Tuesday, April 20, 2010

Angels, entrepreneurs, and diversification: PART 4

Avoiding the mistakes that are easy to avoid.

Investing in startups is an area of investing with more contradictions than any other. For example, in the context used in these postings investments in startups aren’t as accessible as public company investments. In another sense, anyone can start a business; in fact, one of the reasons startups appear so risky and have such a high failure rate is that just about anyone does. The perspective of these postings, however, isn’t entrepreneurial (i.e., actually starting a business). Rather, the postings address the investment issues.

From an investment perspective, it is important to differentiate issues related to the stock of capital in an asset class from those related to flows into and out of an asset class. To illustrate, a number of recent postings on the VC industry discuss the secondary market (e.g., see: http://www.businessweek.com/technology/content/may2009/tc20090520_516821_page_2.htm ). They often overlook the possibility that part of the return VCs and their investors receive is a return to holding illiquid assets. If that is the case, then from VCs’ and their investors’ perspectives, a secondary market could undermine their return. That could be aggravated by mark-to-market accounting.

Generally, what leads to this oversight is illustrated by this quote from the citation: “there's more money going in every year than can be invested properly, especially with Sarbanes-Oxley regulations discouraging smaller companies from going public.” This is not necessarily a problem. Since one exit strategy, an IPO, has become more difficult, the response of the VC industry should be to lengthen their holding period. The implication of fewer companies going public could be that VCs would need to take in additional capital. The imbalance in the flows of capital does not imply a buildup of an excess inventory of capital.

Whether the lengthened holding period will have an adverse impact on VCs depends on how much of their return is due to their investments verses the transactions associated with their portfolio. I have no doubt that IPO bubbles and busts influence whether the portfolio verses the exit strategy yields the greater return. A shakeout, or at least a restructuring of the VC industry, could focus on VCs that are highly dependent on turning over their portfolios.

There is some justification for emphaszing that successful investing in non-public assets requires particular displine in seperating stock and flow decisions. The stock of assets in this asset class that yields the desired portfolio weight, as always, is determined by the total portfolio’s composition. The decision on when to adjust the stock (i.e., initiate a flow) depends on the opportunities available. That too is always the case. What is unique about non-public assets is that both ends of the flow are constrained. For most investors, accessability is a problem on the inflow side, and the very nature of non-public assets is that they are constrained on the outflow side.

The essense of successful investing in non-publis assets is understanding the difference between types of risks. Again, drawing on the discussion of secondary markets for non-public assets, the citation states: “the secondary market takes this de-risking too far. There shouldn't be a guarantee that you can cash out, whether you're an entrepreneur or an investor.” There doesn’t seem to be any basis for assuming reducing liquidity risk actually reduces overall risk. It fact, liquid markets often create their own risk. To appreciate the risk associated with liquidity, one only needs to remember the overheated IPO market.

There are probably many issues associated with non-public assets worth discussing, but the important ones were either covered or implied in one of the postings. So, a disclosure is in order. Specifics are irrelevant since past and current holding are by definition not publicly traded. Suffice it to say, I’ve been lucky enough to have worked for employee-owned companies and acquired other positions through various informal channels. However, like many investors, I've experienced the constraints first hand.

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