The tyranny of infinite choices
Market liquidity
From the outset of continuous trading in the 19th century, to the preeminence of Bitcoin, market liquidity has been exploding over the last century:
it is now possible to trade anything at anytime.
Market exchanges open 30 to 50 hours a week, but with their extended openings, grey markets or OTC markets, trading become omnipresent.
In the US, the New York Stock Exchange opened continuous trading in 1871, decades after London. At the time, trading couldn’t be done quicker than the speed at which traders shouted orders.
In 1973, the Nasdaq introduced the first computerized transactions which accelerated the velocity at which trades were executed: from minutes to seconds in the 1970’s, from seconds to microseconds ever since.
The Bitcoin, invented 10 years ago, is the archetype of this new tendency: there is no border in space or time anymore as anyone can trade anytime any quantity of bitcoins. From discrete and human to continuous and computerized trading. What a change in paradigm!
On another front, the explosion of market capitalization worldwide increased the quantity of assets available for anyone to trade as shown below:
This infinite possibility of choice seems like a great progress as this newfound liquidity brings with it a possibility to manage more actively portfolios: initiate positions, adapt sizing to new situations or liquidate portfolios in an instant.
It comes with a caveat though: the idea that permanent re-sizing is the panacea. From a human perspective, this could not be farther from the truth. Sizing decisions are of the utmost importance as investors should always correct their positions when new information changes their assessment of the risk/reward. As essential as they might be in portfolio management, they cannot replace the fundamental work which brought the position in the portfolio in the first place. If all the available time is spent in resizing, no time is left for in-depth analysis or fresh ideas.
The idea that position sizes can be optimized at any time is what I call the tyranny of liquidity.
The price of illiquidity
Venture capital portfolio risks are often misunderstood (here).
One of the common mistakes is to believe that the extra yield investors require from venture capital investments comes from its higher likelihood to produce losses. It is simply not the case.
Evidently early stage startups have a limited survival rate as shown above.
A portfolio comprised of only one startup would be extremely risky. But the central idea of building a balanced portfolio is to invest in enough names (15 positions and more) to mitigate individual startup risks by lowering the variance of the portfolio return.
In order to attract capital, VC have to offer a disproportionate return premium. This premium comes from assets illiquidity and not only from the elevated likelihood of portfolio loss.
It is usual for an early stage startup to have an 8 to 10 years investment horizon. This is the main reason why this asset class is ranked under ‘Other’ or ‘Alternative Assets”: it usually represents less than 5% of global asset management portfolios and rare professional investors count on it for diversifying their assets. You can see the illiquidity premium below:
Venture capital risks have always been unfavorably compared to other asset classes because of their illiquidity components.
This illiquidity could be attenuated through different techniques:
- One could offer a put option to investors after 3-4 years at a slight discount to the NAV through insurance protection or secondary funds bids.
- One could play on the duration of early stage portfolios which can be diversified to contain a wide range of exit horizons (from 3 to 10 years).
- One could play with the duration of startup assets through sector allocation as they have widely differing time horizon by sector.
Unfortunately, those techniques are byzantine so illiquidity keeps being VC’s primary pain points for a wider usage.
The blessing of illiquidity
What if startup’s inherent illiquidity was a blessing in disguise?
Instead of recalculating ad nauseam the perfect sizing for each position, venture capitalist can concentrate on what really matters: long-term objectives. It sets aside territories where humans still dominate computers: vision, intuition and conviction for the long run.
There is a difference between finding millisecond pricing imbalance as algorithmic trading does and unearthing long-term technology startups as VC strives for. The former has little societal value and should be penalized by unfavorable taxes, the latter is one of its noblest components: one puts its money where its convictions are.
Long-term convictions lack in today’s world and VCs’ main challenge is to breed contrarian convictions, stick to them during arduous times, and amplify them when subsequent rounds ensue. In that case, the most important thing is not the portfolio’s survival ratio, but the confidence one puts in its most successful holdings. Despite being overlooked, re-investment decisions define venture capital returns.
Ex: Peter Thiel, the first investor in Facebook and a very successful VC, got 10% for 500k in Facebook Seed round in September 2004 . He did not re-invest in the Series A in May 2005. Despite the fact that valuation was 16 times higher 8 months later, he said that it was his worst investment decision ever. You can understand why below:
Winner takes all
As VCs have much fewer positions than other asset managers and much less sizing decisions to take for each one of them, quality time can be spent on sizing accordingly.
When you have an intimate knowledge of a company because you have been an advisor, helping founders over time with recommendation and guidance, you are in the best position to trust your guts when a new financing round arises.
Seed rounds offer the most compelling returns but the lack of information available increases the investment risk. Series A rounds offer the best risk/reward as valuation might have drastically increased but a new lot of informations and metrics more than compensate for it. Hence the importance of re-investing wisely when the risk/reward improves.
Additionally, too many VCs can’t follow their guts because of their fund rules. This is a pity because they leave a lot of value on the table. Regular portfolio management rules should apply differently when power law applies: if your success is defined by your most successful company stake, you should be able to resize its important rounds with real faith; because the winner takes all.
At Cenitz, we intend to reinvest when we are comfortable with the founders, when the metrics are good and conditions are respected.
We know that resupplying our winners is the best way to reach the highest returns.
I’ll be glad to discuss any of it, reach out at frederic@cenitz.fr
If you’re an actual European startup looking to close a Seed/Series A stage, make sure to hit us at frederic@cenitz.fr
