Stonehenge, image from Wikipedia

It’s Not Easy applied to Venture Capital

Learning from Howard Marks’ memo on investing

Note: If you’re a founder, stop reading this post now. Your job is to build your company and listening to VCs pontificate about their industry doesn’t do you any good. If you build a good company, investors will hunt you down. If you don’t, no amount of reading this stuff will help you get funded. So move on, recruit awesome people, build product, make your customers happy by delivering value to them and build your company by making them pay you for it. Really, that’s all you need to know.

I know very little about public markets and in fact, actively try to avoid most things in public markets. It’s not my thing. I like to focus on ideas, people, products. I believe that if you get those three things right the rest will figure itself out.

Last night a tweet from @Baris caught my attention:

So I tweeted back at @Baris and asked him what he was reading and he was kind enough to send me a pointer to it: Howard Mark‘s most recent Memo to Clients: It’s Not Easy (pdf).

What followed was a complete derailing of my Monday schedule as once I started reading Mr. Marks’ memo it almost made my brain go bonkers. So much of what he says in the memo rang true to me. I almost wanted to send it to all of my LPs, but then I also wanted to several GPs. So I figured its best if I just post my thoughts openly and let others take what they want from it.

If you’re even remotely connected to the “industry” of Venture Capital, you need to read Howard Marks’ It’s Not Easy memo. In fact, I hope that reading this memo will jolt us back into realizing that it’s important for us to be contrarian and daring as an industry.

Header of Howard Mark’s Memo to Oaktree Clients: It’s Not Easy

I’ve extracted some of my favorite quotes from this memo and am going to translate them into how I think they apply to private markets/venture capital:

On investing, Marks quotes Charlie Munger: “It’s not supposed to be easy. Anyone who finds it easy is stupid”. Marks continues to provide a great explanation why this is so. Worth reading on Page 1.

Second-level thinking: when I first started reading this, I felt this was kind of obvious and almost reminded me of how engineers think through things. I like to think of it as looking at the derivative (in a mathematical sense, not a financial sense) is often more revealing than looking at the raw change in a metric. In fact it also reminded me of this awesome clip from one of my favorite movies The Princess Bride:

But as I continued to read through the various examples in the memo, it just made me realize the point that I under-estimated is the involvement of human players in the market. As Marks points out about what he calls first-level thinkers: “They don’t understand their setting as a marketplace where asset prices reflect and depend on the expectations of the participants. They ignore the part that others play in how prices change. And they fail to understand the implications of all this for the route to success.”

One of the examples Marks cites is that of the ‘”Nifty Fifty”: the stocks of America’s best, fastest growing companies. Since these were companies where nothing could go wrong…’. Well, if I draw the analogy to private markets, the nifty fifty of private markets is probably the Unicorn Club of the 130 or so companies that are valued at over $1B in private markets. Although a lot of VCs including the Jedi Mastersof the art like Bill Gurley and Sir Michael Mortiz have sounded alarm bells about some of the unicorns, Marks point is that “it didn’t matter much what price you paid.” That is precisely how things seems to be operating in late stage private markets. And it isn’t the venture capital firms that are paying these exorbitant prices in private markets it is the hedge funds, corporate funds, and sometimes sovereign wealth funds.

Another comment by Marks: “Following the trends that are popular at a point in time certainly isn’t a formula for investment success, since popularity is likely to lead investors on a path that is comfortable but pointed in the wrong direction.” When I read this I can’t help but think of al the Uber/Lyft for X companies that have/are being funded. Pattern matching in venture capital may work for figuring out how to build companies, but it is less likely to work for ideas.

Marks points out that: “In short, there are two primary elements in superior investing:

  • seeing some quality that others don’t see or appreciate (and that isn’t reflected in the price), and
  • having it turn out to be true (or at least accepted by the market).​”​

It should be clear from the first element that the process has to begin with investors who are unusually perceptive, unconventional, iconoclastic or early. That’s why successful investors are said to spend a lot of their time being lonely.”

Seeing something others don’t see is critical to early stage investing. As an investor you have to believe in a future that will be different because of what you are investing in. That’s the conviction that it takes to be able to believe a founder (or two) who walk in and claim that they’re going to change the world.

And the part about successful investors being lonely… I guess that’s the part @Baris tweeted to me. I would argue that it’s less about being lonely, but more about a willingness to choose, sometimes create, and then to follow you own path. When you come to a fork in the road remember that one option is to create a whole new path; because founders simply don’t take no for an answer, they find a way to make it work.

Marks also says that: “The truth is, the best buys are usually found in the things most people don’t understand or believe in.​” I couldn’t agree more and the best example I can think of is the 7 Rejections post by Brian Chesky of Airbnb, where he states that: “for $150,000 you could have bought 10% of Airbnb.” I saw Airbnb pitch in its early days and I didn’t believe that people would let strangers into their house at scale. I was wrong. I didn’t understand and I didn’t believe and likewise for a lot of other people and investors. (Luckily when it came to Lyft, I believed that people will let strangers into their car and give them a ride and that’s how K9 became an early investor in Lyft.)

Continuing, Marks states that: “The truth is, the herd is wrong about risk at least as often as it is about return.” and that “When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all.” That right there summarizes how I/K9 got into investing in hardware early. The Valley was all about software and few investors at the early stage would take on hardware or devices. This essentially meant that since hardware was “out of fashion” there was better investing opportunities in hardware. Yes, it’s complicated (a lot more than software!), but if you know some of those challenges then you also have an edge over other investors.

As I’ve pointed out in previous blog posts, one of the reasons the late stage investors are comfortable with investing at lofty valuation is because all their investments come with liquidation preferences. I imagine that that’s almost like a new thing for several of the wall-street type investors since they typically only invested in common stock in liquid markets. These investors are often looking for non-venture returns. (Venture is looking for 10x-100x and a 30% increase is just not interesting to venture). If the late stage investors can satisfy themselves that the company is worth at least more than the liquidation preferences, then you effectively have their basis covered and are willing to play at ridiculously high prices (sometimes just for access before IPO). But, as Marks points out: “And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.”

Marks sagely states that: “The riskiest thing in the world is the widespread belief that there’s no risk.” I’ve been hesitant to outright call a bubble, but Mark Suster‘s recent talk on Mourning in VC made a pretty good case for it. Hopefully, posts like Mark Suster’s and cautionary words from Bill Gurley, Mike Moritz and others will help to temper the environment.

​I’m a stickler for walking away from deals which I think are over-priced or ill-structured (read as Convertible-anything rounds). Marks provides a reprieve from thinking that I’m crazy by reminding us that “What has to be remembered is the defining role of price.” Josh Kopelman from First Round Capitalalso noted the importance of price when he highlighted that entry valuations matter in their First Round Capital Q1 Letter to LPs.

Another great quote in the Marks memo: “An absence of losses can give you a great start toward a good outcome.”​ This was one of the fundamental points that I told LPs when I was raising the fund for K9 — that I want an incredibly low mortality rate for my portfolio even though it is at the seed stage. And the way to do that is not by investing in 100s of companies, but carefully trying to pick ones you have strong conviction on. However, conviction isn’t enough, sometimes bad execution, or the market, or other externalities will still kill a company. But the key point is that for my style of investing I prefer a concentrated portfolio rather than a diversified one.

However, Marks comment on absence of losses must be taken with a grain of salt when applied to private markets because the winners out-perform the losers by SO much. I think it was Howard Hartenbaum at August Capital who cited to me that “the maximum you can lose in venture capital is 1x,” but you could end up with a 20xer or a 100xer in the portfolio that makes up for all the losses and then some. Therefore, I translate Marks comment into the importance of being more picky about what you invest in in private markets. It’s still a good rule to start with especially because the losers tend to suck up all of your time as an investor.

“It’s easy for investors to get into trouble if they fail to understand the difference between cheapness and value.” — a good caution from Marks for not doing investments simply because you think you’re getting a good deal.​

“Momentum investing works until it stops.” Hear hear! Marks comment on momentum investing should be a caution to the VCs investing in late stage companies at high valuations. The music will stop. You can keep running till it doesn’t. It’s the game of musical chairs, and the tough call is knowing when the music will stop.

Being contrarian is often celebrated in the world of venture capital, even though the majority of investors are anything but and are instead momentum investors. Marks cautions thought to not err too much on the side of being contrarian with: “But doing the opposite of what the crowd does isn’t a sure thing either.” The key is to be contrarian and right. If you’re contrarian and wrong, then you’re simply wrong.

“Most great investments begin in discomfort.” Do they ever! And in venture capital, they don’t just begin there, sometimes the journey is just as discomforting — it’s a bumpy ride even as an investor (more so for founders). As Jack Welch from GE pointed out to John Chambers that every company must have a near death experience. As an investor I’ve seen so many of these near death experiences — sometimes more than one. But then again Neitszche said that “That which doesn’t kill you makes you stronger” — and yup that applies to startups too.

​“If you let the investing herd — which determines market movements — tell you what to do, how can you expect to outperform?” I loved this comment from Marks, but probably because he refers to the investing herd and it reminded me of why I chose to call my firm K9 Ventures :)

”But something about which I feel strongly is that it’s not the things you buy and sell that make you money; it’s the things you hold.​” Holding is really a form of expressing your conviction. ​Alas in private companies you may have conviction till the cows come home, but what matters is being able to make others believe in that conviction and find someone willing to think differently from the rest of the herd (to get the company capitalized). The good thing is it usually only takes only one to tip things over.

A few other excerpts from this absolutely brilliant memo that highlight why investing is not easy:

  • If you invest, you will lose money if the market declines.
  • If you don’t invest, you will miss out on gains if the market rises.
  • Market timing will add value if it can be done right.
  • Buy-and-hold will produce better results if timing can’t be done right.
  • Aggressiveness will help when the market rises but hurt when it falls.
  • Defensiveness will help when the market falls but hurt when it rises.
  • If you concentrate your portfolio, your mistakes will kill you.
  • If you diversify, the payoff from your successes will be diminished.
  • If you employ leverage, your successes will be magnified.
  • If you employ leverage, your mistakes will be magnified.

And the final quote I excerpted from Marks’ memo is about fund performance: “It is mathematically irrefutable that (a) the average investor will produce before-fee performance in line with the market average and (b) active management fees will pull the average investor’s return below the market average. This has to be considered in light of the fact that average performance can generally be obtained through passive investing, with tiny fees and almost no risk of falling short.” A good reminder for everyone who plays this game.

So thank you Howard Marks for an absolutely brilliant memo. It was so full of good stuff that I had to read it twice to make sure I didn’t miss anything, and I probably still did.

Now I can return to trying my best to do the stuff that I now know is not supposed to be easy. Phew!

You may also follow me on @Twitter at @ManuKumar, and for all things @K9Ventures K9 Ventures is also on Facebook and Google+.