Whatever It Takes

Every morning when I go to the health club, I’m reminded of just how much of a financial mess we are in, what it will take to get out of it, and why of some of us may be mired for quite some time in the economic muck and debris. That’s quite a bit for one trip to the gym, and it’s all because of the locker room attendant Andrew.

The other day when I saw Andrew, he was ecstatic: “I had good news today from the club. I get to work on Saturdays. Now I will be able to work six days a week.”

“Some things are lost forever. This includes certain jobs, industries and markets. It also includes the time and opportunity cost wasted while waiting for them to return.”

Mind you, Andrew is a laid off professional. He worked in the financial services business. Like many of us, he had a substantial portion of his savings invested in equities, and lost much of what he had in the market downturn. Now he works in the locker room of a gym attached to a financial services center. You would think that seeing the (remaining) well-coiffed, well-dressed, cell phone talking, Blackberry-tapping financial professionals who breeze through his locker room would get Andrew down.

Not at all. He is always upbeat, always with a positive attitude.

Why? Because he needs to support his family and he will do whatever it takes to put food on the table, and ultimately, get back on his feet. So working five days a week is a panacea to him. Getting the sixth day is a bonanza.

Whatever it takes.

I see a lot of Andrews out there. I find it encouraging. That’s what we need to navigate our way out of this mess. We need people to continue to work – no matter what the job is – to continue to spend, perhaps even save, and participate in the economy.

Unfortunately, I see a lot of people out there who should be a little more like Andrew but aren’t. That’s a source of concern. Because they won’t do whatever it takes. These people are a weight on our economy. They don’t inch it forward, but rather drag it backwards.

It makes wonder: What are they waiting for? The status quo to return? Some things are lost forever. This includes certain jobs, industries and markets. It also includes the time and opportunity cost wasted while waiting for them to return.

Andrew may never get back to the financial services industry. But you know what? He might find a whole new career path. He just might end up running that club one day, and will never look back. All because he always did just one thing: Whatever it takes.

When Worlds Collide

I have the privilege of interfacing with two different and distinct worlds: financial and academic.

On the financial side as a co-founder of ARKequity, a firm focused on start up and early stage ventures, I get to see comprehensive business proposals in their various incarnations: poorly constructed and presented transactions that will never get done, well thought out transactions that will get done because they are too good not to, transactions that may get done someday but will take time and refinement, and of course transactions (and their accompanying dreams) that are on the verge of dying because their entrepreneurs are close to giving up, wondering how financial firms with a lack of vision could derail their businesses by not recognizing upside potential.

“What I see in the worlds of business and academia – where the former increasingly requires a broad, generalized approach, while the latter is increasingly offering more narrow specialization – presents an interesting contrast.”

On the academic side, I serve as a trustee for an independent coeducational preparatory school. In this capacity, I think a lot about our educational system, where I see schools increasingly teaching and focusing more to narrow specializations and away from more generalized and broad-based curriculums. I frequently wonder if the ideas we held so strongly regarding what constitutes a comprehensive education are outdated.

This becomes ever more clear to me in my role as an investor. Specifically, it is essential to understand all of the components that come into play in a transaction to properly evaluate its suitability, not just the technology, or the market or the regulatory framework. For instance, I am not an expert in health care, but as a healthcare investor, I better have the ability to understand all of the operating activities of a health insurance company start to finish if I am evaluating whether or not to fund a start up health plan administrator, which I did, and which to date – fingers crossed – is prospering.

What I see in the worlds of business and academia – where the former increasingly requires a broad, generalized approach, while the latter is increasingly offering more narrow specialization – presents an interesting contrast. But this is more than idle armchair musing. I can’t help thinking about how they are connected and how there needs to be a proper balance between these approaches.

I came to this conclusion because I believe specialization is what got us into our current circumstances. Ford focused on gas-guzzling trucks. GM focused on behemoth SUVs. Airlines focused on air travel rather than transportation. Compaq focused on computers. Tower Records focused on CDs. The list goes on an on.

In finance, when banks originated, underwrote, funded and held mortgages, the chain of accountability/responsibility for these activities was clear and everyone involved was responsible for ultimate asset performance. And of course, there were fewer foreclosures. When the process evolved to origination being done by one firm, funding by another, servicing by another, then repacking/securitizing by yet another, it became difficult for all the specialists involved to see their way through the entire process. Compound this by large amounts of capital seeking yield, and you can see one of the reasons why we ended up where we are.

If over-specialization led to financial trouble in one world, this very naturally leads to the question for another: are we perhaps doing a disservice to our high school and college students by channeling them down a path towards narrow specialization? Perhaps. There are issues of career fulfillment, and I recognize there are many professions that require a great deal of intensive and specialized training. Still, are we taking a risk that the apparent costs of a narrow focus in the worlds of business and education will be so great as to be fundamental game changers for the next generation? It may be that the costs this generation has already borne for its trespasses have already changed the game for their own and future generations.

Ever since I can remember, people have been bashing the U.S. educational system: Our test scores are too low; not enough emphasis on math and science; our students lack discipline and are not as prepared as their foreign counterparts; our teachers aren’t motivating their students; there is too much emphasis on sports, and so on.

But throughout all this, the United States has continued to be the undisputed world leader by almost any economic or social measurement. I believe this is because our educational system, in it’s lack specialization, has always spawned creative thinkers and entrepreneurs who have been able to re write the rules in such a way that we continue to win. Warren Buffet, Bill Gates, Steve Jobs, J.W. Marriott, Jack Welsh, as well as the many trailblazers in the emerging social media that is redefining the news business, come to mind.

So, if too much specialization leads to costly errors, might more generalization lead to greater creativity and the generation of the kind of wealth that just might be able to get us out of the hole we’ve lately dug for ourselves ?

A Blinding Grasp of the Obvious

The other day someone who I respect a lot said something that was really quite remarkable.

He didn’t say it with any particular amount of drama, or build-up, as if it was something he’d thought about for a long time, and had finally reached a conclusion and had to spit it out. He said this, almost in passing:

“You know, the only transactions that are going to get done nowadays are those with government guarantees.”

Upon reflection, he’s quite right.

The evidence is all around us. According to Thomson Reuters, asset backed securities (ABS) volume declined 82.2% during 2008. The market for mortgage backed securities (MBS) declined 80.2%. Total residential real estate securitizations declined 95.1%. Dismal as they are, even these numbers are misleading in that they include deals from the first half, before shock and awe set in. The fact is, volumes in the forth quarter were virtually nil.

And while I am sure my friend’s conclusion is correct, I’m not sure of the reason why it’s so. Perhaps it’s because there’s so much TARP money out there in so many different forms, that fiduciaries would be foolish to not purchase riskless securities that gave them a 150 basis point premium over Treasuries. If that’s the case, it’s just a matter of time before we burn through the liquidity in pipeline, and once primed, things get back to normal.

But let’s say we burn through several hundred billion in government guarantees, and the pipeline is not primed, then what? Then – to borrow a page from my friend who has a blinding grasp of the obvious – then we go back to zero volume. And then we know that the only emotion left in the market is fear.

Personally, I don’t think it will come to this. The multiplier effect on $700 billion is just too large.

But meanwhile, while we await our fate, issuers and would-be issuers should take note of these historic times. The government, who was always your partner when it came time to splitting up profits, is now your partner when it comes to sharing and bearing risk. And to me at least, it’s quite obvious, that we’ll never, ever see a deal like this again in our lifetimes.

Auto Industry: Cheap at Twice the Price

This post may be far more interesting a year from now, or five years from now than it is presently. At the moment the auto companies are in an epic struggle to extract loans from the federal government to stave off the prospect of a bankruptcy filing.

First they showed up on private jets looking for $25 billion. Then a few weeks later, drove to Washington and asked for $34 billion. The House offered and approved $14 billion, which the Senate summarily rejected.

Now questions abound. Will the White House step in and appropriate TARP funds? Will the auto companies file bankruptcy pre emptively? Can a new package be put together before the auto makers run out of cash? Will American consumers buy products from a bankrupt company?

“Enough already. Lend them the cash.”

And I say this not as an American taxpayer, but rather wearing my private equity investor hat. The reason is simple: It’s chump change. If one of our portfolio companies needed cash, and the amount required was, on a relative basis, so small that it did not even require disclosure to our investors, we would do it in a heart beat.

Let’s examine the chump change statement for a moment. The $14 billion is:

• 2% of the TARP funds allocated
• 0.55% of 2008 federal receipts
• 0.47% of 2008 federal outlays
• 0.1% of 2008 gross domestic product

And if you have ever spent some time examining the federal budget – which every American should do – it will help you put the $14 billion request into perspective. Specifically, $14 billion is:

• 2.1% of the estimated 2008 defense budget
• 2.3% of estimated Social Security payments in 2008
• 3.6% of estimated Medicare expenditures in 2008

When looked at in this light, I begin to wonder what all the hearings and hand wringing is about. It’s not like this is the first time Congress has authorized and spent $14 billion. It seems like a lot of high minded posturing.

I understand tough love. And I understand the reasoning behind the statement that ‘We will doom the auto companies to failure if bail them out this time.’

But I also understand this: tough love is always an option. If we loan the auto companies $14 billion and they fail, there will be plenty of time for tough love. But at the moment, it’s relatively cheap to see if they can turn themselves around, while cost of standing on principal, in terms of jobs and the multiplier effect of their loss, seems very, very high.

The Class of 1987

It seems like we’ve walked up to the edge of the precipice at least three times in the last 90 days with attendant 600 and 700 point drops in the Dow.

I remember the day, a little more than 20 years ago, when we actually went over the edge. October 19, 1987. The 508 point drop represented 22.6% of the value of the Dow. I was working in Chicago at the time in the options market. That day I saw grown men cry and people throwing up in the pits. The world wasn’t coming to an end. It came to an end. In a day, there was a massive destruction of wealth that people said could never be recreated, and predictions that business would never be the same.

But then you fast forward 20 years from that date. The Dow had crossed over 14,000, an increase of more than eight fold. Even in today’s more modest environment, the markets are five times higher than the day than the day we went over the precipice.

If you stayed fully invested since then, you’ve been handsomely rewarded. And while it’s difficult to assume this mantle now, it’s the appropriate one. And this is a message not just for my peers and colleagues who are investors, but also, and perhaps more importantly, for entrepreneurs who are trying to build business.

Now is not the time to pull in your horns. And if you are raising capital, it’s not time to succumb to the notion that investors have ceased putting capital at risk to build great businesses. Look at some of the members of the class of 1987: Invitrogen, with a market cap of $2.7 billion was founded then. So was PeopleSoft, which was acquired by Oracle in 2004 for $10.3 billion. Nextel, another $10 billion enterprise was also founded in 1987. McAfee Software, Gilead Sciences, Carlyle Group, Aeropostale Clothing, Ashworth, Castle Rock Entertainment, Cephalon, Bertelsmann Music Group, among other great companies were all started in 1987.

And that was when the world had come to an end. Imagine what you could do now when the world is merely teetering?

A Little Knowledge: Not So Dangerous

In 2007 there were 3,914 venture capital transactions, and of these, about 1,300 were new deals. There were probably more, but this is the number that was reported by the venture outfits that participate in the PricewaterhouseCoopers/ National Venture Capital Association MoneyTree survey, so it’s a good proxy for national activity.

Here’s what’s amazing about this number. How many times have you talked to a venture capitalist, or for that matter an investment banker or private equity investor, who said, “We’ll see about 2,000 deals this year and invest in perhaps five,”

“This suggests that last year’s nearly 1,300 first time financings required investors to look at nearly 3 million business plans.”

Now that’s picky.

But here’s what I don’t quite understand. How can professional investors look at nearly 3 million plans, and find so few successes? Just 130, if you use the common VC metric of one bona fide success for every 10 investments.

And while I don’t quite understand this phenomenon, I have a theory. The truth is, most professional investors know too much. And this knowledge is what keeps them from finding and investing in some incredible companies.

It’s more than just raw knowledge, and it’s more than just domain expertise that I’m referring to. Really, it’s an investor’s role in the domain. That is, if you are the go-to guy or gal for say, medical devices, you go to all the right conferences, every consulting and accounting firm with a medical device practice knows you, and all the board members and chief executives of medical device companies know you. And because of this the go-to guys get fed deals with all the same biases, and get input from all the same experts.

This doesn’t limit their success per se. It does however have them saying no to transactions that they should perhaps really be saying yes to.

And in a nutshell, this is how we approach private equity. Yes, we know quite a bit about banking and structured finance. But there’s a world of opportunity out there in a wide range of disciplines. We don’t feel we need to know everything there is to know about them. What we need to do is spot the entrepreneurs who can operate effectively in them, and have the guts and tenacity to see their vision through.

It’s a formula that works because it creates a partnership where two parties aren’t trying to run the same business. And it’s worth keeping in mind when the go to investors turn your business plan down flat.

It’s Different This Time

Recently, I heard something that I had not heard in a long time: “It’s different this time.”

The person who said this was a guest commentator on CNBC. She was suggesting that she was seeing things in the sell-off that were never seen before.

An understatement perhaps.

Nonetheless I can’t but help think about the last time the phrase was in common parlance. Anyone? It was during the upside of the dot com bubble. As the market ran to meteoric heights (Nasdaq 5,000, can you imagine?) there were inevitable questions: ‘Isn’t this just a bubble that is bound to burst?’

“No,” the answer invariably came, “It’s different this time.” That’s because at the time, even some of the most intelligent investors and business people believed that the so-called New Economy was going to eat the shorts of the so-called Old Economy.

Well, it turned out not to be so different at all. In fact if there was anything different it was that boring old infrastructure and commodity companies – drillers, miners, steel manufacturers industrial equipment makers – went on a tear, and were the companies to be invested in after dot com bubble.

And so it’s different this time?

Not really. Most people will still pay their mortgages. They will put food on the table and gas in their car. They will grit their teeth and send their children off to college. Policemen will walk their beats and firemen will respond to calls. People will still buy homes and insurance policies and go shopping at Home Depot to buy some or all the things they need for the garage, basement and backyard. Businessmen and women will still go on business trips and walk through airports and stay at hotels and get rides in cabs. Our trading partners overseas will still buy our goods, and Americans will still buy products coming in from abroad.

There’s a good deal of evidence to suggest that all of this economic activity will occur at a much slower pace. However, there is absolutely no evidence to suggest that it will come to a screeching halt and stop altogether.

What might be different this time is that the markets around the world are behaving as if it will. And because so much of investor wealth is under some form of institutional management – mutual funds, pensions, managed accounts, hedge funds, funds of funds to name just a few – the market turmoil does provoke some question about just how bright the best and the brightest really are.

Though at a tremendous cost, the turmoil does one other thing too. It finally confirms the old adage: Those who do not learn from history are destined to repeat it.

Style, 1. Substance, 0

Every outside investor who invests in a company knows their payday rests with it being successfully sold to a larger entity to the public. Thus there’s a real premium placed on presentation and selling skills. And that’s why you hear things like:

“I’d rather invest in a really good company where the founder/CEO ‘gets it’ than the perfect company run by a rocket scientist.”

And so, it this one regard, style actually does finally win one over substance. With this in mind, here’s a list of common mistakes business owners make when trying to pitch their business to people like me.

Bad Timing. Frequently, business owners say too much or too little. On balance I’d suggest that saying too little is worse than saying too much. My experience has been that many entrepreneurs are tight-lipped because they are afraid of giving away the secret sauce. This is silly and makes them appear naïve as well as untrustworthy. Naïve if they really think I’m going to drop everything I’m doing to and replicate their business, and untrustworthy to believe there is some other agenda to the meeting other than trying to figure out how to make money together. While a little naïveté is charming when it’s not tiring, the lack of trust is no basis upon which to build a partnership and usually stops progress in its tracks.

Of course the other extreme is presenting too much information. This suggests a lack of appreciation for what’s important to investors, and thus in it’s own way shows a little naïveté as well.

The right length is 20 minutes. Enough time to sell the sizzle and the steak.

Live demonstrations. These have a knack for failing at just the wrong moment. Much better to save these for the point in time when the investor is emotionally invested and more willing to overcome an ill-timed gaffe.

Droning on About Technology. Granted the technical aspects of company's product or service are important -- inasmuch as they deliver competitive advantages, open new markets, or change the balance of power in an existing one -- but to investors technology is not important in and of itself in the initial meeting. Spend no more than three to five minutes discussing technology. Any more time spent on science is less time devoted to selling the deal.

Poor visual support. The complexity of what’s being conveyed almost always requires some sort of visual support to ensure adequate comprehension. The most effective presentations are accompanied by 10 to 15 slides, overheads or handouts that punctuate the speaker’s remarks, and give the listener a constant source of context. Corporate videos, slides of Byzantine complexity or no visual support whatsoever reduce comprehension and enthusiasm.

Arrogance. A lender will tolerate arrogance. After all, if a company can repay a loan, it can repay a loan and who cares who how its founder acts? An equity investor on the other hand will not tolerate arrogance. The thinking goes, “If my money’s in the company, the founder’s got to be ready, willing and able to take my input, period.”

Poor Response to Questions. The most important part of the presentation comes at the end, when the entrepreneur faces questions from the investor. This gives the investor a real feel for the entrepreneur and the opportunity to drill down to see just how carefully he or she has thought through the business. Sometimes presenters shoot themselves in the foot here by giving the impression that the questions are, well, not very intelligent, and that he or she is smarter than everyone else in the room (see Arrogance above).

But perhaps most importantly, it enables the investor to see if indeed there is any substance or whether indeed they’ve just been treated to a very slick presentation. So in the end, substance does win, but getting to the place where it matters most requires some real style.

Fear & Loathing In The Capital Markets

When I read that some state pension funds (South Carolina and Pennsylvania, see http://biz.yahoo.com/ap/080321/state_pensions_mortgages.html) were buying distressed mortgage-backed securities in an Associated Press story during March, I knew the credit markets had reached some sort of tipping point.

It’s not that state pension funds aren’t good investors. Generally, they hire the best managers in the world and are often quite dynamic. But because they endure more oversight than say your typical hedge fund, and because there are political cross currents in state pension funds, they are the least likely investors to do something outwardly foolish, or even seemingly foolish.

So when they start dipping their toe in the market for mortgage backed securities, it tells me that values in that market have lost touch with fundamentals and are so outrageously compelling that even the most constrained investors cannot ignore them.

How did things ever get this far out of whack?

I’m almost certain there’s an economist at one of the top universities who can map it all out.

But I put it down to something much more simple and much more fundamental: human nature. A portfolio manager who got burned on AAA mortgaged backed securities quickly realized that there were many elements about those assets that he or she did not fully understand. In response, they are now afraid of all [italicize all] asset-backed securities.

So now, no matter how good the underlying asset of an asset backed security may be, or how unrelated to mortgages it may be – aircraft leases, auto loans, credit card receivables, obligations of investment grade insurance companies -- the issuers of those securities are finding no demand, or are paying a much higher spread over treasuries than they used too. Some are finding no demand at all not matter what rate they may be willing to pay.

This is gumming up the works to be sure. But I don’t want to go there. Rather, I’d like to comment on one unfortunate quality of the fear gripping the asset backed market: it’s contagious and it spreads. Suddenly banks are lending, investment banks aren’t doing IPOs, and private equity investors have pulled in their horns.

But if fear spreads, so does opportunity too. That is, if even state pension funds can find compelling opportunities in what are now deemed to be toxic mortgage backed securities, that means there’s opportunity wherever investors have retreated. And that’s why I’m so excited about private equity right now. Sure it’s scary out there. Yes, fewer deals will get done. But if you can look past the pervasive, and in many instances, groundless fear and loathing in the markets, and instead have the courage to focus on facts, you will quickly realize you are uniquely well positioned succeed on a grand scale as an investor or entrepreneur.

Selling the Money Men: You’ll Be Better For It

I remember one highly successful management consultant that I talked to whose advice – no matter how dearly paid for – often boiled down to this: make 12 new business calls a day.

Then he said to me, a little bit on the sly, like he was giving away some of the secret sauce, that it wasn’t the sales calls themselves that were in actuality going to be the savior of businesses he consulted to. In fact he said it was all the structure and process his clients – who happened to be wealth advisors – had to put in place to be able to continuously make the calls, follow-up on them and still run their business at level that was promised during said sales calls.

And I had to admit, it ran pretty deep, from CRM software, to their personnel and new hire decisions, to the structure of the workflow, and the development and honing of key messages, and the ways in which they bundled the services they offered.

“That got me thinking about my own rule of thumb that, when applied, would offer positive implications on a holistic basis. Here it is: learn to sell the money men.”

This seems odd given that financiers are not known for having real operations expertise. In fact they are often chided for not doing much other than deftly re arranging debits and credits on a balance sheet. But here’s what financiers can do, maybe better than any other professional in the world: They can spot the characteristics of a successful business. And they are skilled at asking the kind of diagnostic questions that run very deep.

- What percentage of revenues are recurring?
- What happens to gross and operating margins as sales expand?
- What are the regulatory and or legal threats to your business?
- What are the working capital needs as sales take off?
- What are your assumptions on the collection period for outstanding receivables?

And here’s the twist a la my consulting friend: If you can figure how to speak to the very specific information needs of investors, the benefit accrues to you, not them. For them, getting answers to their questions is the low bar requirement to going to the next step. But for entrepreneurs and business owners being able to address the kinds of concerns investors have requires a level of understanding about your business and the markets it competes in that is essential for success on a very large scale.

Oh, and here’s the other reason you’ve go to perfect your skills at selling to investors. Whether I’m the first investor in, or the next to last investor in, I know that my ultimate payday relies on your sales skills. That is, you’ve got to be able to not only advance the company, but ultimately sell it to another company or the public. And if you can’t do this, or won’t do this, or don’t see the importance of it, then you’re never going to be able to sell me.