Bucket List

The transcript of a keynote speech given by Privcap co-founder David Snow on January 28, 2011, to the New Jersey Technology Council about why institutional investors are reorganizing their alternative strategies into different ‘buckets,’ and even thinking about doing away with certain buckets altogether.

Good morning. I’d like to thank the New Jersey Technology Council for inviting me to share some thoughts with you today. They warned me that I’d be making the trip down from New York on the coldest day of the year. But here it is a balmy 35 degrees, and no snowmageddon in sight.

A little bit more about me – I have to inform you that my knowledge of technology is limited, and my knowledge of New Jersey technology is even more limited.

However, technology needs capital, and capital is something I can talk about. My twelve years spent covering private equity, venture capital, real estate, hedge funds and infrastructure funds has given me some insights into the strange world of institutional private capital. I’d like to share with you a few trends taking place in that world that I hope you find to be interesting.

So here’s a one-word headline for what I’m going to talk about: Buckets. I think if you understand what’s going on with buckets you’ll gain some insight into the future of the technology scene. What’s going on with buckets might explain why someday soon there’s a ton of institutional money chasing big infrastructure assets and not as much chasing early stage companies.

Let me explain what I mean by buckets. “Buckets” is a bit of jargon meaning the categories of investment that large institutions use to divide up their portfolio assets. Maybe one investor, like a pension fund, will have 55 percent of its assets in the public equities bucket, 35 percent in a fixed income bucket and 10 percent in a bucket called alternative investments.

I like the term bucket because it captures a truth about investing, which is that it is very hard to group different opportunities. Each investment has very different potential risk and return profiles. Investments that have a certain look and feel at one point in the market cycle might have a very different look and feel two months later. You might have two stocks, but they are in two completely different kinds of companies. Nevertheless to stay organized you throw them both in your public-equities bucket.

Well, there has been a financial earthquake over the past two years, and these buckets have been upended, have sloshed all over the floor, and the buckets are now being relabeled and used to hold a different mix of assets, with interesting consequences.

I’ll return to these buckets, but first, I owe you a bit of background detail about how I see the private capital market working.
Maybe because I’ve covered this topic for so long I’ve got a bit of Stockholm syndrome, and so I’m biased, but I find it fascinating the way that private capital makes its way from large investors, down into the hands of the investment managers, and into individual businesses and assets around the world. As capital makes this journey, its flow is guided by all kinds of different incentives, philosophies and policies.

It is very much the case that things happening all the way upstream in the world of institutional investment will impact what’s going on downstream, including the way that private businesses are built in New Jersey and around the world.

By the way, I am acutely aware that my comments will be followed by a panel that includes my friend Mark Heesen, president of the National Venture Capital Association. Mark is best placed to give you granular insights into where VC dollars are being deployed. So I’m going to try to focus further upstream on the dynamic between very large institutional investors and their private fund managers. This is a world that doesn’t get covered as much in the press. But it is fascinating. And it is a world that is very much in flux, which is good, because there really do need to be some changes. Unlike Lake Wobegon, in the realm of private partnerships, not all the corporate governance is strong, not all the transparency is good looking, and not all of the fund performances are above average.

Before we get back to our tumbling buckets, I’d like to share with you a true story that I think really captures some of the challenges in the private investment world today, in this case, in the venture capital market. The story was recently relayed to me by an advisor who helps large institutions with their private equity and venture capital investments. He told me he was aware of a certain venture capital firm that had angered its investors with a move that seemed to be so self-destructive and so egregious that the firm risked its own future ability to raise funds and even may have caused some of its own investors to question whether they should ever again be involved with a venture capital fund.

Here’s what happened. The venture capital firm in question is managing a fund that is getting fairly long in the tooth. As many of you know, these funds are supposed to last from 10 to 12 years, but many of them are still alive at age 14, 15, 16, and some of them are sort of staggering along like zombies. Many of them only have a few weak investments left, but the partners just won’t get rid of them. This was very much the story for this particular fund, which still had a number of investments in it – mostly shares in early stage, private companies – and let’s just say that there are currently no buyers in site for these assets, at least not at attractive valuations. And remember, the investors have been in this fund for more than a decade and at this point they’re starting to wonder when they can stick a fork in this thing and get their money back. Well, the fund managers finally decided to liquidate the fund’s position in one of their portfolio companies, but instead of finding a buyer, selling the company and sending cash back to their investors, the VCs decided to simply send back shares in the private company. Restricted, private stock, mind you, for which there are no buyers. It’s not like this is Facebook we’re talking about. Instead, the company is one of many, many VC-backed companies that probably won’t amount to much.
I should note that it is entirely within the mandate of most private funds to distribute shares instead of cash, but it’s worth adding that most investors strongly prefer cash.

So the investors get back these private shares, and they glumly wonder – gee, now what do I do? If my own fund manager had trouble selling these shares, what chance do I have with my little pro-rata sliver of ownership? Another interesting thing about the shares – in making the distribution, the VC firm had of course assigned a value to them, and that became the official value for the purposes of the fund’s performance. As many of you know, it is very hard to determine what shares in a private, early stage company are worth at any given moment, especially when no one wants to buy those shares. And so it often falls to the private fund managers themselves to come up with a value. In this story I’m telling you, the VC firm said: “Here you go, here are your shares, and they are worth X.”

Here’s where the murky issue of fair value accounting comes in. It is unclear if the VCs here were saying that the shares are worth X, as fair value accounting would dictate, or whether they were saying the shares should be worth X, which is different. As in, the shares should be worth X, but the rest of the market refuses to acknowledge the true potential of our little company.

Whatever the case, the investors in this VC fund were chagrined to learn that, immediately after being given their shares in this company, the fund manager contacted all of them to see if they’d like to sell their shares back to the partners for a fraction of the value at which they had just been distributed. In other words, “Dear Investor, Here are your shares, which we believe are worth X. Good luck selling them. If you’d like to sell them back to us, we’d like to offer you a price of X divided by 5.”

I’m told this was not an isolated event.

This story is a good set-piece for discussing several trends going on not just in venture capital but in private investment defined broadly. Here we see a firm that appears to be behaving as if it doesn’t believe it will ever raise another fund, and therefore its general partners seem to be seeking to maximize their own value at the tail end of their final fund, and seemingly to the detriment of their investors. We see a somewhat depressing conclusion to a partnership that might make some of its investors question whether or not venture capital is an asset class they should even be involved with, where the odds are stacked in the favor of the investment managers, where the underlying assets are often speculative companies of which one knows the true value, and where an enormous amount of brain damage is incurred in dealing with a relatively small percentage of the overall portfolio. Events like this might even make an institutional investor decide to dramatically shrink, or even do away with, its venture capital bucket.

Okay so back to buckets. Throughout the 2000s, a style of portfolio management became popular around the world that saw the gradual increase in the allocation to “alternative” investments, although I think “alternatives” is a fairly insipid catch-all term. Alternative investments include all kinds of different strategy descriptions such as leveraged buyouts, private equity, growth equity, venture capital, hedge funds, distressed and turnaround, secondaries. Sometimes real estate is thrown into the alternatives bucket, because people don’t know where else to put it. It’s not stocks or bonds, after all. So throughout this golden era of alternatives, investors were gradually deciding that they wanted more exposure to alternatives, because they gradually came to the conclusion that alternatives performed better than stocks and bonds. For evidence of this they looked backwards over the last 20 years of private equity and venture capital performance and saw that on average it looked pretty good. They also looked at institutions like Yale University’s endowment and felt great envy, because Yale had something like 30 percent of its assets in alternatives and was absolutely kicking ass.

As always happens when an asset class matures, within the alternatives bucket, smaller sub-buckets were forming, with all these different sub-strategy names on them: middle-market buyouts, later stage venture, Asian real estate, etc. It is actually very important what each bucket is called, because unless an institution has a bucket with your name on it, you’re not getting any money. If you were, say, a manager of distressed investment funds trying to raise capital, and a major pension had an allocation specifically to distressed, you just might get a meeting. If, on the other hand, distressed funds got thrown randomly into a bucket that said “buyouts,” you might have an uphill climb getting the attention of the pension fund, which might not have clear guidelines as to how much distressed exposure they wanted.

Institutional investors, with the help of their advisors, became much more scientific in assigning exact target allocations to each type of private investment. The more experienced an investor you were, the more likely you were to have a whole range of pre-labeled buckets from which to draw capital.

This was all very fun and exciting until the earthquake came along and upended everything. We all know that pretty much every assumption and forecast was ruined in the financial crisis. The world changed, and investors have been forced to change their outlooks in response. This has happened up and down Wall Street, and it has certainly happened in alternative investments.

All the buckets got knocked over and all the old assumptions about what should have been in the buckets changed. With interesting consequences.

So here’s one consequence of the change – there are now those who believe that private equity, defined in a certain way, should not be thrown into a segregated private equity allocation, but instead should be blended in with all equities, including stock. This view is based on the argument that, in fact, private equity valuations tend to track stocks and have similar risk characteristics. The California Public Employees’ Retirement System – CalPERS, one of the largest institutions in the world – has taken this view. CalPERS have now thrown their stocks and their private equity funds into a bucket called “growth.”

It is unclear how this will change the way that CalPERS approaches public and private equities, respectively, but CalPERS might want less private equity going forward. If a private equity fund manager comes to them with a certain strategy, will CalPERS say, “Oh, no thank you – we already get that kind of exposure through an index fund.” Too soon to know.

And so if fewer dollars go toward traditional private equity funds, of course that means fewer dollars available for the kinds of deals that private equity firms have recently targeted, potentially.

Another bucket conundrum – what is a leveraged buyout fund? Throughout the 2000s we saw a huge growth in the size of leveraged buyouts, thanks to a massive amount of leverage available. At the time buyout funds, on average, were showing very good historic returns. Not surprisingly, many institutional buckets were created specifically for buyouts as a strategy, and given the size of some of those funds, the buckets were quite large and overflowing.

Well, the world has changed, and most of those buyout firms are still around, but they’re not calling themselves buyout firms. Some of them would rather be thought of as growth equity, or as “change equity.” It is unfashionable to say that you take over companies through the use of enormous leverage. It is better to say that you provide capital for the improvement of businesses. This makes sense in an environment where companies are more likely to need capital to grow, and are not in positions to service a huge amount of debt. Many of the buyout deals done in the boom years are going to produce very weak returns. And so investors have to ask themselves – what should I do with this bucket marked buyouts? Do I want that many buyouts in my portfolio? Isn’t that too risky? Is that what the world needs going forward?

Again, it is unclear how this redefinition will shake out, but here’s a thought: Remember, sometime around 2006/2007, when just about every public company was talking about going private? They were complaining about Sarbanes-Oxley and all the headaches associated with being a public company. Almost all of them were being courted by buyout firms. At that time there were very few public companies that were out of the reach of roving packs of buyout firms. That has changed, of course. You’re not going to hear casual talk about very large corporations going private. And if institutions pull their money back from specific buyout allocations, this type of transaction will take place less frequently and mostly among middle-sized and small public companies.

Venture capital will be an interesting one to watch, because this is the bucket most in danger of, if not becoming extinct, then turning into a small flower pot. Now, let’s be clear – venture capital has a permanent place in the global financial market, and the next wave of revolutionary companies will be backed by venture capital. But it is unclear to what extent institutional investors will participate in that activity.

Following the incredible venture capital successes of the late 1990s, just about every institutional investor in the world sought to create a specific allocation to venture capital. They saw all the dotcom IPOs, they saw Google and they said “I’ll have some of that.” And it wasn’t hard for them to find managers willing to take their money. The investors put a sign outside their door that said “venture capital bucket inside” and the VC managers started lining up.

There was a proliferation of venture capital firms and venture capital funds. In the year 2000, for the first time ever, more money was raised for venture capital funds than for buyout funds. If you think about it, this said that the market expected the capital needs of startup companies to exceed the capital needs of the entire economy of established businesses.

Of course there was a major downsizing of tech and venture capital following 2001, but there is a growing view, especially among certain grizzled venture capitalists, that the thinning of the herd was not dramatic enough.

It has become fashionable to now argue that venture capital is not an asset class at all, and that institutional investors should not be involved in it in a programmatic way. The argument is that there is simply not enough need for the amount of early stage money that gets produced when every institutional investor creates a VC allocation. There is no way that all of this money can be effectively absorbed and turned into value of the kind that would make it worth the while of these investors. It is a game best left to a few small institutions and networks of wealthy individuals, the argument goes.

There is evidence supporting this view. Venture capital returns have on average not been good for the last 10 years, largely because there haven’t been enough venture capital success stories shared among the many firms. Over the last 10 years, the average venture capital fund has turned in a negative return. Now to be fair, the S&P 500 return over the past 10 years is also negative. But venture capital is supposed to be better than that. And indeed, if you look back 15 and 20 years, when there were far, far fewer VC firms, returns are very impressive. 38 percent over 15 years. 24 percent over 20 years. These earlier results were produced by a smaller cluster of firms backing a smaller number of companies. Might we return to those days?

As some institutional investors pull back from the VC asset class, such as it is, many firms are going to go away. In the anecdote I shared, it is pretty clear that the firm in question is not going to raise another fund. Unfortunately, it may have developed some perverse incentives to act in ways that are beneficial to its own partners but not to its investors. This is an unintended misalignment of interests that the next generation of private partnerships is going to have to guard against.

If the institutional backbone of venture capital erodes, the business of innovation will not go away, but it will change. Great ideas will still be backed by risk capital, but the capital will come together in different ways. We have lately seen the rise of the Super Angels, in other words, very well connected, high net worth individuals, many of them serial entrepreneurs, who have backed some of the most successful new technology companies today. Some of these angels have become much more sought after than venture capital firms. And these angels have been especially prominent in start-ups that don’t require all that much capital to get going, as has been the case with many of the social media startups, for example.

So if institutions are pulling back from venture capital and large buyouts, where are their allocations going? When you dump the capital out of one bucket, it needs to go into some other bucket.

Here’s my prediction. Remember that scene in the movie, “The Graduate,” where Dustin Hoffman gets some unsolicited advice about what career move he should make? A man corners him at a party and says: “Benjamin, I just want to say one word to you: Plastics.”

Well, there’s been a new bucket name floating around that I think will really pick up some momentum. You want to raise institutional capital, Benjamin? Just two words: Real assets. Real assets.

Real assets tend to include large, heavy, real things that require lots of capital and generate fairly low but consistent returns. Infrastructure assets, equipment leasing funds, agricultural assets, forests, power plants, airports, and yes, now real estate is being thrown into the real assets bucket. Proponents of real assets argue that this makes sense as an asset class because these assets are grouped based more on how they behave than what they are. Airports tend to produce consistent, middling returns. Likewise, toll roads produce long-term, consistent returns, if you do them right. Buildings can produce predictable returns, unless you bought one between 2005 and 2008.

In many regards, real assets are a perfect match for institutional investors, because they would appear to bring a more verifiable, long term stability of cash flow to the overall portfolio. You’ll not be surprised to learn that most of the largest buyout firms are now offering real asset funds, such as infrastructure funds and real estate funds, and not a moment too soon – their next buyout funds are going to be half the size, if they’re lucky.

What this means downstream is that a large amount of financial activity that was once the purview of municipal bond issuances, of government spending, of engineering companies, will increasingly see the involvement of private investment funds. And you know what? If this leads to an oversupply of great infrastructure in our country, I’m all for it. We might possibly have too many venture backed companies at the moment, and it’s harder to find a social benefit in that.