Sunday, April 11, 2010

Angels, entrepreneurs, and diversification: PART 2

Issues of diversification that are overlooked by investors

There is a saying: “Diversification is the only free lunch in investing.” The logic behind the saying is that higher returns are generally associated with greater risk. However, by holding multiple positions, each with some risk, the overall risk is less than the sum of the risks associated with each position. Put simply, something will payoff to offset the losers.

When risk is defined as volatility and return is measured as increase in value, pursuing a strategy of diversifying allows a greater return for a given level of risk. The logic can be formalized, and, presto, you have just learned modern portfolio theory. Formalize it mathematically, envision correlations to measure how much assets move together, reference co-variances to measure how much they move in opposite directions, plot graphs to show the results, call the graphs risk frontiers, and you’ve just written the section on portfolio theory for a text on finance.

The essential concept from an individual’s perspective is that the average risk associated with each individual position can be greater because the risks aren’t additive; some offset each other. The average risk is higher so the average return can be higher without more overall portfolio risk. All well and good, but a few issues have been ignored not the least of which is that risks can be additive without assets that “zig” when other “zag.” In fact, at the market-level they can be multiplicative.

Once one embarks on the quest for the “zigs,” life gets interesting. In the last market cycle, a lot of people learned diversification isn’t JUST holding a lot of categories of assets. Interestingly, if one looks across the last fifteen to twenty years, one finds quite a few years where every publicly traded asset class went down except one. When that happens, the order of magnitude of the drops is reasonably uniform at an annual periodicity. Further, the return on the asset class with a positive return could be fairly characterized as survival rather than profit.

This leaves the individual with a few options. One is to accept more risk (or really, just recognize it was there all along), or adjust to a lower return at the risk originally desired. In modern portfolio theory terms that is called moving to a different risk frontier. But, adjusting one’s risk tolerance (i.e., moving to a different risk frontier) in response to market behavior introduces a new risk. Behavioral economists would argue that most individuals aren’t wired to time such moves in a way that doesn’t itself reduce returns. Broader studies of market behavior confirm the problem. Performance chasing (i.e., people responding to yesterday’s news rather than a forecast of tomorrow) is well documented.

As an alternative, the individual can view time differently. View each couple of years as a window and the number of times the different asset classes move together decreases. That is equivalent to giving up liquidity. Clearly, it is a path the individual can take since they SHOULD know their liquidity requirements.

Like moving between risk frontiers, adjusting liquidity requirements based on market behavior introduces the same risk regarding timing. However, it seems reasonable to hold hope for a more rational individual response since every individual has experience managing cash flow. But, again, aggregate market data isn’t encouraging.

The final option hinges on the phrase “publicly traded asset class.” Another option is to include assets that are not publicly traded. In short, start with a broader definition of assets and all the risk frontiers are different. In fact, every asset class added to the decision process has a very high probability of opening up new frontiers with higher returns at every level of risk. That follows logically since the chance that the new asset varies in value with every other asset is probably zero. However, as mentioned, it isn’t just how many assets are involved. It is how different they are. Since non-publicly traded assets are quite different, the shift in accessible risk/return options is significant. Think of Berkshire Hathaway or some private equity funds if you want examples of instances where this approach has worked.

Interestingly, even though it is logical, it also conforms to the accounting treatment. On the books, one should carry an asset that doesn’t trade at its historical (i.e., acquisition) price. Thus, for what it’s worth, by definition, it isn’t going to vary at all until it trades. That is, unless, of course, there is some event that justifies writing it up or writing it down.

But this posting isn’t just about diversification. It is about how diversification interacts with angel investing and entrepreneurs. So now it is time to introduce angles and entrepreneurs.

Neither angel investments nor startups are publicly traded. One should realize, however, that most new businesses go out of business, fail, or go bankrupt. Exact figures depend on whether going out of business, failing, going bankrupt is being measured, but with any measure the portion is very high.

Each individual opportunity is very risky. For that very reason, opportunities (note the plural) are valuable from a portfolio perspective because they dramatically shift the risk frontier. Put differently, some exposure to potential disasters can allow the rest of the portfolio to be very conservative without changing the overall risk return profile.

Note that taking advantage of this option necessitates overcoming one of the most widely recognized findings of behavioral economic research. Behavior economists argue that most people feel loss more intensely that gain. There is even neurological evidence that the two are felt differently. However, people can train themselves to focus on the total portfolio rather than each individual investment.

The problem with both angel and startup investing is accessibility. For most people such opportunities are rare. Therefore, anything that restricts who has access is forcing some investor onto a lower risk frontier.

So much for the general, now we need to explore the details.

Most of the public is forced to accept a lower risk frontier or resort to informal channels. Formal angel investing is restricted to accredited investors. Following a logic that escapes me, the financial reform package would raise the income and asset requirements for accreditation.

The full proposed financial reform bill can be found at: . This isn’t a link where most readers will find the content interesting. So, for convenience the relevant section is presented below. Unfortunately, even this excerpt references previous legislation. But, hopefully it can stand alone. The basic thrust is clear. It raises thresholds.

The Commission shall, by rule— (1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and (2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.”

The gates to becoming an angel just got harder to enter.

In an interesting wrinkle, the criteria also create some perverse incentives. The criteria focus on income and assets rather than balance sheets and cash flow. Thus, a highly-leveraged investor who already has taken on leverage-risk can qualify for a very risky investment class when another investor with a less leveraged balance sheet could be denied accreditation. The income qualification is also questionable. The appropriate measure isn’t income; it is income after expenses. Angel investing is risky enough. Why create accreditation criteria that could introduce more risk?

In a broader sense, the entire idea that financial criteria should be decisive is ridiculous. Experience, expertise, and specialized knowledge seem more relevant. Probably the most important skill required is the ability to look at and to pass up many opportunities before adding to a portfolio. That just increases the importance of accessibility.

But now let’s focus on the investor who doesn’t have a million or two in assets and a six figure income. Anything that decreases the total number of opportunities is likely to decrease the informal opportunities also. A decrease in the pool of accredited capital could force more startups into the informal channels. That sounds positive for the non-accredited investor: more opportunities. Problem is that the positive would be offset. The total pool of capital hasn’t changed. So, the “reform” would end up forcing otherwise accredited investors to compete for opportunities in the informal channel.

The real impact would be the change that the reform will make in the number of startups. A smaller pool of accredited investors creates increased search cost for entrepreneurs seeking capital. That increases their cost of capital. The cost of capital, in fact, in some cases its availability at almost any price, is an important constraint on the number of startups. By making angel capital less available, the reform will discourage some marginal entrepreneurs. The result will be a net decrease in the number of opportunities.

There is a potentially more serious impact. Early stage investing is risky enough. I suspect the risk will actually be increased by the change in the accreditation criteria when considered in combination with other changes in the regulatory requirements related to angel investing.

The reasons new businesses disappear (regardless of whether by going out of business, failing and going bankrupt) is well documented. Access to capital is the most frequently cited reason by a large margin. The second most frequently cited reason, lack of a business plan, is so closely related to access to capital that in most studies it is hard to figure out which is being measured.

The entrepreneur’s access to capital is a function of how difficult it is for the investor and the entrepreneur to arrange the transfer of capital. Above, the issue of accreditation was discussed from the investor’s perspective. As noted, a smaller pool of accredited investors creates increased search cost for entrepreneurs. It increases the cost of capital for the entrepreneur.

That isn’t the end of it. Section 926 of the financial reform proposal would increase the cost of accessing the smaller pool of accredited investors by imposing new regulatory requirements. Previously, entrepreneurs did not necessarily need to file with the SEC to raise capital from accredited investors. The relevant section is quoted below. My reading is that it increases the regulatory cost directly by requiring a filing. It raises uncertainty regarding the determination of the process. It introduces a delay.

So, the cost of capital has been increased and a new uncertainty has been introduced into an already risky situation. The uncertainties introduced aren’t just whether early stage capital will be available. It is also worth noting that angel investments are not necessarily the first investments. A potential exit vehicle for the self-financed startup or one financed by friends is thrown into doubt. Further, a business that has proven a concept may be stopped dead if additional capital is needed.

Section 18(b)(4) of the Securities Act of 1933 (15 U.S.C. 77r(b)(4)) is amended—(1) by striking ‘‘A security’’ and inserting
‘‘(A) IN GENERAL’’; (2) by redesignating subparagraphs (A) through (D) as clauses (i) through (iv), respectively, and adjusting the margins accordingly; and (3) by striking clause (iv), as so redesignated, and inserting the following: ‘‘(iv) Commission rules or regulations issued under section 4(2), except that the Commission may designate, by rule, a class of securities that it deems not to be covered securities because the offering of such securities is not of sufficient size or scope.’’.
‘‘(B) DESIGNATION OF NON-COVERED SECURITIES.—In making a designation under subparagraph (A)(iv), the Commission shall consider—‘‘(i) the size of the offering; ‘‘(ii) the number of States in which the security is being offered; and ‘‘(iii) the nature of the persons to whom the security is being offered.
‘‘(C) REVIEW OF FILINGS.—‘‘(i) IN GENERAL.—The Commission shall review any filings made relating to any security issued under Commission rules or regulations under section 4(2), other than one designated as a non-covered security under subparagraph (A)(iv), not later than 120 days of the filing with the Commission.
‘‘(ii) FAILURE TO REVIEW WITHIN 120 DAYS.—If the Commission fails to review a filing required under clause (i), the security shall no longer be a covered security, except that—‘‘(I) the failure of the Commission to review a filing shall not result in the loss of status as a covered security if a State securities commissioner (or equivalent State officer) has determined that there has been a good faith and reasonable attempt by the issuer to comply with all applicable terms, conditions, and requirements of the filing; and ‘‘(II) upon review of the filing, the State securities commissioner (or equivalent State officer) determines that any failure to comply with the applicable filing terms, conditions, and requirements are insignificant to the offering as a whole.
‘‘(D) EFFECT ON STATE FILING REQUIREMENTS.— ‘‘(i) IN GENERAL.—Nothing in subparagraph (A)(iv), (B), or (C), shall be construed to prohibit a State from imposing notice filing requirements that are substantially similar to filing requirements required by rule or regulation under section 4(4) that were in effect on September 1,1996.
‘‘(ii) NOTIFICATION.—Not later than 180 days after the date of enactment of the Restoring American Financial Stability Act of 2010, the Commission shall implement procedures, after consultation with the States, to promptly notify States upon completion of review of securities offerings described in subparagraph (A)(iv) by the Commission.’’.

My contention is that the supposed protection for angel investor and those who are now protected from becoming angels is an illusion. They are just protected from one risk while being exposed to another. Further, there is a net increase in the risk associated with new ventures and it has been shifted to the entrepreneur and into the informal investment channel. The situation has been made more risky and that will decrease the total number of opportunities to diversify into this category of assets. Since most investors will consider far too few startup or early stage investments, the result is unfortunate, indeed.

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