but that doesn’t mean they’re not helping to fill the demand void in the market.

Just as non-bank debt financiers are currently providing a new source of competition for retail and merchant banking, it’s expected a similar phenomenon will follow investment banking with the rise of equity crowdfunding.

As equity crowdfunding becomes more efficient, the cost of capital requisition is likely to decrease over time. Unfortunately, many prognosticators aren’t expecting all the capital efficiency gains to be passed to entrepreneurs in the form of lower fees. While this may be the case in some instances, the greatest advance is likely to be 1) the speed with which capital can be garnered and 2) the confidence in the process. Currently, many “best efforts” offering promoted by investment bankers still go unfulfilled, despite best efforts. The lack of efficient scale can still leave many would-be-successful entrepreneurs empty handed, regardless of the quality of their team and business plan. The increase in the probability and confidence that a full subscription can and will occur further feeds the speed component of getting a deal consummated. While, in the end, the actual paper cost of capital may remain unchanged, the time and confidence factors should fuel the potential for more deals and better deals.

Company Sales & Mergers and Acquisitions

When it comes to crowdfunding, alternative finance and venture capital, the sexy, scalable growth companies get most of the press. This hogging of the limelight may get people excited, but the reality is there are more opportunities to tap existing and profitable companies than there are to seek after pie-in-the-sky growth. The sheer size difference between venture capital and private equity illustrates the point: private equity could be greatly upended by a shift in the process and equity crowdfunding could play a role.

Traditional private equity seeks to raise capital, perform a buyout (LBO or otherwise) and take the platform company on a path toward growth. This path could include organic synergies or a strategic buy-side M&A/roll-up scenario. In almost all cases, there is an extreme focus on eaking out waste and maximizing IRR for fund investors. But how could the crowd upend this deeply-entrenched segment of alternative finance. Here are a few potential ways:

●      Family-owned businesses may opt for next generation transition without the need for controlling outside capital or expensive and often harming Employee Stock Ownership Plans. An equity crowdfunding event could help in the sale of the majority of the shares while still keeping control in the original family.

●      Companies looking to maintain full control of both the board and the shares could vye to sell shares for “taking chips off the table” or for growth capital with an equity crowdfund campaign.

●      Equity crowdfunding may provide capital for the equity funds themselves, allowing them to further growth initiatives and differentiate on a platform company that has massive room for growth.

●      If a business owner wished to sell-out over say a five to ten year horizon, s/he could sell the company off in chunks (say $1M/year) for several years to various investors via a 506(c) offering.

Because a full ¼ of those currently in the workforce will be retiring in the next 15 years, many will be seeking solutions for selling-out prior to retirement. At some point, I would expect a typical sell-side mandate or even an ESOP could be replaced by some creatively-structured equity crowdfunding deal, perhaps even a well-crafted intrastate offering. The creative options for using equity crowdfunding abound and disruption is ultimately inevitable.

Some may claim technological advances in the realm of crowdfunding and other forms of alternative finance are having a deleterious impact on traditional channels for capital advisory. This “upending” may eventually be blamed for net job reduction and ultimately another example of Creative Destruction. As the maturation occurs, other positives are also certain to emerge, however. First, the efficiency of the process may help improve the overall view in what has recently been painted as an industry of money hungry criminals. Second, those working in the capital markets will require greater understanding and more sophistication as it relates to the available tools and options. This will be most important as investment bankers look to act as guides for investors and entrepreneurs along the path from growth to exit.

Nate Nead is a Director at CrowdFund.co. Nate’s roll involves traditional buy and sell-side mergers and acquisitions advisory, investment banking, capital raising and general capital advisory services. Nate specific focus is software and SaaS investment banking where he works with growing middle-market software companies looking for growth capital, buy-side acquisition assistance or sell-side advisory services. Nate resides in Seattle, Washington with his wife and two children.

Venture Capital Pricing: Bubble or Something Else?

Trying to make sense of current VC pricing is a daunting task. The increased pricing is reflected in VC IRRs for the past year which exceeded 25% according to Prequin-exceeding those of PE for the first time this century. Consequently, fund raising is accelerating as investors chase yield. This is producing ever higher pricing multiples. Is it a bubble, a recovery or something different?

My thoughts, which focus primarily on the ecommerce segment, are as follows:

1)     There are only three ways to profit from ecommerce. Either you sell devices like Apple, sell goods or services such as EBay or Angie’s Page, or sell advertising –Facebook.

2)     The implicit assumption for investors is competition is weak due to something like network effects-hence the need to raise lots of money, invest it quickly and get big quick. Investors flock to the industry and its participants creating a momentum pricing effect lifting pricing multiples-a virtuous circle.

3)     Wild changes in pricing occur once evidence accumulates that the competitive advantage period is unrealistic. Investors are reintroduced to Porter's  five forces which eventually impact industry profitability.

4)     Investors recognize they misread market signals and have misallocated capital, and begin to curtail investments. This triggers a reverse momentum or vicious circle.

Investor errors are understandable given the lack of operating history or clear business model for these firms. The impact of seemingly small changes in investor estimates can have a major valuation effect:

1)     Simple earnings calculation model: P=E/(r-g) were E is a horizon value earnings estimate, r is the risk factor and g is estimated growth.

2)     P/E ratio is then equal to 1/(r-g). If we assume (r-g) =2 at the beginning of the investment then the P/E ratio is 50. If (r-g) increases to 4 due to a combination of changes in r and g then the P/E ratio falls to 25 resulting in a massive value change.

3)     The change in estimated growth, g, is probably the greatest wildcard. Over estimating growth (AKA under estimating competition) results in investors over paying for growth and reduces their margin of safety when something causes a reassessment.

4)     VC markets, especially early stage, are by no means as efficient as established markets. Thus, the price is not always right. Even in efficient markets the price is not always right. Rather, it means it is difficult to exploit any perceived errors.

The above volatility is characteristic of investors “shooting in the dark” given the lack of operating histories and clear business models for many of these new firms-leap of faith investing. Warren Buffet calls this speculation and not investing-different strokes for different folks I guess.  Until new information arrives, investors are left following technical demand factors (e.g. momentum which is heavily dependent on the amount of new capital raised) and guesswork. Momentum and guessing are prone to error and wild corrections as the mean reversion impact of the Five Forces kick-in.

So, keep your safety belts fastened and do not bet the ranch. The path for now is up, but how long this lasts is unknown. When it changes things will get bumpy as is characteristic of the creative destructive process of economic progress.

J

Venture Capital and Sardines

Traditional VC investment has focused on firms in the rapid growth stage. These firms have passed the seed or idea stage by demonstrating an ability to generate sales-not necessarily profits. The current trend is an increasing focus on earlier stage investing known as pre-IPO investing. It is driven by the need to invest the large sums of new capital raised venture firms. In 2014 they raised over $30B which is 60% higher than 2013-albeit still substantially below the record in 2000. The investments are rationalized as part of a preemption strategy. These earlier stage investments have a host of different issues compared to more traditional VC-e.g. increased failure and liquidity risk and due diligence needs. I hope they come with higher returns as well.

VC hopes to invest in promising startups before traditional later stage competitors do so. Unfortunately, this is not much help if everyone is adopting the same early stage tactic. The newly funded startups can then exploit Network effects to achieve a First Mover advantage.  Both Ralph and I have expressed concerns with alleged first mover advantages. Its value seems as elusive as synergies in justifying M&A. The impact of all of this earlier stage investing is that VC is focusing more on momentum than the fundamentals concerning the firm, industry and the management team. As money flows in it inflates implied values - and prices. This positive feedback effect then justifies further increased investing at even higher prices.

This reminds me of studies on POW camp behavior during WWII. Prisoners used all sorts of things as money to trade among themselves and even the guards. One such medium of exchange was sardine tins obtained from Red Cross packages. Every now and then some hungry prisoner would open a can and eat the sardines. One day such a hungry soldier opened a tin only to find the sardines were rotten. He brought this fact to the attention of his superior. The wise superior calmed the soldier down by explaining there were two types of sardine tins-one for trading and one for eating. He had just opened a tin meant for trading.

Some day someone eventually opens a sardine tin and discovers they are rotten. Then investors start raising embarrassing questions about the nature of these seed firms such as who is going to buy their app and at what price for how long, their cash burn rate and can they raise additional cash if needed-especially if market conditions tighten. Then the market will re price and the price of sardine tins like seed companies will collapse. This is plight of most momentum based investing strategies. So just like the Wizard of Oz told Dorothy-don’t look behind the curtain or inside the tin.

J

The Venture Capital Lottery

Venture capital investing has never been for the faint of heart. It seems to be getting even less so with a new type of deal risk entering the market. The current VC environment is characterized as follows:

1)     Profitable exits 2012-2014 and LP distributions have increased the demand for VC investments.

2)     VC industry has responded to LP’s forgetting that past success does not guarantee future success by raising new VC funds to satisfy LP demand.

3)     VC funds are having trouble investing the funds raised in high quality investments and are engaging in higher risk transactions.

4)     The number of hyper risk lottery ticket investments is increasing i.e. investments in pioneer-idea only type firms (no sales) at high valuations.

Usually in such investments founders remain fully invested until later financing rounds i.e. they have skin-in-the-game and are committed. Now, VC are allowing founders to withdraw liquidity in the first financing round. This should send a negative signal to investors. If founders, usually an optimistic lot, are willing to share their upside, it suggests they are unsure about that upside. If founders have questions, then so should investors. Founder liquidity should depend on the firm’s success not the VC fund raising cycle. Remember, these firms must at least pass the revenue test, and hopefully the cash flow positive test before the end of the current up cycle in VC fund raising; otherwise they will fail.

This newest development is being rationalized as removing financial distractions from founders. May be I am cruel, but I want the founders to be paranoid committed to their firm’s success. If they want me to take the plunge, then I want them jumping alongside me for the entire journey. This development is another froth indicator in the VC industry along with nose bled valuations.

VC is moving into the lottery phase. In lotteries, the size of the prize, regardless of its likelihood increases the demand to participate. Everyone becomes fixated on the multibillion payouts of firms like Whatsapp. They are focusing on the greatest maximum return or variance, while ignoring the negative expected return. This is not investing-it is gambling.

I hope everyone had a Great Holiday Season.  I wish all a Happy New Year!

J