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3 posts from January 2006

January 29, 2006

Sour Grapes, Wolves and Sheep

Harvard Business School is having a private equity conference for students this upcoming weekend and, regrettably, is featuring Howard Andersen and his ridiculous sour grapes about the VC business.  Because of this, I feel obliged to blog on this topic.

Simply put, Howard Andersen’s article is bunk.

The venture capital business is hardly for the faint of heart and, unlike the brief period in the mid- to late-90s, is admittedly not an easy business where even the dumb and lucky can make tons of money.  That said, there is still plenty of money to be made and breakthrough innovations to support.

Howard’s comment that the “technology supply is bloated” is absurd.  This is an extraordinarily short-sighted view.  In the next decade, many predict that someone will fund a company that will cure cancer, if it doesn’t exist today.  With the modernization of China and India, we have 2 billion additional consumers entering into the wired world.  The venture-backed company, Google, is transforming the trillion dollar consumer marketing industry and print world. The global proliferation of mobile phones has generated a whole new platform of innovation beyond the PC.  Anyone in the midst of a healthy flow of deals across technology and biotech will tell you that the pace of innovation continues to quicken, not grind to a halt.

And the description of poor average returns in the business is a simplistic analysis that misses the “dispersion effect” in venture capital returns.  VC fund returns are one of the most widely varied by fund manager of any asset class.  The top quartile VCs account for the majority of the returns.  Even during a period of 0% average returns, top quartile VCs make their investors lots of money.  The chart below from The Economist is the best I’ve seen on this topic.  Howard is right that if you’re a middling-performing VC, you will not serve your investors well.  But the top quartile returns are far better than the S&P and well-deserving of the risk and liquidity premium.  This was a big driver behind the recently reported fantastic growth of the Stanford Endowment, who gained 23% last year thanks to its participation in top-tier Silicon Valley funds.


My advice for business school students thinking about the VC business would be similar to what my finance professor, Andre Perold, gave me when I was graduating business school.  Andre (who sits on the board of Vanguard and teaches capital markets at HBS) taught me that in every market, there are two types of animals:  wolves and sheep.  The wolves are faster, smarter and have all the innate weapons to take advantage of the sheep, buying low and selling high.  If you find yourself in market where you don’t know if you’re a wolf or not, then by definition you are a sheep and are about to see a nasty finish.  The trick for students who want to become VCs is to recognize that although they are initially sheep, if they hang out with a few wolves, learn from them over a number of years, they can grow into becoming wolves themselves.  If they don’t, then they will leave the business frustrated and disgruntled rather than stuffed to the gills with its spoils.

January 22, 2006

“The Grass Is Always Greener”…aka The Circle of Envy

I have lately observed a strange dynamic in the start-up/private equity community that a buyout friend of mine coined:  “the circle of envy”.  It harkens to the old saying, “the grass is always greener on the other side” (a very capitalistic and classically “American” saying, which actually has its origins in Erasmus’ 16th century Latin writings, admiring the fertile look of a neighbor’s corn!).  It goes something like this:

Entrepreneurs are recently famous for sulkily observing that the VCs have the cushiest of lives.  Unlike entrepreneurs who live and die by quarterly and annual milestones, VCs get paid generous management fees whether they seem to actually perform or not.  In the mind of many entrepreneurs, VCs don’t work all that hard, parachute into board meetings without having done their homework, make a few trite, unhelpful comments and then leave.  In short, entrepreneurs are envious of the VC way of life, which seems to have lots of financial upside and none of the quality of life downside.

VCs are recently famous for grousing about how much money their private equity cousins are making.  A VC struggles to invest $5-10 million at a time while their private equity cousins pour hundreds of millions of dollars, and recently even billions, into a single deal.  Since the fee income portion of compensation is a function of assets under management, the more you manage, the more you make.  The other compensation component is the carried interest, and VCs are green with envy when they see buyout guys use cheap leverage to make money while retaining large stakes in their firms.  In short, VCs see the outrageous financial lifestyles of the private equity hitters, flying around in their private jets and think:  “if only I could be like them – they’ve really got the model figured out”.

Private equity executives are recently famous for expressing their envy for hedge funds.  Unlike private equity and VC firms, who only get paid on the gains when a portfolio company is liquidated, hedge funds take their carried interest off the table every year.  And when a private equity or VC firm gets hot, it has to wait three or four years in between fund cycles to raise new, larger funds.  Those lucky hedge fund executives can sweep big money in at a moment’s notice, raising their fee income with a snap.  Further, complain private equity folks, the hedge fund executives rarely travel to chase around high-stakes auctions and have none of the responsibility or liability that “owning” companies and controlling boards represents.  They just seem to coast along, accumulate more and more capital, and live it up.

And hedge fund executives?  The top of the heap?  Hardly.  I often hear them discuss with envy the life of the entrepreneur – cycling through exciting new start-ups every 5-6 years and then taking long sabbaticals in-between gigs.  Meanwhile, the hedge fund executive is chained to every international market every minute of the day for fear they miss spotting the latest currency or interest rate fluctuation.  Entrepreneurs actually create things of value and leave a mark on society, rather than simply financial engineering.  And that nonsense about money flowing in so fast being such a great thing?  Remember, it can flow out just as fast.  And, besides, the hedge fund business as a whole has little barriers to entry and struggle to find true proprietary elements of the busines, resulting in too much money chasing too few good investment opportunities.  Those entrepreneurs who can come up with original ideas, build proprietary technology and products, and then sell them out get all the glory, reap all the rewards and then unplug.  Now that’s the life.

The result of all this hand-wringing?  Perhaps the Chinese proverb is the truest:  “think about the misfortune of others to be satisfied with your own lot”.  Of course, relative to others in this world, each of these executives is as lucky as lucky can be!

January 10, 2006

Harvard Business School VC Conference

I had the privilege of spending the day today back at Harvard Business School at a venture capital conference organized by the burgeoning entrepreneurship department.  Professor Bill Sahlman (who has easily trained more VCs than any other professor) organized a spectacular affair with 60-70 VCs from around the world, although with a heavy Boston weighting.  In addition to the riff raff such as myself, there were numerous luminaries there, including Arthur Rock (who wrote the business plan for Intel), Peter Brooke (Advent founder), Henry McCance (longtime head of Greylock), Jim Breyer (Accel), Rick Burnes (founder of Charles River Ventures) and others.  And the speakers outshone the audience!

A few interesting perspectives shared today:

  • Larry Summers, Harvard's President, emphasized the transformational impact that technological innovations in life sciences will have on our economy and lives, and the important role of the VC industry in taking projects out of the lab and enabling widespread distribution.  Summers has embarked on a massively ambitious Allston construction project which, when completed, will serve as a haven for inter-disciplinary scientific discovery.  Boston today, like Florence in medievel times, has the opportunity to be the most advanced community for the discovery and incubation of scientific breakthroughs and Harvard seems determined to truly lead that effort.
  • Bob Langer, George Whitesides and Doug Melton added to this perspective with case studies of their own labs at MIT and Harvard and the incredible "innovation productivity" that they have achieved.  Some common patterns they highlighted:  pursuing high risk, big ideas; encouraging external and internal collaboration; stressing interdisciplinary approaches to problem-solving; and strong relationships with VCs and industry to reduce friction and improve throughput in the "from lab to market" process.  They cautioned, though, that typical VC time horizons (4-6 years) may be too short for early stage research commercialization time horizons (6-10 years).
  • Clay Christiansen talked about the power of disruptive approaches (both low-end disruption and new market disruption) and the benefit to VCs of finding and investing behind disruptive opportunities rather than incremental ones.  A good lesson for those in the industry that jump on the "me too" funding bandwagon.
  • Michael Porter highlighted the important role of strategy for the VC funds and their portfolio companies - the need to be unique at something, not "the best", and to make hard strategic trade-offs when building the value chain that delivers the unique product/service.  Good boards and CEOs, he noted wisely, need to be willing to say "no" frequently and with conviction.
  • Jay Light, Andre Perold, Mohamed El-Erian and Jeremy Grantham discussed asset allocation and the capital markets.  They observed that pundits who believe a New Era is upon us are always wrong (as Jeremy quipped after analyzing 27 asset price different bubbles over the last 100 years:  "If it were a football match, it would be Reversal to the Mean: 27, New Era:  0".  They were quite bearish on US equities (predicting only 3-5% real return across a broad range of asset classes) and, like many others, lamented the dearth of untapped investment opportunities and the "stable disequilibrium" that the scary US current account deficit represents.  Makes you want to sit on cash!
  • Felda Hardymon and Josh Lerner talked about the internationalization of private equity, warning against "tourist VCs" in China and India as well as reminding everyone that historical fund performance is best for small, focused firms with lots of experience -- not newcomers parachuting in with large funds and overly general strategies.

Overall, a very thought-provoking event.  Bill Sahlman wraps it up tomorrow, where he will undoubtedly tell us the VC business is a crappy one (newsflash) and that we should all be pursuing new jobs as timber executives at hedge funds.