How many times have you heard someone say, "Don't put all your eggs in one basket"?
When it comes to any kind of investing, this is very good advice.
But, if this is the case, why don’t private equity investors diversify?
Unfortunately, most individual investors in private equity significantly under-diversify their portfolios -- investing in one or only a handful of companies. By so doing, they both greatly increase their risk profile and greatly decrease their probabilities of seeing investment return.
As the investing month of October mercifully draws to a close, there is now a palpable sense of calm in the financial markets. While the horrific damage – in both value and psychological terms – is very, very real, and may take years from which to recover, there has been a healthy mindset transition to a “what is to be done” thinking, feeling and acting.
In times of economic crisis, far too many business owners revert to “safe mode” as panic spreads. A "responsible" course of action typically includes one (or more) of the following:
Here's a download of a fantastic conversation Growthink co-founder Dave Lavinsky recently had with Ron Feldman, Co-Founder and CEO of Kwiry.com. Funded by Hummer Winblad Venture Partners, kwiry is a service that turns text messages into reminders you retrieve online.
The extreme malaise in the financial markets is unlike any of us have seen in our lifetime. It is discouraging and disconcerting on many levels.
As Americans it is gut-wrenching to see so many proud institutions and the country as a whole take such a hit in prestige, wealth, and reputation.
For the private equity and venture capital world's as a whole, the erosion of stock market value reduces the likelihood and size of prospective acquisitions and the buoyancy of the IPO market - which in turn drives down earlier-stage deal valuations and the general "doing deals" excitement levels. We have already seen the shrinking of the hedge fund world these last few months - look for this contract to start hitting the private equity and venture capital markets.
But certainly by no means is all bleak nor are we at the end of days. As we know, at the end of dry desert, green grass grows. Without question, from the seeds of the current market correction will grow the great opportunities of the next 5-10 years.
So, for those with creativity, resilience and persistence, now is a great time to start and/or grow successful, lasting businesses.
We are living through one of the most tumultuous periods in the history of the financial markets. It is rattling even the most steadfast and optimistic of investors. For better or for worse, we can only look with misty memory to the halcyon, golden, go-go market and investment days of the 1980's and 1990's. We are truly in a brave new world - one where the old assumptions and dogmas are truly on the dustbin of history.
A few takeaways:
Big is Not Safer Than Small. Whatever the results of the government mortgage bailout, both in terms of the House vote and its market impact, for equity holders of the big banks and mortgage and insurance players caught up in the mess (Bear Stearns, Fannie, Freddie, Lehman, AIG, WaMu, Wachovia, and to a lesser but still painful extent, Merrrill, Goldman, and Morgan), it is misery. For the big financials, if there wasn't horrendous news these last few weeks, there would have been no news at all. It is absolutely astounding – though not necessarily surprising when viewed through the prism of the dysfunctional and way over-blown incentive systems of key executives and traders at these firms – that so much value could be wiped out so quickly. Investors for a long time will have serious hangovers and reservations regarding investing in these entities in any form – stock, debt, and/or derivatives. Quite simply, the whole sector is tainted.
Cash Is Not Safe. Never in U.S. economic history have there been as many question marks as there are now around the security of cash – passbook savings, checking accounts, money markets, certificates of deposits and other cash-like instruments.
The question marks are threefold:
So cash, our old friend – whether in the bank or under our mattress – is both under parking risk of default (a low risk for sure but much more so than just a few weeks ago) and under systemic, significant inflation risk. .
Executives Good, Traders Bad. In 2007, venture capital firms invested approximately $26 billion in startup and emerging companies. These companies were the best of the brightest stars in dynamic new industries like green/alternative energy, medical technology, digital media, and Internet software. In Washington, the nation's political leaders are committing more than 25 times this amount, effectively, in bailing out the residential mortgage market.
Now don't get me wrong, the housing and foreclosure crisis is real and painful in this country. But let's take a step back and think about priorities for a second:
Thinking about it for only a minute, the answer is obvious. It is even more obvious to the biggest investors in this toxic debt: the Chinese, the Koreans, the Japanese, the Russians, and the Arabs. Certainly, owning U.S. mortgage-backed securities now looks like a losing hand for these folks and far more disturbingly, owning U.S. treasury securities is far from being, as they say in the finance textbooks, a "riskless" investment.
So where is this foreign capital now going to go? Well, most of it will now in all likelihood stay home, or be invested in emerging/developing economies. But here is the key point: while the U.S. investment climate looks very, very unattractive compared to what it once was it is still by far the best place in the world to invest in startups, to invest in entrepreneurs, and to invest in operating companies. And it is not even close.
While most Americans – terrified by the hysterical financial media that the end of days are near – are increasingly blind to this fact, the more detached foreign investment players know the real deal. There are both uniquely and insanely great American operating companies all in our midst. Some are publicly traded, most are not. In the coming years, watch for a return to this kind of back-to-basics business-building/value creation investing. It can’t come soon enough.
"Helping Main Street by Helping Wall Street" is a false claim for which there is no need or rationale.
Acting hastily and out of fear on a bailout plan of highly uncertain efficacy, of a size that will constrain options for other remedies, is irresponsible. Congress is engaging in the same reckless lack of analysis that brought us a prolonged Iraq War, and in the same financial industry wishful thinking that brought us the mortgage crisis.
1. The bailout is irrelevant and unnecessary.
a. U.S. consumers, businesses and governments simply have too much debt. The economy is in the process of reducing leverage through write-downs, bankruptcies, constrained spending and contraction of credit availability. The government is not big enough to stop this inevitable and healthy shift.
b. The private markets are fully capable of recapitalizing deserving institutions. Witness the approximately $30BN raised by JP Morgan, Goldman Sachs and Morgan Stanley in a few recent days. Private capital is perfectly capable of purchasing "toxic" assets by using the same reverse auctions that the Treasury wants to use to deploy public funds.
2. The bailout is far too big given the complete lack of evidence for its efficacy.
a. It is highly illogical to commit to a massive plan whose benefit to Main Street is utterly unclear and historically unstudied. The Treasury and the Fed, like everyone else and through no fault of their own, have been thoroughly ineffective at predicting the outcomes of interventions.
b. What assurance do we have that removing toxic assets from bank balance sheets will result in increased lending by our new, highly concentrated, banking sector? The other Federal Reserve action to promote lending, injecting enormous amounts of liquidity into the banking system, hasn't improved Main Street lending conditions. Nebulous claims about "improving confidence" are no justification for risking hundreds of billions of public money.
c. Let's keep the government's financial powder dry for uses where the effect of the spending is more clear and predictable, including directly helping individuals impacted by any economic fallout.
3. The bailout is un-American
a. There are numerous healthy, successful banks, many at the local level and some national (e.g. San Francisco's Wells Fargo). If you insist on spending government money, why not invest in these institutions in return for their commitment to increase lending? At least, let's help by rewarding success and prudence, rather than recklessness.
b. Our financial institutions are a product of recent human endeavor. They are replaceable. American entrepreneurship, with its hundreds of years of successful track record, is fully capable of quickly replacing institutions that have shown once-in-a-century incompetence and avarice. Why reward failure when so much entrepreneurial energy and capital is available to sweep these institutions aside?
4. The bailout is immoral
a. "We made massive amounts of money making what turned out to be terrible, destabilizing decisions, and now Main Street better save us for its own sake." This is industry's argument for holding up the taxpayers. The only moral path is to show these people the door.
b. Without any direct evidence or certainty of benefit to Main Street, it is immoral and mind-bogglingly circular logic to help the institutions and professionals at fault by taking money from generally faultless taxpayers who are likely soon need help as a result of the perpetrators' actions. In other words, Congress is taking a pot-shot at a plan to help Main Street avoid financial pain in the near future by sticking it with a bigger financial bill today, with the only certainty the benefit to the perpetrators.
Amidst the extraordinary, mournful crisis in the financial markets these last few weeks, a few truths have become painfully evident:
From Growthink’s entrepreneurial economy perspective, a few more truths are less readily evident, but fundamentally more profound. Quite simply, Wall Street finance has lost connection these past few years with its core purpose and intent – namely to provide intelligent advice and capital to operating companies. While significant efficiencies (and correspondingly wealth-building) can be achieved from trading platform and instrument innovation, the value of this “innovation” is vastly over-rewarded in the marketplace.
The very fact that the most highly compensated roles in our economy over the past few years have been hedge fund managers, derivatives traders, and sub-prime mortgage hypsters points to the heart of the problem. While these folks serve a role, for sure, the combination of their almost comically (if it were not so anger-inducing) inflated compensation structures, combined with the systemic risk to which they exposed both their fellow workers and the economy as whole, is a failure of priorities for which we are all paying the price.
Where do we go from here? My hope is that finance and general marketplace incentive structures revert to more wholesome, “vanilla” dynamics. Traders are rewarded less, and company-builders rewarded more. Capital is more difficult to come by for hedge funds, and easier to come by for entrepreneurs. Harder for derivatives traders, and easier for scientists and engineers. Harder for debt, and easier for equity.
The fundamental good that can and should come out of this market cataclysm is a cleansing and a re-ordering of priorities. Provide a milieu and an incentive structure for operating companies to access capital and grow. And contrastingly – devalue activities that simply move capital as opposed to creating it.
"It takes many good deeds to build a good reputation, and only one bad one to lose it." -- Benjamin Franklin.
Fannie Mae. Freddie Mac. Bear Stearns. Countrywide. IndyMac. Lehman. Merrill. Once strong and even great corporate and financing nameplates now sullied by significant business reverses.
On the flip side: Apple. Google. Berkshire Hathaway. Goldman Sachs. Firms with gilt-edged reputations and prestige, admired the world over.