Our perspective on risk
For our current hedge funds, Clarety combines venture (or project) financing with asset management. Venture risk management differs from asset risk management. The combination, however, has an overall risk profile that is increasingly suited to institutional investor tastes. For example, venture investments are often illiquid and difficult to exit. Assets can be more liquid and easier to exit. At the same time, venture investments may in certain cases yield excellent IRR far in excess of, say, S&P 500 returns, while many asset classes have struggled to beat the S&P 500 returns profile recently. When brought together, investors may receive outsized returns with better liquidity, and if the structure is tuned correctly, little downside risk.
Softening returns risk, however, is only part of our capital return strategy. Identifying the actual source of risk in an investment, and the levers for boosting returns, are critical to creating asymmetry.
Simplifying asset management and hedging
First, on the topic of asset management risk: When dealing only with assets such as equities, such asymmetry requires research, leverage, and diligent attention to strategy. Some strategies, such as market timing, are notoriously difficult to anticipate. Those that rely on leverage can work well in the short-term, but in the long-term have to match the cost and risk of taking on debt to macro-economic conditions -- again, difficult to anticipate.
Our asset management approach pools assets that are both directly and indirectly related to structured settlements with mis-priced risk, allowing us to get consistently high yield from these non-correlated instruments. Counterparty credit risk, either direct or implied, ranges from A to AAA.
The amount of leverage we apply depends on how much value is at risk from the associated venture (or project) investments. Given the non-correlation and positive yield curves of the assets we use, the amount of leverage needed over time is easy to plan for and manage, certainly when compared to other hedging strategies, which may reallocate equities, options, and leverage in real-time on a continuing basis.
Venture capital and value at risk
Reducing the value at risk in our venture investments then becomes the next challenge. Since VaR measures risk of loss as a percentage of total portfolio value, then you can lower VaR by increasing portfolio value, or managing risk, or both. While this statement seems obvious, in fact it is hard to do, and most venture capitalists are not terrific at it.
Clarety believes that most venture capitalists seek to reduce risk in their portfolios in ways that ignore reality, are often ineffective, are rarely measured, and are more often based on the "single hero VC" culture than on systems that produce results. This failure by VC to properly optimize value at risk may flow from how busy they are, but generally we observe that VC firms are not well suited culturally or structurally to deal with risk, particularly those VC firms that rely too heavily on the new "portfolio theorist" MBA or on entrepreneurs in their ranks. The portfolio theory approach encourages too much free riding of poor performers because the presumption is that a few big winners in a portfolio will compensate for the losers. The entrepreneurs are often given halos for their past successes, but until the root cause for success is institutionalized at a venture capital firm, such firms are essentially embracing the key-person risk that they would tell their own portfolio companies to avoid.
A comprehensive approach to risk management creates results for firms. "In our extensive experience with our clients, we see that companies with more mature risk management practices outperform their peers financially. Our research suggests this translates to competitive advantage: we found that companies with more mature risk management practices generated the highest growth in revenue, EBITDA and EBITDA/EV," reports EY. In fact, companies in the top 20% of risk management (what EY calls the "most mature") generated three times the EBITDA levels as those in the bottom 20%. In the VC context, this has at least two high-level consequences: During tenure, a mature approach to risk management keeps the company farther away from default (and as a consequence becomes more debt-worthy, reducing total cost of capital for growth); and valuation is boosted, creating a more likely exit.
Our experience comports with this approach, but we have found it artificial in most cases to separate risk management from corporate performance. By corporate performance, we refer to the economic benefits and optionality that come from a well-run business. Given that managing risks with internal processes requires attention to good process design, some of this might be expected. After all, you get a chance to ask all the right business questions at the process level when you're dealing with risk. On the other hand, risk management does require that you ask key questions, and develop key capabilities, that aren't often asked by investees. These might include:
1. Reputation management: How does this differ from brand management, in terms of capabilities, investments, and strategic partners? Frankly, if you have an adverse reputational event, chances are good you'll need to "outsource" that to a legal PR firm, without giving up key control.
2. Currency risk: How can currency risk be mitigated by a careful attention to brand differentiation in a particular economy and culture? Think of Chinese automobile manufacturers -- and players in their supply chains -- as they move to European markets.
3. Regulatory risk: How do current regulations create both constraints and opportunities? Who controls the regulatory changes that you'll face in the next five to ten years? Think of companies serving the tracking industry.
4. Macro market risk: From Porter's Five Forces perspectives, where are the biggest rates of change, and where might disruptions occur? How do you track this data? Using scenario planning, what is the best way to design your ecosystem to monitor, evaluate, and respond? Think about the challenges facing LivingSocial and Groupon.
Much of this situation flows from the traditional measures and management strategies for venture capital.
Failure at the beginning
Consider a typical approach. A typical VC strategy is to put partners on the board. They also establish parameters -- often instantiated in contractual covenants -- on how cash should be managed. Some monitor ratio benchmarks which must be met in order for the investee to maintain management control (governance shift), or to qualify for later follow-on rounds (capital planning shift). In one study, 92 percent of all VC contracts include at least one such covenant. Sitting on the board, reviewing financials, and discussing and shaping strategies, these venture capitalists aim to reduce risk and capture more value.
The issues here are many. For example, the actual work of an investee is often invisible at the board level. Market value is often created or destroyed at the start, in the match between product and market. Even if the product matches market demand, brand equity can be destroyed in interactions between the investee's front line and its customers and prospects. And the invisible rules governing an investee's staff won't be found in the business plan's organizational chart, and are rarely even detected by senior management. These invisible rules constitute the climate and culture at a firm. When these are out of whack, good people leave, bad employees stay but fail to add value, and performance suffers. The C-Suite and top managers, unconsciously and sometimes consciously avoid reporting this kind of information to the board, which includes, of course, VC.
Even worse, most VC oversight is spent on financial statements. We are not critical of using financial statements but they are far from sufficient to asses the health of a company. Set aside that financial statements are usually lagging indicators of value. Focus instead on the point made above: factors that are most highly correlated to customer spend are usually not measured, and when measured, are not articulated into the financial analysis.
Covenants: When the trigger is pulled, the victim is already dead.
And, as a final blow to this approach, violating covenants usually means investees lose control. Who takes over? Control is ceded either to a new team appointed by a fund, or to other creditors (if institutional debt is a heavy part of the capital mix).
A study of situations where debt covenants were violated shows that creditors lack the ability to continue creating innovation when they take over a company (Creditor Interventions and Firm Innovation: Evidence from Debt Covenant Violations, Gu, Mao, Tian, 2013). While the study focuses on banks in particular, a close reading indicates that much of same underlying issues apply to VC managers: Lack of intimate knowledge of the business itself, its most valuable employees, and its value-creating processes.
Such moves are similar in negative impact to acquisitions where a culture mismatch and poor integration destroys end-state company value. Good people leave. Systems (whether value-creating or value-destroying) either fall apart or change to the point where closed-loop assessments are increasingly difficult to execute.
This is not to say that VC lack sector knowledge, nor that they fail to add value to their investees. The point is two-fold: At the time when a covenant kicks in, chances are good that the VC have already added the value they can easily add, and it didn't work; and, moving forward, the horses have left the barn.
Essentially, a covenant fails because it is an imperfect contract: investees have a hard time articulating risks and capabilities; and neither party tend to reflect in the contract reasonable scenarios of the future. (For an interesting discussion on this, see Financial Contract Design in the World of Venture Capital, Triantis.)
The challenge then is managing investee companies for value as early and often as possible, using leading indicators, and articulating these leading indicators into traditional financial statements. This closes the loop: VCs can add value best if they show how specific changes to an investees model, market, management, and customer engagement lead to results in financial statements. (Good exits rely on good valuation, a job that junior MBAs execute using financial statements.)
The notion of leading indicators is not new, of course. Managing companies to indicators such as Altman's z-score happens more often, and corporate failure prediction modeling remains an active area of research for academics, governments, central banks, and large multinationals. Two points are important here. First, many VC are investing in companies that are by most failure prediction models "in distress". Time, then, is of the essence. A great venture capitalist can quickly identify the levers one must pull to fix a situation. Second, most failure prediction models -- some of which are even used by a few VCs -- rely heavily on financial statements, which we know are trailing indicators. Baked into most of these prediction models, then, are metrics that are not as forward-looking as you might infer given the phrase "prediction model". Whether the prediction model is a static one or time series based, the inputs are lagging.
Our view is that this problem has been generally solved, but that few VC -- and few academics -- have noticed it. We'll share our approach in the next section.
Top-tier funds normally are well-connected to other top-tier funds. It has been suggested that this characteristic actually reinforces fund performance, and we find this a credible hypothesis. Two key reasons are that economic and management conditions that impact investees at a given fund are driven by macro trends that are easier to identify when you talk to other VCs, and opportunities for developing synergistic investments are greater when a firm has excellent external information.
External knowledge is critical, in fact. Few VCs institutionalize gathering this data at the macro level, and -- even more staggering -- they primarily fail to gather this information in conjunction with investees for the markets in which the investees act. Normally we find that VCs and investees compare notes on their assessment of the market at the time of investment. Rarely do they continually monitor the market in a consistent way that is also actionable at the investee level. Where does the intangible value of a venture capital firm lie: it is precisely in its ability to apply external data in rational process to improve investee value and reduce portfolio risk. In The Geography of Intangibles (Tommaso, Paci, Schweitzer), the authors say, "Nowadays non-physical assets remarkably contribute to increase the competitiveness and the value of firms." This applies as well to VC firms as it does to the companies in their portfolios.
Such monitoring, in fact, requires a careful articulation of metrics such as perceived customer value, customer engagement, process design, and resulting intangible asset value (even down to the SKU, interaction, and customer ecosystem level).
This indeed is the critical point. All sustainable value to a firm flows from customer value.
Using perceived customer value (as extended beyond product benefits to service and experience) as the independent variable and looking for key financial ratio improvements (profit per SKU, customer acquisition cost, and so on) as dependencies allows a firm to better predict free cash flows to the firm as a function. Such measurements are leading indicators. A change in perceived customer value detected today provides an indication of a change in free cash flows to the firm sometime in the future (depending on the sector, the time may be short or long).
Risk reduction applied to value-creating processes
Let's combine these observations. The first observation is that creating greater perceived customer value creates greater value to the firm. Assume a portfolio company aligns people, process, technology, and market monitoring around creating greater perceived value than competitors. The company focuses its projects, activities, and rewards around building a competitive position in the market, and avoids projects and activities that fail to move the "customer needle". This improved market position can either be exploited by raising prices (increasing free cash flow to the firm), or increasing market share. If properly managed, the overall amount of value is increased, so if you hold the cost of risk at the same level, value at risk has gone down.
The second observation is that risk reduction will more likely occur if leading indicators are constantly observed, and fixes to people, process, and technology at the firm are implemented. This closes the loop on linking risk reduction to value creation.
Note here that some approaches using trailing indicators can be very useful. Some VC "manage to the Z-score", which is to say they constantly monitor how common financial ratios indicate default risk for portfolio companies. As we indicated above, these ratios are trailing. But two points are key: The Z-score may still be just-in-time enough to indicate when problems occur; and when changes are implemented to boost perceived customer value, the Z-score should improve (after accounting for some sunk costs in projects that create such perceived value). Also, the Z-score and its component ratios may give managers and VCs some hints about which changes should be prioritized, especially useful when time is of the essence.
Other sources of value
This is not to say that other value-creating tools should be ignored.
M&A can create value if done right. Changing the capital mix can create value. Opening new channels, changing sectors, adjusting the business model -- they all create value.
But these other tricks fall into three categories: financial tactics that do not create sustained value (tax structuring, for example); operational discipline; and new market acquisition. Most financial tactics are available to a company's competitors -- a tax strategy available to Apple is also available to Samsung. Operational discipline provides only asymptotic improvements to EBITDA -- is Burger King notably more efficient than Arby's? As for new market acquisition, just having a new list of customers does not guarantee the customers will want to stay with you. Again, it comes back to creating a competitive level of perceived customer value.
The one exception to this analysis is a transformational change to the business model. A company can alter its cost and value delivery structure in radical ways, creating new models and capturing additional profits, before competitors show up to erode market share. SAP is trying to do this with their major pivot to the cloud. And the Netflix challenge to Blockbuster proved that such model innovations can work. Blockbuster had a chance to pivot earlier, but they just did not see the threat, given Netflix's size. The question they should have been asking: What is our perceived value relative to Netflix's?
What this means for institutional investors
While this discussion is critical for the venture capital community, it is also important for institutional investors that fund venture capital funds. Public and corporate pension funds are the largest contributors to private equity markets (thanks to the "prudent man" rule).
The role that venture capitalists and private equity specialists should play is that of a trusted intermediary. These professionals presumably know their assets, know their deal flow, and know how to extract value from them. The evidence is not clear they do. In aggregate, VC and PE professionals struggle to create outsize returns, and often recently have posted negative real returns post-fee. Top performers seem to know what they're doing (by definition), but even in those cases, top performers tend to build larger funds and invest in a more diverse set of targets. These portfolios naturally will perform increasingly like the overall market.
A concluding note on this part of our discussion: Our criticism of overwrought covenants and the ivory-tower position of VC on boards does not mean that these tools are unimportant. (See Monte Carlo Simulation of Contractual Provisions: An Application to Default Penalties in Venture Capital Limited Partnership Agreements, Litvak, 2008, for a good discussion.) But many covenants are unnecessary, and in any event covenants are usually insufficient. What good is a performance penalty if an investee lacks the tools and insights to avoid being penalized? VC need to do better, and covenants are only a small part of their fiduciary obligations to LP investors.
The key variables in our view are to ensure that investor capital is locked into an investee, and to ensure that leading indicators (linked to financial statement analysis) are used to measure and improve the total lifetime customer value that investees create. This makes elemental sense: locked-in capital is similar to "compounding"; and when customer engagement leads to higher price points than competitors can offer, the firm captures outsized EBITDA and free cash flows to the firm.
And yet most VC promote themselves has having board level governance and strong industry contacts. Where in our analysis above do you find that having "board seats" and "strong contracts" are both necessary and sufficient?
Disclaimer: Clarety Global Investments, LLC, is not a registered investment advisor. Information herein is provided for informational purposes only and does not constitute or imply an offer to buy or sell securities of any kind. As with all investments, seek the advice of trusted advisors and counsel before making any investment or signing any contract.