Allocation investing and the social premium

The rational way to invest in something – a startup, public company, venture capital firm, real estate project, etc. – is to base your decision on an assessment of its fundamental value. The most common way to do this is to try to predict the asset’s future profits. In reality, many of the largest pools of capital in the world – pensions, endowments, and mutual funds – think in terms of “allocations.” This means they start with a model for how to distribute their funds across a set of dimensions, including asset classes, industries, and geographies. This allocation mentality is based partly on prevalent academic theories (the “Capital Asset Pricing Model” or “CAPM”) and partly on the success of certain famous money managers (the “Yale Model“).

Allocation investing has a number of perverse effects on financial markets. For example, in the 80s and 90s venture capital was deemed to be a successful, independent asset class. As a result, many funds decided to allocate some portion of their capital to VC. These pools of capital were so large that they caused the VC industry to grow orders of magnitude larger – many say larger than it should be. In turn, this led to many bad venture investments that drove down returns in the industry (these problems were further exacerbated by the fee structure of VC that encouraged funds to get large and rapidly “put money to work”).

Another perverse effect caused by allocation investing happens in public stock markets when investors decide to allocate a portion of their funds to specific sectors. I recently heard some money managers saying they wanted to allocate portions of their funds to “social media”. Combining this “allocated” demand with a constrained supply (due to the small float of many of these IPOs) can lead to prices that are disconnected from fundamental values. In this scenario, supply will try to match demand, which means mediocre social media companies will go public and non-social media companies will reposition themselves as social media companies or acquire social media companies. They will be chasing the “social premium.”

We saw this happen in the 90s with the rush of companies to reposition themselves as internet companies. In that case, many non-professional investors ended up owning shares in crappy companies when the music stopped. The primary difference now is that the flagship companies like LinkedIn and Facebook have excellent fundamentals. Hopefully this time the market will be discerning and value investing will win out over allocation investing.

A few points about the “tech bubble” debate

Pretty much every day now a major blog or newspaper writes an article asking whether we are experiencing another tech bubble (e.g. see today’s NYTimes). I don’t know whether successful private companies like Groupon, Zynga, Facebook and Twitter are over or under priced since I don’t have access to their financials. Regarding public tech companies, it seems to me that incredibly innovative companies like Apple and Google trading at 19 and 22 P/Es respectively is pretty reasonable.

Rather than take a side on the bubble debate, I mainly just wanted to make a few points that I think should be kept in mind in this discussion.

1) A bubble is a decoupling of asset prices (valuations) from their underlying economic fundamentals (which is why the graph at the top of the NYTimes article today is meaningless). During the housing bubble of 2001-2007, smart economists noted that housing prices were significantly higher than their fundamental value (in housing, a common way to measure this is price-to-rent ratio, which is analogous to price-to-earnings in the stock market). During bubbles, investors stop valuing companies based on fundamentals and instead invest based on the expectation that prices will continue to rise and “greater fools” will buy the assets from them at a higher price. This process is unsustainable, which is why bubbles eventually pop.  But when the economic fundamentals are strong, the last buyer can always hold onto the asset and collect a return through the asset’s cash flows, thereby preventing a pop.

2) The forces that drive the internet economy are strong and will probably only get stronger. I argue this regarding online advertising here so won’t repeat it. Since I wrote that post we’ve also seen a number of tech companies emerge that are generating significant revenues through non-advertising means – “freemium” (e.g Dropbox), paid mobile apps, virtual goods (e.g. Zynga), transaction fees (AirBnB), etc.

3) I think it’s a good thing that the speculation on large private tech companies is happening in secondary markets where the risks are being taken by institutions or wealthy individuals. This is in stark contrast to the dot-com bubble of the 90s where many of the people holding the bag when bubble popped were non-rich people who bought stocks through public markets. Obviously this could change if we have a bunch of tech IPOs.

The “ladies’ night” strategy

Many singles bars have “ladies’ night” where women are offered price discounts. Singles bars do this for women but not for men because (heterosexually-focused) bars are what economists call two-sided markets – platforms that have two distinct user groups and that get more valuable to each group the more the other group joins the platform – and women are apparently harder to attract to singles bars than men.

Businesses that target two-sided markets are extremely hard to build but also extremely hard to compete against once they reach scale. Tech businesses that have created successful two-sided markets include Ebay (sellers and buyers), Google (advertisers and publishers), Paypal (buyers and merchants), and Microsoft (Windows users and developers). In some cases individuals/institutions are consistently on one side (buyers and merchants) while in other cases they fluctuate between sides (Ebay sellers are also often buyers).

In almost every two-sided market, one side is harder to acquire than the other. The most common way to attract the hard side is the ladies’ night strategy: reduce prices for the hard side, even to zero (e.g. Adobe Flash & PDF for end-users), or below zero (e.g. party promotors paying celebrities to attend). Rarer ways to attract the hard side is 1) getting them to invest the platform itself (e.g. Visa & Mastercard), and 2) interoperating with existing hard sides (e.g. Playstation 3 running Playstation 2 games).

If you are starting a company that targets a two-sided market you need to figure out which side is the hard side and then focus your efforts on marketing to that side. Generally, the more asymmetric your market the better, as it allows you to market to each side more in serial than in parallel.

Capitalism just like Adam Smith pictured it

From far away, things that are very different look alike. I grew up in a family of musicians and English professors. To them, the entire financial industry seemed corrupt. When I worked in finance – first on Wall Street and then in venture capital – I saw that the reality was much more nuanced. Some finance is productive and useful and some is corrupt and parasitic.

Most financial markets start out with a productive purpose. Derivatives like futures and options started out as a way for companies to reduce risk in non-core areas, for example for airlines to hedge their exposure to oil prices and transnationals to hedge their exposure to currency fluctuations. The sellers of these derivatives were aggregators who pooled risk, much like insurance companies do. The overall effect was a net reduction in risk to our economy without hampering growth and returns.

Then speculators entered the market, creating more complicated derivative products and betting with borrowed money.  This was defended as a way to increase liquidity and efficiency. But it came at the cost of making the system more complicated and susceptible to abuse. Worst of all, these so-called innovations increased the overall risk to the system, something we saw quite vividly during the recent financial crisis.

Venture capital is a shining example of capitalism just like Adam Smith pictured it, where private vice really does lead to public virtue.  Consider, for example, two of the largest areas of venture investment: biotech and cleantech.  Here we see the best and brightest – top science graduates from places like MIT and Stanford – devoting their lives to curing cancer and developing new energy sources.  These students may be motivated by good will, but need not be, since they will also get rich if they succeed.

A strong case can be made that the financial industry needs significantly more regulation, particularly around big banks and derivatives markets. But it would be a tragic mistake to create regulations that hinder angel investing and venture capital.  From the outside, VC and Wall Street might appear similar, but the closer you get, the more you understand how different they really are.