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Private Equity Investing: Secrets of Doing it Right (Part I)

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Last week, I talked about the communication breakdowns that occur when investors and entrepreneurs talk about risk.  

Well, in most forms of angel and early-stage private equity investing, these breakdowns flow from a misunderstanding of the power and nature of outliers.

The concept of outliers and how they apply to early stage private equity investment was best described by the Lebanese thinker and writer Nicolas Taleb, in his best-selling books "Fooled by Randomness" and "The Black Swan."

In the Black Swan especially, Taleb described the nature and importance of outliers in a modern, inter-connected economy:

“What we call here a Black Swan is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable."

Taleb continues, "I stop and summarize the triplet: rarity, extreme impact, and retrospective (though not prospective) predictability. A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives."

Less famous, but more helpful when it comes to designing an effective private equity investing strategy is Taleb's theorizing on how technological interconnectedness vastly intensifies Black Swan impacts.

This idea of technological interconnectedness is related - though not exactly the same – as that of the much ballyhooed Network Effect that is so much at the heart of many of the biggest technological and investment success stories of the last 15 years, Facebook, Twitter, and LinkedIN, being first and foremost amongst them.  

In its simplest form, the Network Effect posits that the value of a network increases exponentially with each new user on it.

Or, in other words, the primary reason why folks use Facebook, Twitter, and LinkedIN is because there are a lot of other folks that use Facebook, Twitter and LinkedIN too.

And, as more users join, such the value for others to join grows that much greater.

And so on and so on.

Thus, one of the first screens that the intelligent early stage investor should utilize is the degree to which a network effect is present in a company's business model.

Now, let’s get to the rub of the matter as to how Taleb’s interconnectedness concept both informs and signals danger for the thoughtful investor.

Simply put, global technological inter-connectedness drives the winning business models to heights never seen before …

…and because of this, there are a lot fewer of them.

Simply put, the winners are bigger and happen faster than ever - Facebook's IPO was bigger and faster than that of Google’s which was bigger and faster than that of Microsoft’s, which was bigger and faster than that of Apple’s.

And because the winners are bigger, there are less of them.

So that giant sucking sound you hear is the consuming of so much of the energy and return in the deal economy into fewer, bigger and more lucrative deals.

To put it another way, turning $500,000 into $1.8 billion in seven years as Peter Thiel did as a small minority investor in Facebook is just not beyond extraordinary - it is also unprecedented.

And, correspondingly, returns of this scale crowd out and widely skew the distribution to fewer, higher returning deals.

Now, how should we respond to this brave new and highly challenging investing and entrepreneurial world?

Well, one obvious response is to proceed extremely carefully.

Investing in early stage private companies can be great fun and you can make money beyond your wildest dreams if the stars are aligned right doing it….

…but the probabilities of doing so in any one company or deal are low…and getting lower.

And unfortunately, this is true no matter how enthusiastic, how passionate, how hardworking, how brilliant the entrepreneur that is pitching his or her deal happens to be.

So does this mean that early stage private equity investing is for the birds? And that we all should just stay away?

Of course not.

You just have to do it right.

Next week, we’ll share how today’s most successful investors and entrepreneurs do just that.

 


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