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October 06, 2010

Can VCs Be Value Investors?

Security Analysis is cited by Warren Buffet as one of his top four favorite and most influential books.  Written by Columbia University Professors Benjamin Graham and David Dodd, it was first published in 1934.  

The book is a thick tome that articulates the thesis of value investing – the analytical techniques for valuing securities and seeking to invest in those securities in the context of their underlying value.  The latest printing, the sixth edition, contains a foreword from the Oracle of Omaha himself as well as a preface from hedge fund investor Seth Klarman of The Baupost Group, who is regarded by many to be one of the modern masters in the art of value investing.

As a venture capitalist reading the book and trying to absorb its investment lessons, I wondered – can VCs be value investors?  After all, the philosophy of value investing, in theory, should cut across all asset classes and managers.  The precepts and principals therefore should apply to the venture capital business as well.

Sadly, they don’t.  

Klarman writes:  "Investing in bargain-priced securities provides a "margin of safety"-room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market.”  

Unfortunately, VCs don’t operate with a margin of safety, even if they are able to find and negotiate good deals. Later stage investors may have downside protection if they buy smart, but early-stage VCs do not.  If a portfolio company goes bad, there is typically barely any salvage value.  

As one of my partners is fond of saying, “A good price doesn’t help a bad investment”.  That is why VCs tend to emphasize “clean terms”, which are entrepreneur-friendly rather than focus on complex bells and whistles to protect downside.  And that is why you will see large loss ratios in VC portfolios, sometimes as high as 20-30%.  In fact, if a VC doesn’t have high a loss ratio, one might argue they aren’t taking enough risk.  As one Silicon Valley veteran put it to me the other day, “I can only lose 1 time my money.”

There is a see saw debate often heard in the hallways of VC firms – does success come from being a good stock-picker or company-builder?  In other words, will a VC generate strong returns because they are good at finding the best companies and entrepreneurs to invest in, or will the returns be generated by adding value to companies through shrewd strategic guidance and savvy recruiting and team-building?

The answer appears to be both, but even the debate itself is also framed incorrectly, I would argue.  Entrepreneurship is all about people.  The VC business has evolved into a world where the challenge is less about choosing the best entrepreneurs to invest in, bur rather convincing the best entrepreneurs to take your money.  This dynamic is unique as compared to other asset classes.  Imagine a world where the highest quality forests choose which endowment they’d like as their owner; or a public stock chooses which hedge fund they want to own 10% of their outstanding stock.  Sounds ridiculous?  That’s precisely what is happening when VCs compete with each other and chase after the best entrepreneurs, offering entrepreneur-friendly terms, supportive advice and value-add.

But although the VC business doesn’t lend itself to value investing, VCs would benefit from many of its lessons.  For example, placing an emphasis on thoughtful analysis and due diligence of business models and market dynamics rather than pure, instinctual speculation.  Further, in a world of multi-hundred million dollar exits and a weak IPO environment, exerting some price discipline makes sense for VC investors, who are often pushed by entrepreneurs beyond their limits (“If you like the deal at $20 million pre, why wouldn’t you like it at $25 million?”).  Deal prices must be scrutinized in the context of realistic growth assumptions, future capital intensity and target market sizes.  As Graham and Dodd put it, when an investor is blinded by the pursuit of growth, “Carried to its logical extreme, there is no price too high for a good [company], and that such an issue was equally ‘safe’ after it had advanced to 200 as it had been at 25.”

That’s why, in the end, the VC business is still a blend of art and science.  It is part financial asset class, part creative entrepreneurial endeavor.  And, under any analysis, is not for the faint of heart.

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Have you seen that working paper by HBS prof. Gompers et al on "Performance Persistence"? It's worth a read. Once of the "conclusions" is that good VCs don't add value, rather they are good "stock pickers."

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I have seen some papers from others on
that topic but haven’t seen that one. I’d love to see it if you get a chance. 
Thanks!
 

"In fact, if a VC doesn’t have high a loss ratio, one might argue they aren’t taking enough risk."

I've definitely seen some momentum behind this idea from some in the vc community (Fred Wilson, for one), but imagine it's a bit tougher to swallow in practice. What's the threshold on risk though? More risk might be in the best interest of the fund, but how much is too much?

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It’s a tough balancing act and obviously
the key is to fail fast and small.  In other words, if you put out $1-2 million
behind a big idea and realize it didn’t work after 1 year, it’s a much easier
pill to swallow than when you put out $10-20 million after 5 years.  Being crisp
about milestone-based financing and setting up short run-way seems to be the
way to go, although entrepreneurs would prefer more runway.
 

"Imagine a world where the highest quality forests choose which endowment they’d like as their owner; or a public stock chooses which hedge fund they want to own 10% of their outstanding stock. Sounds ridiculous?"

No, doesn't sound ridiculous at all. Indeed that's exactly what's always happening in a market system. The highest quality forest chooses which endowment they'd like as their owner (the one that pays the most money for it). A public stock chooses which hedge fund they want to own 10% of their outstanding stock (the one that pays the most money for the position).

Same with high quality entrepreneurs. They choose the VC that takes the lowest stake and pays the most money for it. Nothing unusual here.

Ah - you are assuming that entrepreneurs choose VCs based on price. That's not true. Price is typically a minor factor relative to value-add and chemistry when entrepreneurs choose VCs.

"VC investors [...] are often pushed by entrepreneurs beyond their limits ('If you like the deal at $20 million pre, why wouldn’t you like it at $25 million?')."

Jeff, I agree that the vc business does not in general lend itself to value investing, except around the edges (i.e., what you might call "small growth equity").

I thought I would share what I consider one of the most important quotes from Graham and Dodd:

"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."

For most people today, speculation is a pejorative term. But it certainly was not to Graham. In The Intelligent Investor, he wrote:

"There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose."

Classic line isn't it?

If vc isn't value investing, then Graham would say it isn't intelligent investing. But maybe it is intelligent speculation!

I would argue that all the recent heat around angels v. vcs v. super-angels etc. obscures exactly this point. The speculators who got a heck of a lot MORE intelligent in recent years were the ones -- be they vcs, individuals, or individuals-gone-pro -- who use internet-infrastructure capital efficiency, or risk control around capital deployment in general, to their greatest advantage.

-Ben

I like that Ben! "Intelligent speculation" it is. More art than science.

Jeff,

I am reading your blog for the first time and really enjoy it. I am curious what your perspective is on distressed investing within the clean energy sector? Do you consider that in the same light as value investing? Just my opinion, but I believe that their is real opportunity in distressed investing in the clean energy sector. It seems that the market is highly inneficient due to all the uncertainty surrounding the industry (ie. gov't regulation, gov't funding, few large successes). There are a lot of businesses that have received considerable VC funding, are further along with technology development, actually have businesses in place (albeit not always businesses that make sense) as well as leveragable assets which can be picked up for very little. In my mind you potentially can lower your risk while also potentially shortening your investment period. It becomes much more an execution play, where blocking and tackling can go a long way. I look forward to your thoughts.

Thanks,
Mike

Finding a fit with VC is half the battle.

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