Monday, March 21, 2011

More angels? Sometimes they won’t leave you alone

Where’s the disclosure in this?

The WALL STREET JOURNAL had an article entitled “Investor Criticizes 'Shadow' Market” on March 17, 2011. The author should be ashamed. The entire article doesn’t contain a single criticism by an investor. Rather, it is based entirely on an interview with a Venture Capitalist. The author has clearly been made a tool of a Venture Capitalist.

The VC doesn’t come off much better than the author. Judging from what he says, he comes off as a bit of a shark, certainly not someone a serious journalist should use as a primary source. He states in reference to the prices in the shadow markets “these prices don't affect the prices his firm pays in its transactions.” Later is the article he’s quoted as saying “his firm is in competition with the bidders in the secondary markets for equity in private companies. His firm has acquired stakes in Twitter and other start-ups by buying shares being sold by employees or early investors.” How dumb does he think JOURNAL readers are? He’s in competition with them, yet the price he pays isn’t affected. Get real!‬ Maybe the journalist is naive enough to let that slide, but the VC should be embarrassed to have pulled it off. He’s probably a decent guy, but he really does himself a disservice.

You’d think the journalist would pick up on the fact that his source was talking out of both sides of his mouth. If he did, he’d realize “potential conflicts of interest” extend to sources as well as market makers. If he took it a step further, he could have written an interesting analytical piece about what’s happening in the startup sector. He could base it just on JOURNAL coverage. A week or so ago they had a piece about the shifting balance of bargaining power between entrepreneurs and VCs. Then there was the article discussing angel networks that was cited in the last posting. Now a series of quotes that reflect a VC’s sour grapes attitude toward second or shadow markets for startups. It’s pretty clear that as more alternative sources of capital become available to entrepreneurs, VCs are experiencing some discomfort. If the author went back a few months to the JOURNAL’s coverage of VC’s increasing reliance on private equity and corporate buyouts, he’d complete the loop.

Anyone who has followed the discussions of angel investing referenced in the last posting, Investing PART 12: Angel Investing, may have detected that The Hedged Economist isn’t an advocate of using the second market. In fact, I’m of the opinion its development isn’t very beneficial, but that has more to do with how mark-to-market accounting is misinterpreted and abused than anything else.

Wednesday, March 16, 2011

Investing PART 12: Angel Investing

“This is a land of confusion”

THE WALL STREET JOURNAL; (3/12/2011) had an interesting article entitled “An Easier Way to Bet on the Next Facebook.” As I read it, I thought: “There are too many men, too many people, making too many problems, …This is a land of confusion.” Angel investing may not be what Phil Collins was singing about, but it fits. Back in April, a series that started with “Angels, entrepreneurs, and diversification: PART 1” then again in June and July in a three-part series that started with “The discussion Congress should be having: PART 1 Angels, entrepreneurs, and diversification” The Hedged Economist made a reasonable argument for angel investing.

While the WALL STREEET JOURNAL article contains lots of interesting factoids, in total it just muddies the water. For example, it notes: “While the basic requirement is that investors be "accredited," having a $1 million net worth excluding the value of their primary residence….” That’s true, but totally irrelevant. Why should I care what the government thinks should be the liquid assets that an angel investor should have? Quite frankly, Government doesn’t have the foggiest idea what constitutes good financial behavior, and it certainly doesn’t have any insight into what constitutes a good investment- - except perhaps investing in pork. Angel investing is just one of many potentially beneficial financial behaviors the Government makes difficult. A more useful discussion would be when angel investing makes sense (i.e., under what circumstances) and how to participate in investments in startups without accreditation, topics discussed in the postings referenced above. Help on those issues would be appreciated.

The statement quoted above continues “….they also should have the stomach for blowups.” Again, true, but in this case redundant. Any investment can “blow up.” Investing inherently involves risk. Values go down as well as up, and some go to nothing. The notion that there is such a thing as a risk-free return is a fiction; a point noted before in The Hedged Economist (e.g., see the April 1, 2010 posting entitled “Beware the risk-free return”). While talking of blowups adds drama, the more useful info is presented when the article leaves the drama to the screenwriters’ guild and turns to reporting. At that point the article goes on to note interesting factoids. For example, one of the factoids references a study that found that one in four angels in a particular category goes bust. That’s interesting. I’ve seen other numbers. But, it leaves a legitimate impression.

If the author wants to imply that a million dollars makes sense, just quoting accreditation standards is a pretty weak argument. To add confusion, a million dollars is inconsistent with the implications of some of the “experts” quoted in the article. To illustrate, one advisor states, “angel investments should make up no more than 5% of a wealthy person's overall portfolio.” At a million dollars, that is $50,000. Another advisor states, “Only one or two of every 10 investments will generate any significant return.” Another states, "Don't do it unless you'll make 10 or 20 investments over time.” Then the article quotes another advisor who points out, “Since $25,000 is generally a starting point for angel investments, that requires plenty of cash to spread around.” But, you should note that 10 to 20 investments at a minimum of $25,000 each works out to $250,000 to $500,000. That’s a lot more than 5% of a million dollars. Somebody is wrong. But then, “This is a land of confusion.”

It’s interesting to note that angel investing as currently defined is a relatively new concept: not a new activity, just a new concept. If one reads studies of how wealth is made and preserved, one see terms like non-public companies, technology companies, startups, new businesses, non-traditional assets, and concept investments. All of these overlap with angel investments. But, angel investment is a term that doesn’t often appear. For what it’s worth, adjusting for differences in definitions, the older research seems to imply a higher portion than 5%.

It’s as if the concept of angel investing developed to accommodate regulation, as in “something’s going on so let’s give it a name so we can regulate it.” Meanwhile, the article provides some insight into angel networks and how angel investing works. That’s important. Many of the financial and social institutions that supported new ventures in the past have weakened or vanished in Western societies. Angel networks may be the substitute.

In fairness, the article wasn’t all confusion. It gave a ballpark feel for returns on successful investments and the probability that any one investment will succeed. It also pointed out, “Angel investors should be prepared to have their money tied up for seven to 10 years.” But, for The Hedged Economist, the section that describes some tax benefits was the most interesting. Not because of the tax benefit itself. Rather, the creation of the tax benefit is interesting because it implies that policy makers have woken up to the importance of startups. Now, if only policy makers would recognize the damage they do to investors by trying to “protect” them from the confusion that is angel investing. We can hope.

Monday, March 14, 2011

Investing PART 11: The dreaded 401(K), what good is it?

Like the song says: “Don’t it always seem to go that you don't know what you got've ’til it’s gone”

Investing PART 6 of this series stated: “These comments should provide a hint at how I suggest you incorporate your 401(k) into your portfolio, but that’s a topic by itself.” Yet, other postings have mentioned a dislike of mutual funds. One summarized my thinking with the statement “The only thing that is more dangerous than advice is letting someone else manage your money.” But, you say: “401(k)s pretty much limit the options to mutual funds and add a layer of someone else managing your money in the form of the plan administrator.” So, it is quite legitimate to ask how I square that circle with the defense of 401(k)s in PART 6.

Some people view 401(k)s as investment vehicles; I don’t. They are an excellent accumulation vehicle. As explained in PART 6, the 401(k) is an almost unbelievably good deal as an accumulation vehicle. It follows that absent some important offsetting consideration, one should “max out” one’s 401(k) contribution. That’s not to say they’re a substitute for all other savings and investment vehicles. One needs some “money in the bank,” and the Roth IRA is a good enough deal to rival a 401(k).

Schwab just published some interesting data in ON INVESTING, “factoids” if you will. The factoids are from a study of Schwab clients. Seems the portion of 401(k) participants who reported changing their contribution rates after receiving professional advice was 70% and the average increase was 100%. Now, the sample isn’t scientific and the study was far from a double blind experiment. Nevertheless, it strongly hints that people underestimate what they need to save, and once they realize they need to save more, they recognize how valuable a 401(k) is as a method of saving. I only wish it showed that people were realizing that whether one is saving enough for retirement is irrelevant; a 401(k) is too good of a deal to pass up.

An interesting side issue is how to treat a 401(k) if you also have a pension and have access to a 401(k)-type program. I’d just reiterate that a 401(k) is a good deal, period. That’s true regardless of what anyone else promises you. Further, pensions have some major drawbacks. It seems to me that turning your money over to a Wall Street pension manager because someone on a committee believed him when he said "trust me" (or if it's a public sector pension, got their palm greased with a campaign contribution) is foolish. Plus, an employer-sponsored pension increases risk since both employment and retirement are dependent on a single organization’s management judgment. That’s a level of concentration that is worth worrying about.

Give me a 401(k) where I have some control any day. If one has a pension, great, but it’s no excuse for ignoring a good deal like a 401(k). The big advantage of pensions is they're mandatory. They're great if they're funded, but they're seldom adequately funded because everyone involved has an interest in keeping funding cost down. Thus, they become a crap shoot, a Ponzi scheme if you will. Not what I want for retirement.

There is an important implication of viewing a 401(k) as an accumulation vehicle rather than as an investment vehicle. Once contributions are over (e.g., one is laid off, switches jobs, or retires), a rollover out of the 401(k) into an IRA should be the default. There can be offsetting considerations that could be decisive, but the 401(k) doesn’t get the benefit of the doubt.

The 401(k) could offer some compelling investment options not available or replicable in an IRA. That’s rare, but possible. The other two more common justifications for staying in the 401(k) are things that counter balance its inferiority as an investment vehicle. The 401(k) could offer some major tax advantages like a markedly different tax basis. If the exit from employment is into retirement, the tax basis could matter to someone with both a 401(k) and an IRA. Finally, the difference between how IRAs and 401(k)s are treated in a litigation could mater. But, generally IRAs are the default purely from the perspective of which is the better investment vehicle.