Investing for the Long Term: Sounds Nice, But Who Pays the Bills Meanwhile?

As a fan of the musings of Brad Feld I often read his blog posts and then stop to think for a minute or two how I incorporate his thoughts into my own outlook and daily work.

Below is the full text a recent posting of Brad's, but bottom line he is coming to remind us of the difference between speculation and investment. The work of a Venture Capitalist is to invest, not to speculate.

I wholeheartedly agree with Brad, but my question is while we are patiently tending to our investment[s], who pays the bills? The answer is obviously our LPs (Limited Partners) who pay us not only a success fee (usually 20% of the profits) but also a management fee (standard is 2% of total committed capital of the fund). From this fee the VC is expected to pay their overhead and take something home everything month, i.e. to draw a salary.

When the cycles are short, 2-3 years, and new funds get raised every 2 years, these fees are almost ignored. But do they add up, and VCs managing multiple overlapping funds can sometimes be double or triple dipping. What happens when the cycles are more like 5-10 years? When exits take longer to happen (assuming they do), the VCs can get stretched in etrms of remaining committed to the investment process (rather the much easier speculating). For the VC to remain focus in a stretched out cycle truly demands a dedication over and above the assumptions that based the original fund formation.

What to do? First, to communicate with your LPs. Let them know what the effect of a stretched out cycle is on the VC, and what the potential implications will be (extending the investment period, for example). Plan for the long haul -- redo the assumptions based on the [lack of] visablity that currently exists. This all needs to "trickle down" to the assets themselves, the portfolio companies, who need to be in step regarding the VCs assumptions and forecasts.

I believe if everybody can be kept on the same page, value will continue to be generated, with minimal friction. When one player in the ecosystem  is out of step, however, you have an implosion.

For us at Jerusalem Capital, we are planning for the long term, which has affected our investment philosophy and process. Like Brad, I remain optomistic, but we will need to stay focused and on message.

Now here is Brad's original posting:

Feld Thoughts

 

Investment vs. Speculation Posted: 02 Mar 2009 05:41 AM PST As I read the Berkshire Hathaway 2008 Annual Report, a thought kept popping into my mind that had also come up over and over again while reading Bogle’s Enough: True Measures of Money, Business, and Life.  “Be an investor, not a speculator.” As a venture capital investor, I have a long term time horizon on my investments.  Since I’m investing very early in the life of a company, I’m usually an investor for five or more years.  Sometimes I’m an investor for over ten years.  I’m rarely an investor for less than a year, although it happens occasionally. I don’t invest directly in the public markets and I haven’t for a long time.  Periodically I end up with a public company stock as the result of the sale of a company I’m an investor in to a public company, or via that mythical thing called an “IPO”.  In these cases, I have a very specific strategy for exiting my position in the public company over time.  I do have public market exposure, primarily through a combination of index funds (and equivalents) and some hedge fund investments with friends.  However, I pay zero attention to this on a daily, weekly, or monthly basis.  When I look at the aggregate performance over any meaningful period of time, it is irrelevant when compared to my performance as a VC and angel investor. When I reflect on this, I realize that I spend 99.9% of my time as an investor and 0.01% of my time as a speculator.  Whenever I realize that I’m in a speculative thought process (such as noticing the Dow on CNN on the ubiquitous airport TVs), I immediately try to stop.  My goal is to spend 100% of my time as an investor. Not surprisingly, there’s a huge amount of noise going around the system about speculation that is masquerading as investment.  Worst, the two get conflated on a regular basis in the context of what the government should be doing (e.g. incenting “investment” when they are merely either "incenting speculation” or “encouraging speculation”).  Of course, the endless stream of talking heads in the media don’t help this distinction. When I read Buffett or Bogle, the distinction between investment and speculation is painfully clear to me.  I believe that much of the pain the global financial markets are feeling right now is a direct result of speculation.  As a result, I’m trying to come up with some simple parables for “investment vs. speculation.”  For example, “if you don’t understand what you are investing in, it’s speculation.”  Or, “if your time horizon is less than two years, it’s speculation.” One of values I’ve always adhered to is that “I’m an investor, not a speculator.”  Now that the government is deeply in the mix, I think we need to spend a lot more “system time” thinking about how to incent and motivate investment, and how to avoid speculation.

Comments

[Peter Cranstone]

Well stated. Pies not free even for the VC's. The double/triple dip is well known for the big guys, however for the smaller funds it's not there. Sarbanes killed the IPO which means that it's either M&A or profitability or Zombie status. That means a longer cycle - so VC's are in effect working for a paycheck (like the entrepreneurs) which is great because now everyone is in alignment.

Cheers,

Peter

[Brad Feld]

Thanks for the call out - your statement "I believe if everybody can be kept on the same page, value will continue to be generated, with minimal friction. When one player in the ecosystem is out of step, however, you have an implosion." is right on the money.

There are many subtle aspects in fund dynamics that are sometimes hard to explain, but if the VC really understands them, believes them, and has an investor (LP) base that supports the construct, it works out nicely. For example, our goal is to always investment 100% of the fund. This means that we have to "recycle" our management fee - earn it from returns from our companies and then reinvest it. As a result, our LPs get 100% of their money invested, vs. 100% - the cumulative management fee. While the management fee pays the bills in the short term, this creates much better long term alignment since we are really playing for the profits on our investments.

This just reinforces your view of the importance of alignment throughout the chain of the investment (from LP to VC to entrepreneur).