At the end of 2015, I randomly came across a PBS special that was debating the value of the growing number of entrepreneurship-based learning programs at Liberal Arts Colleges. I learned about the MiddCore program at Middlebury College from this special. MiddCore is a mentor-driven, experiential learning program where students build solutions to real life problems through developing products or services.
I had mixed feelings when I volunteered with MiddCore in Vermont this January. Such a program didn’t exist when I was in college and in my five years as a VC, I have only encountered two businesses founded by Middlebury entrepreneurs. The program thoroughly overwhelmed my expectations! The students’ ideas and write-ups were among the most well thought out and eloquent I’ve encountered. I’ve spent a few weeks contemplating on why entrepreneurship and Liberal Arts are so complementary.
At the core of both entrepreneurship and Liberal Arts is the application of critical thinking to tackle complex problems. Liberal Arts curricula expose students to multiple disciplines that form the fundamental frameworks/mental models for problem solving. As students acquire this skill set, there traditionally haven’t been formalized platforms to apply it to practical problems in the course of school. During an economics examination in college, I remember a question that asked us to apply the knowledge acquired in class to react to a recent WSJ article. This experience stuck with me because it was the moment I began to think about my education from a perspective of its application to solving real problems. MiddCore takes this experience to the next level. Charlie Munger, a famous investor and partner to Warren Buffet, credits his success to the application of a multidisciplinary approach. He has written several books to explain the merits of his approach. Here are examples of some of the principles he consistently applies:
- Biology: Genetics, Natural Selection, Physiology
- Chemistry: Autocatalytic reactions, Bohr Model, Kinetics
- Computer Science: Abstractions, Algorithms, If-statements, Recursion
- Economics: Agency Problem, Asymmetric Information, Behavioral Economics, Cumulative Advantage, Comparative Advantage, Competitive Advantage, Creative Destruction, Diminishing Utility, Economies of Scale, Elasticity, Externalities, Markets, Marginal Cost, Marginal Utility, Monopoly and Oligopoly, Network effects, Opportunity Cost, Price Discrimination, Prisoner’s Dilemma, Public and Private Goods, Specialization, Supply and Demand, Switching Costs, Transaction Costs, Tragedy of the Commons, Time Value of Money, Utility
- Engineering: Breakpoints, Feedback loops, Margin of Safety, Redundancy
- Law: Burden of Proof, Common law, Due Process, Duty of care, Duty of Loyalty, Good Faith, Negligence, Presumption of Innocence, Reasonable doubt
- Mathematics, Probability, Statistics: Agent Based Models, Bayes Theorem, Central Limit Theorem, Complex Adaptive Systems, Correlation versus Causation, Combinations, Compounding, Decision Trees, Inversion, Kelly Optimization Model, Law of Large Numbers, Mean, Median, Mode, Normal Distribution, Permutations, Power Law, Regression Analysis, Return to the Mean, Scaling, Sensitivity Analysis
- Philosophy, Literature, Rhetoric: Metaphors, Similes, Abduction, Pragmatism, Realism, Reductionism
- Physics: Critical Mass, Electromagnetism, Equilibrium, Inertia, Newton’s Laws, Momentum, Quantum Mechanics, Relativity, Shannon’s Law, Thermodynamics
At Middlebury, I certainly didn’t take the most advantage of exposure to all the different disciplines. I spent too much time trying to teach myself finance. I have repeatedly learned since then that no one has really ever made money from spreadsheets. Multidisciplinary critical thinking overtakes the technical stuff sooner than we think. If you don’t believe me about the liberal arts stuff, at least you can believe Mark Cuban, he’s been there and done that.
Many years ago on rainy night in East Village I decided to flag an empty cab that was passing by. As soon as the driver spotted me, he quickly switched off the “available” light. He stopped a few meters down the road and picked up a group of four white guys who were quite drunk and rowdy.
As much as I was perplexed by the discrimination and could have taken down his license plate etc., I was drenched and tired and just wanted to go home. That’s was when I came up with Uber. I had engaged a driver on a previous trip on why there was so much discrimination and he told me that some drivers had encountered infrequent, but truly memorable negative experiences with people of color, especially those traveling to the outer boroughs.
I’ve read many theses from savvy investors on why Uber/Lyft are such special businesses. Some of them include route/logistical efficiency, flexible work schedules etc. Frankly, I don’t fully understand some of the more complex ones. Truthfully, that day in the rain, I came up with the idea because I had a few, very real, basic, problems I wanted fixed.
- Information asymmetry – If the cab driver had known that I was paying in cash (no credit card fees) and I was going to 34th and 3rd (low traffic and no outer borough), he would have stopped. Unfortunately there was no way of communicating this via telepathy when our eyes locked
- Elimination of friction – If there was a way for me to prepay and provide my trip detail so that I can just walk in and out of the car without unnecessary interaction, the probability of misunderstanding resulting from difficult situations (lost wallets, cash only cabs, language barriers etc.) would fall dramatically
- Tracking and feedback – If we both agreed to the trip being tracked and to providing our personal identification information, then the driver’s willingness to take risk would increase. Additionally, both parties’ fear of a negative review would encourage civil engagement
I suspect that Uber’s founding team was solving for the problem of sprawl in SF – I once had to walk for half an hour in Dogpatch to arrive to an area with any traffic. I don’t know that any of these founders would necessarily relate with my pain point.
As an investor, this experience taught me to develop what I will call “experience empathy”. When evaluating a new opportunity, I work to identify and really understand the multiple distinct profiles of customers/users whose experiences/problems (especially those I don’t relate to) would be solved in a transformative manner by a company’s products or services. It demands constant humility to suppress the “if it’s not relevant to me then it’s not so great” proclivity.
In closing, I would argue that, through addressing information asymmetry, Uber is making society much better by contributing massively to the data, education and human contact, critical to reducing the chronic dependence on stereotypes when making business decisions.
Yesterday, Pitchbook published a series of charts summarizing the state of private equity in the US. The basic message was how cutthroat the industry is becoming. The key points I picked up from the article are summarized in my somewhat gloomy tweet below:
I haven’t delved into the full report, but I’d be interested to learn more about strategies that differentiate successful managers. After all, alpha/expertise is the reason managers enter this business. A relevant takeaway for me is how growth equity has become increasingly attractive to “visiting investors” with core expertise in other asset classes/investment strategies and looking to compensate for softness in key drivers for their models (leverage, yield, etc.).
I recently attended a conference where a panel of seasoned growth equity investors shared perspective on the pitfalls encountered by visiting investors in growth equity. Whereas the discussion took a combative tone often used by incumbents in industries encountering disruption, there were some tidbits that could probably help entrepreneurs evaluating an investment from large hedge funds vs. growth investors:
- Tourists don’t have home advantage: Visiting investors don’t often possess the skillset, temperament and rolodex that are critical to invest successfully in growth equity since these ingredients take a long time to accumulate. For example, a visiting investor might misprice the risk of an asset due to the typical absence of clean historical data often used as basis for valuation. Inability to emotionally stomach the chaos and rapid change associated with high-growth businesses might result in conflict (e.g., when hedge funds publish large markdowns for their holdings in private growth companies). Also, visiting investors may still need to amass value-add strategic resources e.g., network
- Liquidity overhang can hang you: As the queue for realizing returns keeps getting longer, business models are increasingly becoming exhausted before they are exited resulting in value contraction. For example, early investors in digital media platforms were able to exit on the promise of “monetization of audience/microtransactions” but as those models became harder to execute, investors increasingly questioned whether these platforms were primarily b-2-c/branded consumer or b-2-b/advertising. Visiting investors rarely have a complete playbook to help entrepreneurs either pivot from low-value models or install additional high growth channels to preserve value
- Base case doesn’t cut it anymore: Because of pricing pressure, investors can’t simply value a business based on the base case. The growth model used to be about a profitable businesses promising to deliver incremental growth with additional funding. Today, businesses ask investors to fund operating losses in exchange of future growth. The best solution however, is when investor/entrepreneur teams sit together and develop a shared growth plan. Unfortunately, this creates logistical challenges e.g., the entrepreneur having to choose an investment partner ahead of discussing valuation. Many growth teams have invested in incubator structures, designed to partner with entrepreneurs from the start before approaching the broader market
Returns are increasingly harder to come by in private equity. However, this is also an opportunity for good investor/entrepreneur teams to stand out from the crowd and win!
Private equity is an apprenticeship. As a young practitioner at a start-up, I spend a decent amount of time picking the brains of the many grey-haired executives that have made their mark in the industry. I try to ask variations of the same questions to each investor so I can tally their responses. Below is a summary of responses to two questions I asked the most in 2016.
Question 1: What are the key drivers of success for a fund?
- Valuation: Valuation is often the biggest driver of return. Valuation must allow for the investors to achieve their mandated return while representing (i) a realistic growth profile for the business and (ii) the operating team’s capability and ambition. Not all businesses must achieve 100% C.A.G.R and billion dollar valuations! Venture investors looking for outsized returns should avoid investing in entrepreneurs seeking to optimize for other equally noble goals e.g., social impact or steady profitability. Additionally, investors must adjust their calculations for the impact of other systematic factors – economic cycle and exchange rates – on exit valuations.
- Intentions and proclivities: It’s tempting to pick business partners based on resumes, references and stated intentions. However, certain contextual factors that are harder to uncover might result in value-destroying conflict. Entrepreneurs feeling pressured to conclude a deal might agree to restrictive conditions, but retain the resolve to renege. Minority investors feeling confident about their legal prowess or their skill to influence might include “Convince the entrepreneur…” as part of an investment thesis. Even where there’s honest intent to cooperate, certain inclinations that are a result of character traits or past experience, could result in even more debilitating conflict.
- Idea/strategy vs. execution: (I’m lumping ideas and strategy to tie to the chart below): Mike Tyson once said that “everyone has a plan until they get punched in the face”. The strongest of business strategies barely survive impact with reality. Great investors spend time with operating teams to thoroughly unpack, test and update execution plans. Derek Sivers presented this idea succinctly in the illustration below. They also update their competitive edge e.g., through engaging advisers, recruiting stellar hires, participating in industry events etc.
Question 2: What is a PE firm’s most meaningful contribution to its portfolio companies?
- Facilitation: A private equity firm’s mandate is to build a platform around its core strengths and to render the platform accessible to its portfolio companies. Successful firms are able to subdue the common penchant to dominate relationships with portfolio companies, but still command professional trust and respect to be summoned early for material issues. Entrepreneurs place their first calls to firms whose competitive advantage is clear, relevant and accessible. For example, family offices with more flexible mandates for capital deployment can cement their advantage by maintaining ample reserves and developing clear processes to efficiently fund follow-on rounds. Eventually, this reputation could translate into preferred access to proprietary deals.
My article is a simplified summary of the opinions I’ve collected. I’d love to gain additional perspective from your experiences and research.
I intended to share this post closer to the beginning of the year. I wasn’t able to because my post marathon recovery and subsequent planning for 2017 took much longer than expected. However, better late than never. In 2007, I adopted a framework to reflect on the previous year and to (sort of) assess the future. The framework is a cumulative assessment of three questions: (i) What is the best gift I have ever received; (ii) What is my best lesson so far; and (iii) What biggest opportunity lies ahead. Since I began performing this exercise, my answer for best gift has not changed. The answer for most important lesson has changed once. The answer for largest opportunity changes all the time due to the dynamic nature of my opportunity set and occasional changes in the rank of priorities.
- Best Gift: The best gift I have received is being part of a large family. I have six siblings. My childhood environment was training ground for key skills that have been critical to my career:
- Teamwork – Competing for scarce resources fosters skills required for teamwork such as: Compromise – How to navigate commercial breaks to simultaneously watch two TV shows; Guile – Where to hide the remote ahead of your favorite show; Sharing – Everything
- I am my brother’s keeper – As the oldest sibling, I have had the opportunity to share real adult responsibility for my siblings’ welfare. As a unit, we’ve also learned to unconditionally look after, challenge and defend each other
- Relationships – My siblings are also my friends and the best joys and pains of my life are from sharing in their successes and failures
- Best Lesson: I learned in 2009, during a high-stress project to always and “relentlessly stay on the side of value”. I was part of a team appointed by the CEO of one of our investment banking business units to execute a large transaction for his group. The corporate group that was (technically) responsible for such transactions was not too thrilled with this breach of hierarchy. The leader of the corporate group “replied all” to an email sent by my direct manager with vicious personal attacks on my team. My manager printed out the letter, highlighted what he thought were legitimate concerns, and organized a conference call to address them. He never once discussed the personal attacks. Later, over a drink, he elaborated to me the principle of alignment with value. Aligning oneself with value purifies motive and clears conscience. Alignment with value is what enables me today to stomach tough criticism without taking things personal and to deliver negative feedback without guilt.
- Biggest Opportunity: For the last two years, career development has been my highest priority and my opportunity has been to nurture a set of skills that allow me to add real value to entrepreneurs that my organization partners with. The greatest satisfaction from this experience is that the education, exposure and experience I acquire only reveal how much farther I can go. Larger lands are available for conquering!
A few weeks ago, my brother completed high school! His graduation was the culmination of a personal “no-sibling-left-behind” mission that I set to help my siblings attend college. My brother moved in with me “fresh-off-the-boat” right after I graduated from business school. I assumed guardianship of a teenager when most of my friends were setting up their own families. My adult life started in reverse…hence the title. My four year experience with my brother contains parallels to the investor/entrepreneur relationship during an investment cycle. I wanted to share a few lessons:
- NO helicopter parenting – I consistently felt the urge to hold my brother’s hand through tough assignments and difficult personal situations. However, I observed that the more I got directly involved, the slower he progressed and the weaker his resilience became. Additionally, I’ve learned that college admissions reject applications with evidence of adult meddling. Similarly, companies subjected to “helicopter-parenting” from existing investors might scare off potential new investors due to perceived operator incompetence. Also, investor intrusion is often a sign for strategic misalignment. The best role for investors is to facilitate the execution of the company’s vision through supporting competent operators.
- Progressive chaos is good – My brother’s stay was chaotic. At the beginning, the challenges were rudimentary, e.g., confusion about class scheduling, misplaced laptop/phone etc. Over time, the challenges became more complex, e.g., deciding on colleges to apply to or unpacking the emotions of love. Chaos is a constant for businesses, but its nature should evolve similarly. Entrepreneurs that succeed face increasingly complex problems that if cracked, will create sustainable competitive advantages critical to return generation.
- Jack of all trades – About halfway through this journey, I increasingly became overwhelmed and occasionally dropped the ball in other important areas e.g., love, fitness, sleep. I paid the price. Unfortunately, “I took on too much” is not a valid excuse for poor execution. Investors/entrepreneurs must learn to efficiently manage their myriad of responsibilities through tools such as saying NO, clear communication, delegation, humbly seeking help, outsourcing, better time management, etc.
- It takes a village – My brother and I didn’t always get along since we spent too much time together during his “teenage phase”. However, different mentors, at different times, built credibility and ability to influence him on important issues. Companies must surround themselves with a deep bench of trustworthy stakeholders that add value. In times of internal conflict, there needs to be someone who steadfastly remains on the side of value.
- There’s a seat for every a** – At the start of freshmen year, I considered my brother to be Harvard material, but when the college process begun, we had been humbled and were “just happy to be here”. After we rid the anxiety, all stakeholders convened to assess his grades, preferences, goals and curated a list of schools that fit his profile. He got in. Not every startup becomes a unicorn, goes public or is acquired by Google. Stakeholders should explore other avenues of value realization e.g., recaps, partial sales, etc.
Recently, I was considering investing in a business whose brand I really like. The capital structure was unique because although young, the company had been funded through a very low-interest loan from an angel investor. Maturity for the loan was approaching in six months and the investor refused to extend the term. The company desperately needed cash to pay down the loan and to support growth. Our investment committee wasn’t thrilled that a large portion of the investment would “leave” the company.
Young businesses are highly risky due to size, market uncertainty and other operational challenges. Understanding this risk is the most valuable skill set for both investors and entrepreneurs. Investors work with hurdle rates – minimum required rate of return – and will only invest in companies whose expected return clears the hurdle rate. Similarly, entrepreneurs apply hurdle rates to capital budgeting – allocation of capital to projects whose return is higher than the cost of capital. Entrepreneurs who don’t fully understand the risk of their businesses could make investment mistakes that destroy value. In this particular case, management assumed that the cost of capital of the debt security equaled that of the overall business. This underestimation of risk resulted in fast growth, but through reckless investment decisions. Underestimating risk creates several business challenges. Below are a few examples.
- Paradox of Choice: When cost of capital is superficially low, a large number of projects clear the hurdle rate and management will spend too much time deliberating on opportunities that would normally be unworthy. Faced with too many options, management could lose the stamina, rigor and discipline required to make good investment decisions. The more the errors made, the more each incremental investment destroys value.
- Smoke Screens: Revenue growth is usually a leading indicator for return on investment. And, since young companies are often valued on a revenue basis, entrepreneurs could get caught up in premature value celebrations before discovering lagging investment mistakes e.g., revenue with low gross margin, revenue with high fixed cost, or revenue that is inconsistent with overall strategy. Investments accompanied with high fixed costs are particularly hard to unwind.
- Capitalization: Today’s high valuation must be paid for by high revenue growth or through a future down round, both of which induce tremendous stress to the entrepreneur. Additionally, debt often results in complications around secondary transactions when paying back the principal and around interest obligations that affect profitability.
- Adverse Selection: Investors with an ability to augment value often have a strong grasp of business risk for target companies. Investors offering valuations that are “too good to be true” may not fully understand the underlying business and therefore cannot add much value. Some might have ulterior motives that create distraction. Before accepting capital, entrepreneurs should perform due diligence on potential investors as if the company were using its stock to buy into the investor’s value ecosystem (network, technical expertise etc.).
In summary, whilst cheap capital might appear attractive on the surface, it presents challenges that can potentially result in future value destruction.