Show me the money

11/6 OpenView Capital Markets Roundup

Show me the incentives and I’ll show you the outcome (Charlie Munger)

Venture capital is a fairly straightforward asset class. General Partners (GPs) raise funds from Limited Partners (LPs). The GP then invests those funds (less some management fees they take off the top to pay their salaries and rent and travel, etc.) with the goal of returning multiples of that invested capital back to LPs and earning their share of the profits (carried interest, or “carry”). Of course, there are power law dynamics in venture – the greatest realized returns are concentrated in a long tail of a few funds (see page 10). And given this, as was noted by Chamath Palihapitiya in his 2018 shareholder letter some firms live on management fees. They chase unrealized mark ups for investments to raise funds and draw more fees without any real results (raise fund, get a markup, raise on the paper results, and repeat until late stage LPs and employee option holders are left as bag holders of underwater equity assets).

But let’s cut through the angst that obscures what Chamath is frustrated with: incentives. So if incentives are the issue, let’s talk about SPACs. I won’t cover what these “Special Purpose Acquisition Companies” are in any significant detail (summary here) or why these are better (or worse) than IPOs (many others have here, here, and here). Nor will I talk about outcomes: A Sober Look at SPACs covers the results for companies who have pursued SPACs. I want to address incentives in SPACs, and what the market is being misled on. Let’s focus on sponsor economics specifically.

Like a venture investor takes their carry, SPAC founders (i.e. famous investors like the Bill Ackmans of the world) take promote (their carry) for literally just spinning up a SPAC. On day 1, a SPAC sponsor owns ~20% of the post-IPO entity for some de minimis amount ($25k) and warrants for much more ownership down the road.

Note: Ackman’s SPAC actually aligns incentives well, so he is a bad example.

At least in venture funds, investors need to return 1x capital before taking their 20% (yes, I know SPAC investors can redeem anytime, but this is still tough for me - if the SPAC merges and the stock stays high, the investors are diluted 20% unnecessarily - this means that the vehicle is expensive for them and for the merger target company).

It is intellectually dishonest for anyone to claim that “In [traditional fund] investing, so many people seem to have ‘the solution’ but they are incapable of profiting from it themselves so they convince you to pay them fees and carried interest to do it with your money.” Because this is what sponsors are doing with SPACs. Sponsors get “promote” for raising SPACs. And what is better, there is (almost) literally no downside for anyone. SPAC investors are often arb funds who will make a quick 10%+ when the stock pops or in a downside redeem and recoup their piece of the capital raised + interest. Sponsors are incentivized to find a deal, hype it up, and get it closed so the stock is up and they make a lot of money for virtually free. If the stock goes down, or there are redemptions, the Sponsor stands to lose some capital (they have to buy their warrants, pay fees). So in fact, they’re more incentivized to get deals done towards end of life in hopes that on announcement price rises, a deal is done, and they profit. The incentive then, is to get a deal done at any costs (low price early, any price later) to turn paper dollars into real money. A non-Sponsor stakeholder loses – right?

So much of what we do comes down to incentives. Why did Alteryx report 606 numbers instead of ARR? Incentive: growth correlates with valuation, 606 growth was strong when demand was robust, a high stock price made more money for management and shareholders. Why do companies want to raise at high prices, like Fast at $1B despite just launching last month? Incentive: they keep more equity for themselves, equity that is much more valuable after the round. Why do SPAC sponsors claim they’re better and more certain alternatives vs. an IPO? Incentive: probably not because they’re actually better, but because that will make said SPAC sponsor a lot of money with very little risk, and the market hasn’t figured out their game yet. It isn’t bad per se – incentives help push innovation – as more alternatives to IPOs emerge banks have to adapt their fee structures and pricing to remain competitive.

But as Mark Twain said “what gets us into trouble is not what we don't know. It's what we know for sure that just ain’t so.” We had an intern on my team this summer, and my first piece of advice was to not think in definitions. Finance can be a good place for truth seekers, because in seeking out truth (incentives) “information arbitrageurs” with asymmetric data often generate superior results. Trying to define something, a CDO for example, and assuming every A tranche of a CDO was filled with A-rated mortgages is what brought the banking system to its knees in 2008. Truth seekers found out what was really in those instruments and why (bankers taking fees with absolutely no risk on the line for them) and profited beautifully. And sort of like with SPACs today - while it would be easy to take the pro-SPAC folks at their word -we can’t. Each and every single prospectus must be read in detail, and companies and investors must understand sponsor incentives first and foremost.

Beyond that, if you are at company, what incentives matter to you? Your shareholders? Your customers? And how do you identify those, and leverage them to create superior outcomes for either yourself, your shareholders, or even your customers?

Market & Economic Data

The public markets indices we track finished the week up a bit. First it was “rally on Trump win”, then “rally on Biden win”, and finally “rally on lol, omg, who even knows anything anymore.” SaaS +10.60%, Dow +6.50%, NASDAQ +8.91%, S&P 500 +6.67%.

A summary of Q3 earnings released so far. All but one public software company – SurveyMonkey – missed their consensus revenue estimates and only three companies guided down: SurveyMonkey, New Relic, and Benefitfocus. Demand remains robust.

Market & Economic Commentary

As it relates to high growth stocks, it seems that the largest rate limiter on growth is total addressable market, or more specifically competition slowing a company’s ability to penetrate their market. In the case of Datadog the Street has been concerned that the monitoring landscape is crowded – but with New Relic’s quarterly report (company guided down, retention dipped below 100%, and worse) Datadog should be well positioned. This is something to keep an eye on for growth names – sustained 40%+ growth is possible if differentiation remains at scale. The virus is having significant impact on employment in small businesses, and despite many local economies being open, data suggests that individuals are making decision irrespective of what their economies have done. There has been a clear downtick in diner seatings at restaurants that have reopened. Google mobility data in U.S. slowly declining, probably as people react to growing epidemics and reduce activity. We’re putting a cork in a broken dam when we need to fix the dam. As noted last week the first rule of virus economics is control the virus to fix the economy. Yet here we are, slowed by rhetoric and inaction.

What Else We’re Reading

The Most Dangerous Equation: ignorance of how sample size affects statistical variation. Tips for Being a Better Manager. The Art of SPAC Arbitrage. Power Laws in Venture.