24 July 2015

The Good Guys are (Finally) Winning

When high finance first comes to mind, one immediately thinks of the excesses.  The $10M birthday parties, the "wolves" of Wall Street, and the Goldman bonuses.  However, the financial services industry, as has been the case with numerous others, is finally experiencing a seismic shift in power.  Innovation, transparency, and even lower fees are becoming the norm as pro-investor trends gain in popularity.  Has Main Street finally gotten control Wall Street?

For one, the largest asset managers, who happen to be the most investor friendly, have taken significant market share in recent years.  Vanguard, Blackrock, and Fidelity, now collectively manage over $10 trillion of assets  Vanguard and Fidelity are non-profit institutions and best known for bringing down transaction costs and low- fee, successful, passive investment tools.  Blackrock has taken it a step further as its popular exchange-traded funds have brought once untouchable asset classes into common stock like vehicles available to the masses.  According to a recent Fortune article, not only are these firms gaining share at the expense of high-priced competitors, but also now using its clout in board rooms to influence executive compensation and thwart short-term focused activist investor efforts.

And for those who have felt shut out of the hedge fund craze, innovative startups have paved the way for individuals to leverage some of those strategies.  The growing roboadvisors, such as Wealthfront and Betterment, provide sophisticated portfolio management techniques at a fraction of the cost.  For investors that prefer a live human, RIAs have become the industry norm.  These advisors, unlike their transaction-based fee predecessors, adhere to a "fidcuiary responsibility" standard that focuses on long-term planning and better aligns incentives.

Even the closed door world of private equity and venture capital have felt the impact of changing times.  Crowdfunding has brought early stage investing to the masses, which has in some ways created competition for VCs.  Many have now embraced the platform by creating their own syndicated investment vehicles on sites such as AngelList and Indiegogo.  Private Equity firms have started to feel the effects of declining pension allocations and increased competition both for deals and funding.  Large firms such as Carlyle and KKR have recently filed for IPOs to find new sources of liquidity and are even opening up to smaller investors.

No the world is not quite caving in for the Manhattan financiers.  But bonuses have not nor expected to reached pre-credit bust levels.  And the industry continues to lose top talent to Silicon Valley companies. With the shift towards friendlier asset managers, the democratization of information and services, and good old fashioned innovation,  the "Flash Boys" are facing the stiffest competition yet.   Perhaps the next big set of investment opportunities for them might be the very ones that disrupt their own industry and unseat them from power.




22 April 2015

Why Unicorns Matter

Call them unicorns.  Or bubble companies.  But there is something significantly relevant about the technology startups that have joined the $1B+ valuation club.  When investor Aileen Lee coined the phrase "unicorn" in late 2013, there was an estimated 40 companies on the list.  Now there are almost 100.  Whether or not these valuations prove in or not is a hotly contested debate right now;  but what is missed is how important these companies are to the world.  To consumers.  To innovation.  To the balance of power.  Whether or not venture capital IRR's are met are not.

Most can remember the time of the DOS operating system and the step change that occurred for consumers once the upstart Microsoft released Windows.  Good timing and strategic blunders by the hardware vendors at the time (i.e. IBM) afforded Microsoft to quickly gain a dominating position in what became arguably the most important market on the planet.  Forget that hasn’t been any meaningful innovation to the computer operating system since then; it never mattered to Microsoft's shareholders.  It still controlled over 90% of computers.

You can see similar domination by many of the new technology incumbents in markets very important to consumers and enterprises.  Apple took a similar approach and market share gain in mobile phones (at least now it’s a two horse race with Android).  Oracle and Salesforce have dominated the enterprise software space for many years now.  Amazon crushed every meaningful ecommerce company that stood in its way in the 1990s and 2000s.  Google continues to dominate search.  Facebook boasts 1 in 7 people around the world as active users.  While many of the new incumbents appear much more friendly that its predecessors (i.e. “Do no evil” compared to Ballmer’s Dr. Evil appearance), their market dominance should continue to be tested.  Enter the unicorns.

Uber may not only be a cab company but also a formidable commerce competitor in the all important race for local services.  Pintrest and Nextdoor have cult-like followings that Facebook has not had since it was in the university setting.  Hootsuite and Palantir have a leg up on the big data front compared to Oracle and IBM.  The unsustainable profit streams of big pharma and large healthcare service providers will be tested by ZocDoc and Theranos.  And even the country itself faces stiff competition as many of the unicorns such as Meituan and Flipkart are based in Asia. 

In a lot of ways, the unicorns took similar paths to the preceding incumbent technology companies before them.  They gained aggressive valuations through market acceptance, university connections, speed, innovation, and strong management teams.  And now, thanks to frothy capital markets, they now have cash warchests to compete with any incumbent.  These valuations afford flexibility, independence, and an ability to pace growth based on long-term vision.  The beauty of many of the unicorns is that their business models are very low cost and highly scalable; in fact, many of them don't need cash now but are raising funds for the future and to cash in on generous capital markets.  


Its true that Apple or Google could acquire many of these companies if they wanted (and will);  but they can’t buy all of them.  While each individual company creates unique challenges and competition to market leaders, the litmus test of success will come over time.  Once the bubble pops, will the unicorns continue to thrive, keep prices down, and continue to provide innovative products and services to the market? I don't know if I believe in unicorns or not, but i don't think it matters.  They are here today.  They are preparing for battle.  And lets hope they win.

03 March 2015

Is the Uber ecosystem sustainable ?

Will Uber get an opportunity to grow up?  Armed with a $40B valuation, many investors think so.   Whether you believe in the app based taxi hailer or not,  Uber’s impact can be felt all around the world.  There are millions of people using it everyday, momentum that its lofty aspirations will prove true, and intense controversy everywhere it goes.   Is this the world changer that it purports to be, or just the latest multi-billion dollar company to go bust?

Strategically, Uber is in a strong position.  Its logistical system, army of drivers, and competitive intelligence gives it a first mover advantage in its ambition to become the Walmart of personal services.  Cabs are just a platform for worldwide domination of local distribution.    But Uber is asset light, and its not  hard to see big players move into its space.  Amazon’s 2 hour delivery is gaining momentum.    Upstarts like Favor and Grubhub are cornering specific niches like food.   And how can you bet against Google or someone with significant physical infrastructure like Fed Ex?  The barriers to entry are not clear particularly against well capitalized companies.

Speaking of capitalization, Uber’s dot-com esque valuation has helped them act as a much bigger player than its revenue would suggest.  Even if Uber could continue to grow its value and raise gobs of money (hard to swallow by every conventional metric), some of its challenges cannot be resolved by throwing more money at it.    Governments, lobbyists, and pretty much every existing transportation company have vowed to fight Uber.  Even tech savvy cities like Austin and Vancouver have even banned the service.  Further, Uber faces a very micro problem;  it has to fight county by county, city by city, and country by country.  How long can it continue these individual battles?  And don’t forget about all the other legal battles such as data breaches and personal security cases from bad drivers. 

The more intriguing facet  of Uber’s uncertainty relates to the company’s mysterious pool of drivers.  Who are they and will they continue to support the company?  Uber recent survey showed glowing demographics of the people that drive for them (underemployed segments like the elderly and minorities).  A big question is how reliable is Uber for its drivers.  Starts and stops in markets have reduced the recurring nature of this income.  Few of its drivers derive their primary income from it.  The disparate nature of its drivers makes it hard to fathom that all of  these contractors will be available to support the service levels that Uber’s valuation implies.  Can a group of part timers be leveraged into a massive service provider all around the world?  It is very opaque, but a very interesting question nonetheless.    

Despite Uber’s uber-unicorn status, it is hard to bet against it.   It’s the poster child for the sharing and distributed economy.  Its challenges are greater than its tech giant predecessors have faced.   In fact, the laws actually supported Amazon and Google early on through a sales tax ban and broadband subsidies.  Uber’s road seems long and unchartered, but it has not blinked an eye through adversity.    Call it entrepreneurial, innovative, and principled.  But will we call it a survivor ?

18 January 2015

The New New Bond Market

Forget everything you know about fixed income investments.  The days of corporate bonds, treasuries, and real estate income properties are over.  In are crowdfunded startups, movie projects, and student loans.   The new class of exotic asset backed securities promises investment choice, high yields, and upside.  But are the risk and fees worth the return?

I remember in 1997 when the “Bowie Bonds” turned heads.  For the first time, one could invest in the individual portfolio value of the rock icon’s song library.  Since then, alternative bonds have come in large baskets of regulated instruments such as mortgage backed securities and REITs.  But a loosening of regulations coupled with an increase in investor demand has brought excitement back into fixed rate securities.  The website SoFI gives access to a yield-producing basket of student loans from your alma mater.  Upstart can help you provide loans to individual people or career paths.   I got an email last week from a Hollywood producer who was looking to fund her next movie with a guaranteed 20% return.   There is something for everyone.  

Despite the implied steady returns, I wonder if they are sufficient enough to cover the risk.  Even back then, the unproven Bowie Bonds only offered a 1.5% premium above the 10 year treasury rates.  I don’t know if a 5% interest rate for Harvard loans are worth it (certainly a personal decision), but people should be cognizant of the risk associated with them.  Remember the AAA mortgage bonds?  Even the top credit agencies in the US failed to understand these novel complex securities.  It is tempting to chase yield in the current near zero interest rate environment, but the returns should be commensurate for the incremental risk taken.   

Fees associated with these securities also come into play.  Taking a page out of the hedge fund playbook, many charge both a management fee to participate and a “carry” percentage of the profits.  For the asset managers, it is a good way to shift capital risk to investors while taking fee income and participating in the upside.  Some will promise a “preferred return” which is far from guaranteed (despite a stated interest rate) and the ones that don’t charge a start fee (such as the crowdfunding sites) will take a larger percentage of the profits.   While I can understand this hefty cost in an equity-type scenario when the upside is tremendous if the next Facebook hits, it’s hard to justify them in a fixed interest rate arrangement.  A 2% charge on an 8% net return is a 20% fee.  Large fees don't always mean good performance;  remember the popularity of actively traded mutual funds that charged big loads despite most of them doing worst than their benchmarks.

Simply put, equity risk should not be taken for fixed income investments.  While I like the flexibility and ease in which to get into some of these new investments, it is imperative to assess the quality, diversification attributes, and fees associated with them.  There are many creative instruments out there with a limited track record and opaque risk disclosures.  While we'll never know whether the Bowie bonds were a financial success (Prudential bought them for the in-house portfolio), the choice is ultimately yours.  Do  you want to merely listen to “Ziggy Stardust” or invest alongside it?

29 December 2014

Selling in a seller's market

From residential housing to Uber's dizzying $40B capital round,  asset valuations have never been so high. Understandably, many small business owners looking to sell expect to write their "own number."  While it may be possible in a few situations to do so, these expectations along with other perceived business risks have created substantial difficulty in executing deals in the small to mid market space.  As we wind down the year, I thought I would write about some tips (from a buyer's perspective) to prepare a small business to fetch top dollar while minimize the risk of remaining on the sidelines.

Grow, Grow, Grow: Even though most deals are based on a multiple of earnings, top-line growth is probably the single most important characteristic that increases business valuations.  Layer in two or three years of steady gains and a seller will see much more cash in a sale.   In any market, buyers struggle to find growth; they particularly recognize the premium required for entry in today's climate.  Smart buyers know how to cut costs and and improve profitability; finding sustainable growth avenues are much harder to manufacture.  This is why growth stocks yield a larger P/E ratio than dividend or stable companies.

Stay in (sort of):  Most owners know not to wait to sell the day he or she is ready to walk out the door.  By that point, the business has probably declined as would the valuation.  But even more importantly from a buyer's standpoint, they need people to run acquired businesses.  Some may claim they can bring in experts or leverage existing operations, but they all recognize the importance of keeping the existing entrepreneurs involved post-close  By keeping even a sliver of equity in the business (even 5-10%), buyers will be willing to increase their purchase price due to reduced risk.  A go forward interest may be viewed as an insider continuing to invest in the business and a seller might pick up some are all of the reduced cash upfront through increased valuations.  Timing is key; at least two to three years prior to exiting the business is ideal.

Address customer concentration proactively:   Many small business owners dance or try to conceal the fact they have one or two customers that drive much of the company sales.  If this is the case, it's best to discuss this early and openly with a potential buyer.  If you have a strong relationship with the customer, talk to them about a potential deal.  Even offer to introduce a serious buyer to them.  Trump up the fact that you have penetrated a large customer and have the savvy to do this with other similar ones.  Buyers often use this as a way to structure deals so that sellers take most of the risk (i.e. earnout, minority investment).  If this is not ideal for you as a seller, get the buyer involved in the customer relationship to get them comfortable with taking on some of the perceived risk.

Keep the books clean:  A common piece of advice, but it's very important.  It's very easy to use your business account to pay for college, vacations, and cars.  Sellers take pause in this advice because doing so will increase tax bills.  Too many personal expenses will raise red flags.  Buyers see this as increased risk and bankers sometimes do not allow all of it to be considered when potentially financing a transaction.  Conversely, a "clean" company will often be seen as easier to transition and yield a greater valuation.

Know your industry: I often hear that the buyers that show interest are not the ones originally anticipated.  A successful business should be courted by a host of different types of buyers.  If utilizing a banker or formal process, make sure the firm understand the full industry dynamics and are open minded to explore different types of potential partners. Also,  when in discussion with a potential buyer, understand their endgame. Ask them a lot of questions. By doing so will help in negotiations (i.e. is this a stretch deal or blank check situation).

With most markets at an all time high, it is a good time to get your small business ready to take to market.  As we've seen before, an economic downturn usually has a magnified effect on small businesses.  What's most important is to find the appropriate partner to make sure that the enterprise will continue to have a lasting impact in the space it operates;  a successful business will find lots of suitors, so it's good to pick wisely.   By following a few simple steps and keeping your eyes wide open, you can actively participate in this white-hot seller market.

02 November 2014

The S&P Paradox

Despite all the complex options available, one of the most effective investment strategies has been to simply play the S&P index.  I readily complied with success without giving much thought to the underlying paradox that was always in the back of my mind.  Large companies are riddled with inefficiency, myopia, and an overall lack of agility; so it seems counterintuintive to bet on them.  I never quite understood why S&P returns were higher than others because in my mind bigger is not always better.

For one scale matters.  In the past, large capital expenditures were required for entry into top industries like automotive, real estate and oil and gas.  Even today, most markets still tip to the big players.  In healthcare, it is required to extract better rates from payers.  In distribution, size helps gain operating leverage over fixed costs.  In retail, the likes of Amazon and Walmart use it to squeeze unmatched purchasing savings from suppliers.  Large companies use its power to build barriers that make it difficult for smaller companies to compete with them.   Warren Buffett calls it a "moat".

The numbers don't lie.  Over the past 50 years, the S&P 500 has gained 10% a year on a compounded basis compared with 3% for the US GDP over that same period.  Despite what people say about small companies being the "growth engine" and "lifeblood" of the country, large companies have grown more than three times faster than the overall economy over a long period of time.  Further, valuations of the S&P have historically been around 15 times earnings (with a current P/E closer to 20), which is at least twice as much as private companies.  Simply put, larger enterprises are valued more than smaller ones.

But isn't this counter to those in the inside of a large company know to be true?  Meetings to discuss meetings.  Consultants to develop ten year strategic plans.  Steering committees to make even the smallest decisions.  Meanwhile, nimble entrepreneurs come up with new products and services, focus on customer service, and find new approaches to enter established markets.  At some point, diminishing returns come into play as companies grow.  And it today's market, that size is getting smaller and smaller.

"Moats" are harder and harder to keep thanks to rapidly deployed technology and more open markets.  Uber and AirBnB, for example, are scaring some of the most powerful oligarchies in the world.  Further, some of the tailwinds that have been fueling S&P companies such as global gains and consolidation are in the rear view mirror.  For years, successful private equity firms have yielded superior returns in the small company space; perhaps there will be a more broader movement towards entrepreneurial companies.  It is very interesting and hopeful to think about; but no question it will be hard to fight a trend that has withstood the test of time.

09 September 2014

Will local come back ?

Is the age of the local services company over? Outsourced call centers, online help tickets and IVRs have been around for decades, but the progression towards centralized support has now moved into the once untouched neighborhood service provider. Rapid consolidation and the introduction of technology into fragmented service industries have brought about some positive changes, but has the pendulum swung too far the other way? Or is Joe the Plumber on his way out?

To be sure, many of the local businesses you normally frequent are consolidating at a fast clip. Local auto repair concerns like Service King, for example, have been recently purchased by PE firms with large expansion plans. The last three pest control companies that serviced my house have all scooped up by Terminex, a subsidiary of publicly traded Servicemaster. Even the local medical providers and lawn care concerns have become targets of consolidators. All of these companies employ similar playbooks: cut costs, centralize functions, and grow a small menu of highly controlled services into new locations. In many instances, even if customers want more beyond the 800 number, there are very few options on the table.

Walmart and Amazon has trained us to think that only price matters. Big business wins when we as a society expect no frills, price matching, and a ubquitious customer experience. I think this is helpful for some things, but not all of it. Today’s airline experience is very uniform - it sucks. Online shopping has gained mass adoption in commodity items, but still only represents 8% of total retail purchases. People still stop at local stores and want customized solutions and local touch points.  There is probably a finite saturation point.

Many of the big entrants try to delicately balance the best of both worlds. Whole Foods has done a good job of localizing their stores to cater to its serving area. Nordstroms and Best Buy have been successful at an omni-channel solution brings both the power of scale and good customer service. But local players are responding using similar playbooks as evidenced by the emergence of multi-location local restaurants and retailers.

But the current trend is real.  A recent study conducted by HBS highlights, for the first time, the diverging performance of small business compared with its larger peers in the most recent economic turnaround. Simply put, big business is taking market share and jobs away from small business. However, I think there are cyclical trends at play here and pockets of the small business sandbox that wont't get "rationalized." As I like to say, Dallas has cheaper food at the chains, but I don’t mind paying extra for the PHD wait staff at Shady Grove.