Can Active Managers Outperform?

How to invest can sometimes be more important than where to invest. That is why looking at the rationale to invest in active or passive strategies  is highly relevant

The ability of managers to over-perform the market is the source of much debate in the Financial Economics discipline because of the underlying debate on the validity of the Efficient Market Hypothesis. The consensus is that the degree of over-performance a manager can achieve is related to the level of inefficiencies in the market it operates in. Illiquid assets are usually associated with higher inefficiencies, as shown by the higher dispersion of returns on Venture Capital, LBOs and Real Estate (basically Private Equity), because of the higher valuation uncertainty. 

Furthermore, in Private Equity there is a big set of  evidence showing that fund managers that outperform the market consistently do so over successive funds: it is not only the volatility of returns that drives the differences, it is the difference in skills among managers.

Therefore, good fund managers can greatly outperform the market in these asset classes, making a solid case for active investments through funds.

Publicly traded asset classes such as stocks and bonds show more concentrated returns across asset managers with lower after-fees persistence in returns. The main driver in these markets is the return of the benchmark. Consequently, good asset managers perform similarly to bad ones and they usually barely justify the fees spent on them. 

Private Equity assets are also the ones where it is harder to diversify a portfolio of direct investments passively since minimum tickets are usually sizeable, there are no direct investment diversified vehicles and the costs of analyzing and selecting deals is very high. 

Publicly traded markets provide easier ways to have a diversified exposure to a whole array of individual assets across an asset class through ETFs or directly investing in the individual assets. Consequently, investing in active funds does not provide diversification advantages over passive funds. 

I avoided talking about Hedge Funds on purpose because their case is more difficult. On average, Hedge Funds exploit the inefficiencies of liquid markets, but they amplify these differences by deviating from benchmarks, using leverage, beta neutral strategies and many other non-conventional tools. There is no passive way to do a Hedge Fund, so there is no way to avoid them and get exposure to their strategies.  Risk-adjusted returns analysis for HF is very hard to perform since they use non-linear trading strategies; but most evidence is consistent with pointing out that they do not outperform the market on a risk-adjusted basis. So, the decision here is not whether one should get active or passive exposure to HFs strategies, but whether one should invest in HF strategies at all. A debate for a different entry. However, I do believe that HFs are a more sensible way to search for alpha in public markets than regular mutual funds since they have enough discretion to do so.

Conclusion

To sum up,on average, it is better to invest with active managers in illiiquid, inefficient and volatile markets (Private Equity, Frontier Markets Equities, Frontier Markets Debt, Emerging Markets High Yield. etc) and to invest passively  in liquid, efficient and stable markets (Large Cap, US Treasuries). 

Has Buenos Aires become an IT hub?

The positive Network Effects of Clusters are a cornerstone of modern geographic and development economics. The concept is pretty intuitive: having a lot of companies in the same industry creates a pool of talent, buyers and suppliers that simplifies the establishment of new similar companies in the same place. Therefore, acquiring a critical mass of companies is crucial for the future development of the industry.

In IT, the main advantage of these clusters is the reduction of the acquisition costs of talent. Someone has already done 95% of what an IT company is doing; acquiring people with the right capabilities and experience lets you jump ahead of the competition. The most famous cluster in IT and innovation is, obviously, the Silicon Valley. It is not only for ideological reasons that the Valley has been pushing so hard for changes in the immigration policies and the JOBS Act.

It is very hard to know what is the minimum size required to call a place a hub: you know one when you see one. But the most important characteristic of an IT hub is the access to talent when building a new company in the sector.

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Buenos Aires has been an important software and IT services center for a long time. Almost 90% of all the Latin American start-ups of the 90s where originally from Argentina. The country still has one of the most literate populations in the continent.

Furthermore, it has picked up significantly duriing the 2000s, with sales growing a fivefold since 2003 and standing today at a staggering USD 4 Billion. Buenos Aires and its suburbs concentrate ~70% of the more than 1400 companies in the sector. A lot of them provide IT Services , but 52% of them are pure software development companies.

ICT Sales, Exports and Employment in Argentina

Source: OPSSI - Semi-annual report on the Software and IT Services Industry in Argentina. Seprtember 2013

Even if  significant for a country with a USD 470 Biillion GDP like Argentina, the ~50.000 employees in the sector in Buenos Aires are very small when compared to the Silicon Valley where ~300.000 people are dedicated to the industry and 150.000 people are dedicated to innovation. Moreover, most of the firms in the SV are dedicated to software development (vs 50% in Buenos Aires) and their employees have a better education and perform more sophisticated non-standarized tasks. So, no, Buenos Aires is not the Tango Valley.

However, the city does have enough resources to be a hub in some sectors. Buenos Aires is the home town of the two biggest IT companies of Latin America and they are both in Consumer Internet: Mercado Libre is quoted at a USD 6 Billlion Market Cap on NASDAQ.and Despegar was valued at ~USD 1 Billion in recent private transactions. These companies are creating a huge pool of knowledge in the sector and it is empowering new ventures like OLX, the Craiglist of Emerging Markets with presence in over 100 countries that was founded by the owners of De Remate, a competitor bought by Mercado Libre.

The city also has some sectors that are gaining significant traction like video-games with more than 70 companies and 1000 employees, where 72% create their own IP. Another relevant sector is Business Process Outsourcing, where Globant alone has USD 120 Million in revenue.

The high level of development in some sectors and the nascent status in some others makes public policy all the more important to capture the full value of the network externalities. The most obvious thing Buenos Aires needs for this industry to develop is a stable macroeconomic environment in which to operate. Even if, as we have written in previous blogs, the VC industry can circumvent most of the red tape, most of the IT industry is not VC material and is highly sensitive to the business environment. The other main driver of the industry is education since, as we have discussed earlier, talent is the most important asset. Finally, the state could help industries export their services and connect with each other.

In conclusion, the software sector in Buenos Aires is far from the biggest international IT hubs. However, it is a world-class hub in Consumer Internet and it has the potential to be a hub in the whole industry if public policy gives a helping hand.


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Thank you to Gabriel Wallach and Marcos Amadeo from the Government of the City of Buenos Aires for their assistance with the data

Venture Capital in Latin America over the next decade

Latin American Venture Capital will remain attractive for investment in the middle of a deceleration of the Emerging Markets in general and of the BRICs in particular. The appeal of its Copycat Ventures continues in place due to its still high growth and large market size; while the appeal of its Innovative Ventures grows because of a maturing ecosystem, backbreaking growth on R&D and Education Investment and active Public Policy to promote Innovation, Entrepreneurship and Venture Capital.

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As we discussed in a previous posts, Venture Capital in Latin America has mostly focused on Copycats that replicate and adapt US business models in their local markets (i.e. Mercado Libre/ Ebay, Despegar/ Expedia). Over the past ten years there has been a surge in the interest for these investments with key GPs (i.e. Redpoint, Burril, Sequoia) and LPs (i.e. Horlsey Bridge, Silicon Valley Bank, Cisco) entering the Region with a focus in Brazil.

VC Investmet Distribution in Latam

Source: Axia Ventures Proprietary Analysis

This growing interest was the consequence of Latin America´s high growth, Brazil´s new role in the world as a key market and a member of the BRICs and the successful Copycat Ventures of the 90s.

Today, the main driver of the growth of the last 10 years in the region is not there anymore: the rise in in commodity prices is slowing down as China rebalances and reduces its growth. Furthermore, the increase in asset prices via reduced risk spreads caused by institutional improvements has evaporated since spreads have compressed to almost zero.

Therefore, the growth of Latin America over the next few years will not come from the rise in commodities; it will come from productivity gains. Productivity gains in Latin America could be achieved by raising the capital and technological intensity of production, specializing through more trade or innovating.

In this context, the decision by the Pacific Alliance (Chile, Colombia, Peru, Mexico) to create a regional free-trade market for their already open economies has been appreciated by the markets that believe such strategy is a cornerstone of future growth and a sign of a willingness to eliminate red-tape that will allow for higher capital efficiency and intensity. Although we agree with this view, we believe that the region as a whole will continue to grow at a higher pace than developing nations because it is still far from the capital and technological frontier and it has stable institutions in a converging world. This is the fundamental secular reason to invest in the region since the rest of the issues will prove cyclical (i.e. politics). Most International Economic Organizations are forecasting Latin America to grow at a 6% CAGR over the next five years, 50% higher growth than the Advanced Ecomies.

Source: IMF World Economics Outlook

Furthermore, the valuations in the region have already adjusted to the slow-down of the past 2 years, paving the way for further gains by riding the growth in multiples and diminishing the downside risk. Low entry multiples have been one of the most important conditions for high PE and VC returns over the decades. Jim O'Neil, the former Goldman Sachs guru that coined the BRIC term in 2001 and predicted the emerging markets rally, says the selloff has made the Emerging Markets "very attractive".

Consequently, we believe that investing in Copycat Ventures in Latin America continues to be a sound investment due to Latam´s big and growing market and its discounted valuations and costs.

Source: Yahoo FInance

But above all, we believe there is a great story to invest in Innovative Ventures in Latin America. The Region has doubled its R&D and Education Investment over the past 6 years, on the back of growing GDP and the increasing relevance of Innovation Policies. However, there is very little capital pursuing these opportunities since there are no key innovation hubs in Latin America when looking at it on a single city or country basis. 

Source: OECD

Innovation Policies in South America

Sources 1) 14/03/2013 – FINEP- Launch of Plan Inova 2) http://www.finep.gov.br/inovaempresa/ 3) Financial Statements 1H 2013 4) Colciencias 5) MINCyT 6) “Fronteras en Biociencia" 7) Cumbre Latinoamericana de Innovación 8) Josh Lerner and Ann Leamon – Harvard Business Review

This is starting to change because R&D and Education are cumulative long-term investments that are starting to show the results of a decade of hard work and Rio de Janeiro, Medellin, Santiago de Chile and Buenos Aires are aggressively trying to position themselves as Innovation Hubs with a global competitive mindset. The Region is already producing some top-notch innovative companies like IndexTank, CVDentus, Amyris, Ciencias para la Vida, Keclon or Bioceres.

These opportunities are coming at very competitive valuations today because of the lack of capital for such investments, the recent steep decline in foreign exchange rates and the competitive pricing of technology experts and scientists. Those investors prescient enough to invest in this embryonic part of the Latin American VC ecosystem will get rewarded in kind. 

To exploit these opportunities consistently as a Venture Capitalist, a Latin American geographic and a generalist industry approach are necessary since only then will the Deal Flow have enough depth to make an Innovative Fund viable. Also, Innovative Ventures need to have Validation from Key Innovation Hubs and Business Development in the Advanced Economies. In the past, this would have been a great difficulty; but in an integrated digital world it is actually an opportunity since it creates a global company from day one.

To sum up, Latin American Copycat Ventures are still a sound investment since the Region has a big market that will continue to grow. But we also believe that there will be a growing success story in the Innovative Ventures of the Region.

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Thank you to Lisandro Bril -Managing Partner of Axia Ventures- for his collaboration on this piece

Globant. A new Latin American IPO. Another Argentinian

Yesterday, Globant filed for an F-1 with the SEC to raise USD 86 million in an IPO in the NYSE, the second Latin Tech Company to have that privilege along with Mercado Libre, another Argentinian company. Paradoxically, this happens the same week that a New York court ruled against the Argentinian Government for the restructuring of its defaulted debt.

http://www.sec.gov/Archives/edgar/data/1557860/000114420413048053/v350224_f1.htm

Globant is a symbol of Argentina´s renaissance after its 2001 crisis. Founded in 2003 as an outsourcing IT services firm, it took advantage of the abundance of talented and trained people in Argentina that were available at the cheap after the crisis and the threefold devaluation.

Since then, Globant has evolved its offering by providing more sophisticated services to its clients and refining its financial structure compensating for the loss in competitiveness of the increasing USD costs that the recovery brought with it and the complexities of the highly volatile Argentinian labor market.

Its current revenues stand at a staggering USD 120M with 82% coming from US clients like Google, Electronic Arts, Linkedin, Cisco or Coca Cola. Their revenues have grown at a 50% CAGR over the past 3 years.

The company´s bredath of services and geographies and their strategic stand in the IT sector have prompted WPP -the world´s biggest advertising company by revenues- to invest in the company and it now owns 21% of the company.

The only stain on their balance sheet is the USD 1.3 million recorded loss in 2012 which they attribute to USD 11.7 million share-based compensation charge; but it was probably also due to the high real exchange-rate fluctuations in Argentina. In 2013, they established a different compensation mechanism for exchange rates via bond purchases and they have already recorded USD 8 million earnings in the first 6 months.

The company is not alone in the world of successful technology companies of the 2000s from Argentina: Despegar is headed for an IPO, Restorando raised a 12MM Series B, Technisys is growing very fast and headed for a Series B itself, Onapsis is growing at amazing speeds in the US...

All in all, Globant´s success is a living proof that there is a lot of competitively priced talent in Argentina and that, with a management team capable of navigating the country´s financial instability, there are big opportunities to invest in its world-class technology sector. Those who decide their investment allocation based on political headlines alone are bound to miss out on a lot of opportunities. 

Disrupted Venture Capital - Part III: Seed Financing

This is the third and final article of this series. So far, the title seems more than a little misleading as the Venture Capital Industry does not seem to be facing any sort of disruption in its relationship with LPs nor with its portfolio and prospective portfolio companies. 

But there is a sector that has undergone substantial change and continues to do so: Seed Funding.

Traditional Venture Capital has been moving out of the earliest financing stages in investments for digital businesses and has been replaced by a combination of Accelerators, Company Builders, Angels/ Super Angels and Crowd-Funding.

There are many reasons for this shift in stages. The main one is that it has become much cheaper to start Internet and Software companies; making the tickets too small for a hands-on Venture Capital. If the VC funds made their usual 10-20 investments in the early stage with the amounts currently being raised, they would have a very small fund, with very little management fees and, consequently, not enough resources to consistently add value.  

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The most common starting point for most VC-style digital companies today is being accepted into an Accelerator. These programs provide financing (USD 10-50k) and coaching for start-ups for a short 3-6 months period as well as access to key players in the industry (Angels, VCs, Lawyers, Digital Marketing). The key difference with VC Funds is that they invest less capital and add value more intensively during a much shorter period. Since the investment is smaller and the time-frame for adding value is shortened, Accelerators invest in a lot of companies taking a new "class" every year or semester. 

This approach is superior to Early Seed VC Funds because the resources offered to the entrepreneurs are standardized and optimized across classes, the size of the investment and the time-frame are the appropriate ones to test the business models and the extra-diversification is consistent with the much more skewed distribution of returns at this stage.

There are three main problems with Accelerators: the valley of death, the returns and the exit. 

After finishing their program the start-ups have accomplished their MVP (Minimum Viable Product) and are ready to expand; but since most digital companies do not grow organically, they need financing. The need for extra capital is the biggest difficulty companies face after their acceleration because there operations are financed for a very short period of time and they struggle to survive this valley of death. Accelerators work hard on demo-days and luring investor to solve this shortfall. The rise of Angels and Super Angels is helping a lot at this stage. 

The second issue is that the economics of Accelerators remain uncertain for its investors. Although they are rather new enterprises, as of today, very few ones have reported good returns. As we discussed in a previous entry, average VC returns are not very good. By investing in so many companies, it is hard for accelerators to outperform this average. Obviously, this issue could eventually be addressed by changing the terms of investment or having a side-car fund. So, returns are in no way a limit to the existence of Accelerators but a reflection of its current market dynamics.

The latter problem is more structural since Accelerators do not seem to have a proven exit path. Investors do not know how or when are they getting their money back. The most conventional view is that they could pay dividends after a series of successful exits of their portfolio companies or pay back all the capital and investment and raise money again after a few years. However, none of this is contemplated at the moment of investment, putting  investors in a difficult situation. Nowadays, most investors consider their investments as a way to gain strategic access to portfolio opportunities and not as a financial play. This has to change for Accelerators to survive.

To sum up, Accelerators are a superior approach for early stage investing that still needs to refine its financial model.

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A new force that has emerged with strength coupled with Accelerators is that of the Angels and the Super Angels. This are individual investors that commit 10k - 100k (Angels) or 100k - 250k (Super Angels) per venture.

These investors have emerged from a very successful generation of entrepreneurs that remained involved in the ecosystem once they had cashed-out of their companies at a very young age. This phenomena coupled with a general distrust in the financial system after the 2008 financial crisis has spurred this form of direct investments.

Angel Money covers the capital gap between accelerators and fully fledged Series A VC Funds. They usually do not come with as many demands as VCs and help with some introductions and general counseling, but they do not offer the same degree of hands-on approach VCs usually do. At this stage, start-ups face the challenges Accelerators trained them for: product development, traction, etc.

Angels do not have the same screening capacity a Seed VC Fund has, so they rely on recommendations and, yes, accelerators to get a level of deal flow they can handle individually. That is why, even if accelerators might not be great investments per se, they provide the deal flow Angels need to invest correctly and get good returns.

Accelerators+Angels have created a Lean Symbiotic Ecosystem for early investments that is more appropriate than the standard Seed VC Fund approach.

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Crowd-Funding is a practice where many people invest/ donate very small amounts into a project, most likely via a webpage. According to Massolution, more than 1.7 billion dollars were raised in 2012 using this mechanism. However, most of those funds were donations, geolocated projects or loans. The Equity Investment Crowdfunding niche is still under development because the SEC has not yet regulated the JOBS Act that opened the door for the mechanism that was prohibited before in the US.

Crowdfunding gives small investors the opportunity to invest in projects they would otherwise not be able to; increasing the overall availability of funds for early stage ventures. That´s great!

However, there are a number of concerns. The first and most significant one is that there is a high probability of fraud. To avoid this, crowdfunding sites have to make a lot of due diligence that makes the investment process more expensive than it would otherwise be and they have to use standardized equity contracts to avoid malpractice that diminish the flexibility. Also, equity investments into startups cannot be algorithmically studied the way loans are with your credit score. Consequently, it is really hard to help uneducated investors to invest in endeavors with fair valuations and the returns could be dismal. Finally, early stage investment is a high-risk / high-return game. If investors are not properly advised, they could end up losing more money than they were willing to.

In conclusion, Crowdfunding is a great idea, but only people with some understanding of the industry should get involved in it. A lot of money coming in through crowdfunding could have negative effects on the long term for the VC Industry as returns fall and the industry gets a bad rep.

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Company Builders are a new trend that has emerged over the past few years. They are companies that create start ups from scratch by recruiting the founders team to address a problem or copy a business model in other part of the world. Usually, the Managing Partners are former entrepreneurs with a lot of operational experience. The aim of this company builders is to take their companies all the way through their seed stage and then get a Series A round.

I am very bullish about the success of this business models to create copycats in Emerging Markets. The Managing Partners have the skills to correctly identify the business models and they can recruit the best teams to execute them. Finally, their structure finances its companies all the way through the Seed Stage allowing them to execute faster then Accelerators+Angels, a key in these copycat business models.

Their ability to create truly innovative companies is a bit more questionable since the innovation process seems a lot like the failed Corporate Innovation Process.

To sum up, company builders have Team+Opportunity+Execution for Copycat Ventures, a winning combo. However, they might not be the most innovative ones.

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In conclusion, the Early Stage Investment world is mutating very fast with a lot of new business models. Only time will tell which ones survive. 

Latin American Private Equity and Venture Capital: A Decade in Review

Latin America has had a decade (2002-2012) of solid growth and social improvements.  We believe there were two main factors behind this success: the steep rise in commodity prices and the significant improvements and stability in the politic and economic institutions after 20 years of democracy.

Source: World Bank and IMF

The result was a boom focused in the industries connected to commodities (energy, agriculture, metals) and the industries with high leverage and low risk that benefit from falling bond rates (infrastructure, real estate, transportation, utilities); with spillovers to domestic-demand industries via income growth.

Source:  IMF (2005 base=100)

Source: Multiple sources via http://www.quandl.com/economics/spread-over-us-treasuries-all-countries

The Private Equity Industry had a very good decade as it rode the growth in revenues and multiples of their companies:

• It went from USD 0.5B raised in 2003 to USD 10B in 2011 according to private sources
• It had Return Multiples of 2.4x Market Returns (Bovespa)

Ernst & Young assumes these extra returns come from PE Strategic and Operational Improvements, but that is a rushed conclusion since PE Investments are usually highly leveraged and have a higher beta. However, 2.4 times market returns are great returns and probably well in excess of its risk premiums. PE in Latam was a great investment. 

It is interesting to understand the main drivers of EBITDA growth. PE is usually associated with cost reductions and hard social outcomes as it lays off workers. However, as we can appreciate from the data, PE benefited mainly from Organic Revenue Growth, specially when investing in companies under USD 100MM. Geographic expansion and demand growth, both deeply connected to macroeconomic growth, were the key growth sources. Upon exit, high multiples via lower risk-premia and high growth rounded up the great returns.

This decade also saw the rise of Brazil as a new economic power and a part of the BRICS. Brazil is half of the South American Economy, but it received way more attention from the investment world than the other half. According to private data, Brazil represented 80% of the total Fund Raising of 2011 and 60% of the Investments.

The Venture Capital Industry took part in this wave by investing mainly in Copy Cat Ventures that expanded and replicated companies across the Latin American Market. The focus was mainly in Internet where replication is more often not protected by patents, the technical threshold is low and the market is regional. The main strategic focus when investing in a Region for such ventures is the Size of the Market and its growth. Therefore, its incentives and timing are closely aligned to those in standard PE.

VC Investmet Distribution in Latam

Source: Axia Ventures´ Proprtietary Analysis

Since most investments in VC were made over the past 2-3 years, the jury is still out on its performance. However, early signs suggest good returns for the bigger funds in the Region.


This decade things are starting to change. Growth has slowed down a bit, the investors are paying more attention to the Pacific Alliance countries, R&D Investment is growing quickly, Exchange Rates are changing directions, Bonds have almost no default-risk upside, the Political Map is mutating...

How will the next 5-10 years look like? Should one invest in Latin America? How? Where?

 A new article soon to come.

Disrupted Venture Capital - Part II: Money Ball and Spread and Pray

Part II: Money Ball and Spread and Pray

In an underperforming industry, innovation and disruption are the norm. In Venture Capital, however, we have not seen many transformations over the past 30 years... but that seems to be changing

Recently a set of new tactics has emerged: Spread and Pray and Money Ball. In a nutshell, both strategies are using portfolio theory and econometrics to generate what they believe are better investment decisions.

Spread and pray is a strategy where one invests in a big portfolio of companies without investing too much in nor adding too much value to any of them.The investment thesis is that since VC returns are driven by home runs and predicting them is impossible, investing across a big portfolio increases the probability of getting  one and delivering good returns. 

This strategy is often compared to investing in indexes of the stock market where one gets diversification and  low costs. When the investment is diversified, the expected return is the same; but the volatility is lower because the idiosyncratic risk is greatly reduced. If costs are reduced, then, expected returns are also higher because of the savings. This strategy is sound because financial markets are first-degree and possibly second degree efficient; meaning that stock prices fully reflect all public information. Consequently, investing blindly in the stock market yields the same return as "studying" stocks.

Venture Capital investments are slightly different. First of all, there are thousands of people investing in stocks and at least a dozen analysts covering each company from investment banks and major investment funds. Venture Capital deals are analyzed by only a few funds and valued, at most, by a couple. Consequently, to invest in a VC-style company you cannot just invest by assuming market valuations correctly reflect underlying fundamentals, because such information does not exist. You have to pay analysts to make an educated valuation and perform due diligence, so you cannot save money on costs. 

A second difference is that VC investments cannot be fully atomized the way stocks are. Even if funds spread their money across many investments they will still have at most 20 investments of a universe of thousands of companies. Early stage and Angel investment allows for smaller investments and, in that case, it might be possible to spread your investments a bit more. Accelerators are good examples of this trends with 500 startups and Y Combinator investing in hundreds of new companies.

A final difference is that a regular asset allocation is mainly invested in stocks, so investing in an index is a way to diversify the whole portfolio. A VC Fund represents at most 5% of a portfolio and, therefore, the volatility it adds to the portfolio does not only depend on its own volatility but on the covariance with the rest of the assets. This cross-effect is constant, no matter how big the portfolio.

To sum up, spread and pray does not give better expected returns because the fixed costs are the same as more concentrated Venture Capital; but they give a little lower volatility to the portfolio. In exchange, Fund Managers cannot add value consistently to their portfolio, reducing the potential upside of each company. If Limited Partners want more diversification, they could simply make smaller commitments into many non-spread and pray Funds and get the same lower expected volatility with more GP value added. Spread and Pray is a good strategy for an Angel Investor, but a poor one for a Fund.

The Money Ball strategy is a little more vague on its meaning; so I will take the definition by Matt Oguz -Palo Alto Venture Science- of what Money Ball VC does:

• Establish a data-driven selection model
• Optimize investment sizes per company
• Optimize investment portfolio of companies

Creating a data-driven automated algorithm for investment is an idea taken from Wall Street´s Quant or Algorithmic trading strategies, a long standing practice in the financial markets. These strategies rely on sophisticated Financial Econometrics to predict prices or relative prices.  They have been very successful in the past, but statistical arbitrages have become harder over time because of stern competition and unstable market conditions.

To generate a robust predictive model one needs a lot of data and good and stable relationships. Venture Capital lacks all of this.

First of all, there is very little data on Venture Backed Firms. VC information is private, so getting access to it is really hard. Also, a lot of the ex-ante important info on start-ups is subjective (i.e. the quality of the team). Finally, financial markets have operations every second; VC has only 500 exits a year.

Also, I have not crunched the numbers nor seen the databases, but  it is hard to believe there is a strong correlation between risk / success rates and measurable variables (years of experience, team size, industry, etc), even if complemented with internet data-crawling (visits, growth, mentions, links).

Finally, even if those relations exist, they should be very unstable since successful VCs have invested in companies with very different profiles across time. This is a recipe for harder econometrics (building completely time varying correlation matrixes is hell) and diminished robustness.

This does not mean that you cannot extract value from data, but that you cannot rely on it solely. Data-crawling can help you understand the real depth of penetration of a brand or product and understand trends. Data analysis can give you hints, add information and insight.  But they cannot give you yes or no answers to investment.

The Start Up Genome Project has put together a database of 16.000 start ups. Their conclusions are a good guide to what you can do by using statistics. They have established that: Pivots, Team Size and Team Experience are valuable inputs into the Investment Decision Process; while Mentorship, Experience and Super High Growth are not. They did not say how valuable Team Size is, but they found bigger is better. So, you should value big teams, you just do not know how much.

The most relevant Fund that uses Big Data and Statistics is Correlation Partners. However, they are never the lead investors on their ventures. This means that they believe that the data helps them predict within the firms that get funded which ones will do better; a much more subtle claim than being able to choose from the whole investment universe. In lots of ways, they are free-riding other VCs!

Most firms that talk about Money Ball only claim that they complement their decision process with data: Google Ventures, General Catalyst, OpenView, Greylock.

Data-driven selection models do not seem like a sensible claim as of today. Data-supported decision processes on the other hand are here to stay.


Then there is the "portfolio theory" part of the Money Ball: optimize investment size and optimize investment portfolio of companies. A pretty similar claim to Spread and Pray: lower volatility and lower risk  by optimizing correlation (Markowitz, etc) instead of increasing portfolio size.

In a regular VC fund only 10-20% of the companies survive, mainly because of idiosyncratic risk. So, it is not clear how can an industry correlation analysis significantly diminish the volatility of returns, since you have no idea which companies will survive.

There might be a claim that survival depends on industry performance and, therefore, portfolio theory also reduces volatility by stabilizing survival ratios. This is a fair point, but only valid for "generalist" funds since industry-specific funds cannot diversify across counter-cyclical and cyclical businesses. Once again, LPs could invest among many industry-specific funds and get similar risk/ return profiles.

Maybe, this technique is used to reduce the covariance of the VC investments with stocks and reduce the Beta of the portfolio. However, a good valuation already takes Beta into account, so this would hardly be an improvement.

In conclusion, portfolio theory seems to add very little value by increasing the number of portfolio companies or their distribution across industries. And there is no reason why this shouldn´t be done at an LP-portfolio level instead of a VC-portfolio one.



All in all, Spread and Pray and Money Ball can help individual VC funds perform a little better by reducing volatility and increasing returns. But, only some of the techniques are really useful. I am particularly keen on data-supported decision processes.



Other opinions:

http://venturebeat.com/2012/11/09/startup-algorithm/
http://venturebeat.com/2013/01/10/vc-moneyball-rebuttal/
http://venturebeat.com/2012/12/23/venture-moneyball/
http://online.wsj.com/article/SB10001424127887323384604578326221992355916.html+
http://www.slideshare.net/paulsingh/moneyball-a-quantitative-approach-to-angel-investing-austin-tx-aug-2012

Disrupted Venture Capital - Part I: The Industry - Returns, Fees, Structure

Venture Capital is changing  as many long-standing practices are mutating or being completely disrupted by technology and new business models... Just like any other industry!

The idea is to approach the forces that are changing the Industry in 3 articles.

1. The Industry- Returns, Fees, Structures
2. MoneyBall and Spread and Pray
3. Seed Funding: Accelerators, Crowd-funding, Super Angels

1- The Industry - Returns, Fees, Structures

The evidence is there and it is hard to deny it: over the past 10 years, Venture Capital has not given its investors the appropriate return for the risks it entails. 

The biggest and most compelling piece of evidence is the report prepared by the Kaufmann Foundation, based on the 88 top tier VC Funds they invested in over the past 20 years. Their conclusions and solutions might be debatable, but the symptoms are undeniable as reflected by the data from the Kaufmann Foundation, Prequin and Cambridge Associates:

• Only 20% of the Funds got the targeted 3pp better returns than an investment in the Russel 2000 Small Cap, a relevant benchmark, in the Kaufmann report
• Only 38% of the Funds got better returns than an investment in the Russel 2000 Small Cap
• The Kaufmann Funds have returned on average 1.31x; well bellow the target 2x.
• The Median IRR has been bellow 10% every year for the past 15 years according to Prequin data
• The Pooled Return of Early Stage Investment has returned 6% vs 10% by the Russell 2000 over the past 10 years according to Cambridge Associates

The Industry has clearly underperformed over the past decade. 

A meaningful caveat is that, according to Cambridge Associates, Venture Capital has returned an astonishing 28% over the past 20 years against a 9% return by the Russell 2000. Clearly, the bad performance can be attributed to phenomena that occurred solely over the past 10-15 years.

So, what happened?

There are a number of possible explanations for the dreadful performance of the past decade, mainly capital cycles and/or technology cycles.

The first is the most cited cause for these results. The increased offer of funds in the industry drove prices up and returns down. A simple supply and demand explanation.

National Venture Capital Association - Yearbook 2013

The technology cycle theory claims that the 90s where a great era due to the IT and Internet revolution and we have not had an equivalent technology boom since. This hypothesis  is a lot more difficult to assess than the capital cycle one. The only evidence we have is a big fall in the number of IPOs. However, this could mean a) yes, less fantastic new technology b) more M&A exits c) less market appetite.

National Venture Capital Association - Yearbook 2013

The latter reason for the low IPOs is also the base for an argument in itself. Maybe it is not that this decade was bad, but that the 90s where uniquely good. The last decade of the XXth cenntuy saw a market/IPO bubble for technology firms that drove valuations to unrealistic exits. The VC Funds got great returns, but the public markets´ investors got burned. Therefore, the theory goes, VC returns will never be that good again.

The truth is probably a combination of all of the above hypothesis. Venture Capital had very good returns in the 90s, but that was due to a technology shock and a market bubble. Subsequently, investors invested heavily in the early 2000s searching for the same success, only to see low returns because of the absence of the key drivers of the previous decade and the new abundance of capital.


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The poor returns have pushed many investment experts, including the Kaufmann Foundation, into a belief that the industry is broken and that its structure and fees need to change.

The most common structure in Venture Capital is the famous 2/20 -2% Management Fees and 20% Carry-. Before, when we analyzed the possible causes for bad performance, we did not mention Fees as one of the causes because it was present both when VC gave great returns and when it did not. That does not mean that structures could not be improved to diminish rent seeking and generate better incentives, but they are clearly not the reason behind performance.

One of the main conclusions from the analysis made by the Kaufmann Foundation, and shared by Harvard Prof Josh Lerner of Harvard, is that funds over 300MM underperform. At the same time, running a big fund has almost the exact same costs as running a small one making the 2% management fee much more valuable for the General Partners. Consequently, there are big incentives for funds to try and raise bigger funds in a rent-seeking behavior, even if returns do not justify them.

The easiest way LPs could address this issue is by simply not investing in big funds. Alternatively, they could demand from the Funds  fixed cost management fees, lower percentage management fees or budget-based management fees.

Another even stronger conclusion is that the distribution of returns is very skewed with a small proportion of the funds providing a big upside and a lot of funds barely breaking even.

This has driven some investors to propose a non-linear carry structure with carry rising as returns go up and diminishing as it goes down. It is a stretch to argue that this new structure will provide further incentives for GPs to invest wisely and work harder, since 20% carry of a successful portfolio is already a lot more money than management fees. If anything making carry lower in the 5-15% returns bucket would bring down incentives to perform better once within those moderate returns.

Also, this proposal would very likely be prejudicial for LPs since most of their returns are focused on the funds that perform the best and they are now giving those funds a higher proportion of their returns. Maybe this structure could be implemented by raising payments very little in the upper tier, but bringing them down a lot in the lower tier. In lots of ways this is the way it is already being used since most partnerships have a hurdle rate that distributes carry only after returning investors a sensible rate of return; a straight forward application of this tiered-carry proposal.

If anything, some incentives should be created for GPs to add value to their portfolios even if at some point of the funds´ life they are highly unlikely to get paid carry as it is mostly the case according to data. For example, GPs could get paid smaller total carry (say 10%); but be paid 0.5% carry for individual ventures; keeping incentives aligned  in all possible scenarios and partially avoiding the discontinuities of thresholds. This structure addresses the real problem -the 90% that underperform- instead of looking for solutions within the successful group

The final part of the structure is the GP commitment that is a good way to align interests and should remain the norm.

Maybe the problem has not been the way VC are invested in, the amount they invest or their incentives; but the way they invest in and help their portfolio companies. We will look at the new ways VCs are investing in the Part II of this report.

In conclusion, yes we can make small tweaks here and there to make VC´s structure and fees more efficient; but it has little relationship to the bad returns of the last decade.To get better returns, LPs should:

1. Invest more selectively without bucket allocations
2. Invest in markets with lower competition (i.e. Latin America, Eastern Europe)
3. Invest in funds with the right size, costs and incentives 

Some resources and other opinions:

www.kauffman.org/uploadedFiles/vc-enemy-is-us-report.pdf‎

http://pandodaily.com/2013/06/24/venture-capitalist-bill-draper-takes-the-long-view-of-history-2/
http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture-capital-is-broken/
http://blogs.wsj.com/venturecapital/2012/05/08/kauffman-foundation-bashes-vcs-for-poor-performance-urges-lps-to-take-charge/
http://freddestin.com/2012/05/kauffman-report-broken-vc-guilty-lps.html

Financial Risk in Latin America: Beyond Country-Risk Analysis

The financial risk of investing in Latin America is usually misrepresented because of a tendency to synthesize all the risks in a "country risk" analysis.

The most simple way this is implemented is by selecting target countries deemed for investment because of their general risk configuration.Another common analysis of an investment includes building an earnings projection and producing a discount rate. The discount rate is where the risk is accounted for and it is built by adding to the comparable rate from a US company, a "country risk" factor based on the sovereign spread over treasuries.

However, this represents an oversimplification of the risks associated to investments, mainly: Firm Risk, Macroeconomic Risk and Political Risk. 

I have little objections to the analysis of firm risk per se since it is not where the country risk usually comes in. However, the interaction between certain sectors/ firms and other risks should be accounted for.

When investors usually talk about investing in a country, its Macroeconomics are the first thing they look at: GDP growth, Inflation, Real Interest Rate, Probability of Default, etc. However, not every company is equally exposed to these macro trends.

For example, exporters have little exposure to the local GDP, but are exposed to the volatility of the Real Exchange Rate. Even within exporters, Capital or Land intensive companies -i.e. Farms, Metals- are less exposed to Exchange Rates than Human Capital intensive companies -i.e. Business Process Outsourcing-.

Also, the cash flow stress associated to this risk can be stabilized by hedging in the financial markets; but markets are not deep enough to hedge currency or GDP risk for long periods.

To sum up, Macroeconomic risk is based on the company´s exposure to a local economy which is not necessarily only the country where it produces and the risk can be reduced (or exacerbated) by correctly managing it in the financial markets.

Political risk is even more subtle since a company is evidently exposed to the local politics that can expropriate, tax, regulate, declare war, etc. Some extreme events, like war, affect every company alike but are very unusual and have barely ever occurred in Latin America in the past 3 decades.

The main political risk in Latin America is a market disruption (expropriation, regulation, tax), that is why the most "market friendly" governments in the region are the ones foreign investors usually target. This targeting  has three main shortcomings.

Firstly, this analysis overestimates the duration of the political processes in Latin America, extrapolating current government behavior into future decisions.

Also, even if market friendliness is a good proxy for political risk, it overlooks some other associated risks. For instance, Peru and Colombia are the new vedettes of the Latin Financial Markets for their market-oriented governments and their high growth rates. However, in Perú police brutality is a big problem and in some regions in Colombia security risk is still an issue.

Finally, the political risk in every sector and industry is very different in each country. For example, Brazil has more political risk than Chile; but investing in Apparel Retailing in Brazil has much less political risk than investing in Copper Mining in Chile; not only for Copper´s general political risk, but for its cornerstone role in the Chilean Economy. There are differences even within mining: being a supplier to mining companies is a much safer bet than being directly involved in the industry.

In conclusion, yes there are some countries that are more risky than other, but the risk of a company or project should be fully analyzed without simplifications and investors should focus on the level of each risk they are willing to take.


PS: Thks to James Knight of Pionero Partners for his input

What does Brazil´s slowdown mean for Brazilian Venture Capital?

Recent data has confirmed the trend of the past 2 years: Brazil is slowing down.

Counter-intuitively, this might be good news for innovation-driven Venture Capital in the region.

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Between 2006 and 2010, Brazil grew at a CAGR of 4.6% ; but it has only grown at a 1.8% rate since. Moreover, forecasts have been revised down by the Brazilian Central Bank  for 2013 and 2014.

There are many reasons behind this slower growth, but the halt on the bull market for commodity prices is probably the main one. Arguably, the other one is that Brazil has only been investing 20% of GDP (vs 45% in China), resulting in bottle-necks in two key sectors: Infrastructure and Human Resources.

Our main interest is in the latter since labor, more specifically highly-qualified labor, is the main input of the Venture Capital industry.With salaries in San Pablo being second only to New York City and London, Brazil became a very expensive place to produce for-export products, specially if they needed a lot of skilled labor. Furthermore, a lot of talent was driven to real estate and banking where the most money could be made.

However, the recent slower growth has had a significant effect on the BRL/ USD exchange rate that went from 1.6 in 2011 to  2 today, making Brazilian salaries much cheaper from a Foreign Direct Investment perspective.

At the same time, it can be argued that this diminished growth will provide the incentives for the government to invest in infrastructure, innovation and education that will be the pillars of future high growth in 5-15 years time.

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There is good evidence that Venture Capital is a cyclical business with a Beta ranging from 1.1 to 2.4 depending on the chosen methodology. Financially, the causality is pretty straight forward as valuations are driven by comparables and lower stock prices ultimately drive start ups' exit multiples and returns down. Economically, lower GDP growth leads to lower projected sales (and harder market entry) that drive valuation.

Consequently, getting the cycle right is very important to achieve top percentile VC returns.

The first important clarification is that VC investments last 8-12 years, so getting the cycle right means being at the top of the cycle in the next 6-10 years. It does not require high growth at the moment of the Vintage. Quite on the contrary, hard times provide with low entry multiples and can provide high returns.

The second caveat is that this relationship is mostly based on US Venture Capital Funds where  the company's origin is usually also its main target market.

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The Brazilian Venture Capital Industry is mostly focused on copy-cats. This means that they invest in Brazilian versions of successful US ventures. The objective of these companies is to capture the local market with foreign innovations copied and produced by local companies. The success of this model depends heavily on the size of the market so this recent change in macroeconomic trends is worrisome.

This is were the first caveat we mentioned before comes in. Slow growth means cheaper valuations today, allowing for good returns by riding the potential future growth in multiples tomorrow. So, this might just be the perfect time to invest in Brazil.

We are even more bullish about Brazilian Funds that invest in companies that produce innovative technology for the world.  These companies take Reais-priced labour as an input to produce products valued in USD. So, the exchange rate jump caused by the slowdown has already made these investments around 25% cheaper. Also, the slowdown of Brazil has little effect on their target market, the global market.

At the same time Brazilian investment in R&D continues to grow at a back breaking speed. Consequently, the deal flow of of companies with VC-style technologies is set to grow steadily over time.

Furthermore, as we said before, there are good reasons to believe recent economic developments will refocus government efforts towards investments much needed for the future success of technology companies.

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To sum up, the slow down in Brazil can actually be good news for its Venture Capital Industry as Funds ride the future growth in multiples while investing cheaply in lower salaries in a fast-growing industry

Intellectual Property - Breaking Trade and FX Barriers in Argentina

There is a great opportunity to invest in the Argentinian production of IP by using the big distortion in the price of Capital Flows.

Several countries in Latin America have severe restrictions on Capital Flows and Exchange Rate Transactions. Some restrictions on short-term Capital Flows are sensible protections from the high volatility of financial flows that can be highly damaging to small interdependent  economies (i.e. Asian Crisis of the 90s). This is the case with the restrictions in Chile and Brazil that have regimes that regulate and tax short-term foreign investments.

However, there are some cases where these restrictions are extreme and generate enormous distortions as  in Argentina and Venezuela. The most interesting case is Argentina where you have 3 types of FX: "Official" at 5.20, "Black" at 10 and "Contado con liqui" at 9.4. The "Official" is the exchange rate on the trade of goods and services, the "Black" is the exchange rate on small savings and illegal transactions and the "Contado con Liqui" is the exchange rate on Capital Flows.

At 5.20, the official exchange rate is the most expensive it has ever been in real terms in the last 30 years of Argentina, including its infamous "Convertibilidad". 

At 9.4,  it is close to the cheapest it has ever been to invest in Argentina.

But the cheapest for what? 

Most big investment physical assets in Argentina are traded in dollars (i.e. real estate) and the price is not significantly lower than it used to be. At the same time, all of these assets have significantly diminished there return on USD because they are exposed to the local salaries (rental property) or the official trade exchange rate (farms´exports).

Investments in Salaries are cheap. But only if you can produce something that you can sell at 9.4 and not at the prohibitive 5.2 (goods and services), that is if you can make them produce capital.

And how does labor produce capital? It produces Intellectual Property! 

There are no trade barriers for IP. IP is transmitted through a fiber-optics line or a piece of paper and it has no home nor country. You can produce a patent in Argentina, but patent it in the US. You can design a WebPage in Argentina to sell goods in Brazil. Consequently, your IP is sold abroad directly without customs and is therefore valued at 9.4 $/USD.

There is a great case to invest in IP in Argentina:

- Pay salaries at 5 $/USD, but produce something worth 9.4 $/USD

- Argentina has a long tradition of Entrepreneurship (Mercado Libre, Despegar, OLX) and Science (Bioceres, Keclon, 3 Nobel Prizes in Science)

- No political risk: you do not own anything in Argentina, you only pay salaries