Long PM Health/Short Tums

What do you get when you cross good, thematic long-term investors and stock pickers with quarterly or annual redemptions? Perverse decision-making and style drift. Or a portfolio manager with an ulcer. There is a fundamental mis-alignment of motives in the hedge fund business, and my guess is that it will push truly excellent investors into one of two camps:

1. Becoming "institutional," substantially growing assets, running an overly diversified portfolio in order to dampen volatility by pandering to institutional risk-aversion, and generating mediocre returns in the process; or
2. Becoming disenchanted with the focus on quarterly performance and forcing out most outside investors or imposing a super long-term lock-up which will likely have a similar effect.

I've spoken to several friends in the fundamental long/short business who are good, really good, and they all get stressed out and irritated by quarterly performance measurement because this is not their investment horizon. Many of the value-oriented funds I know will hold investments for years - whose value naturally oscillates due to both company-specific and market forces - but ultimately the thesis plays out over time. Their approach is more akin to Warren Buffet than it is Jim Simons, and turnover as a rule is quite low. Just look at Berkshire's stock price; it whipsaws around regardless of the rate at which book value compounds over time. Market sentiment, sector rotation and macroeconomic factors have dramatic effects upon stock prices over short time periods, which may have little to do with the intrinsic value of a business. Quarterly reporting and redemption horizons that are mismatched with investment holding periods exacerbate the problem and lead managers to consider portfolio management decisions that are suboptimal for maximizing long-term returns. Two excellent managers I can think of off the top of my head, David Tepper and John Zwaanstra, run very concentrated, volatile portfolios with dramatic swings in performance year-to-year. And their investors understand this and are willing to take the roller coaster ride. But they are rarities indeed.

So why has this pervasive asymmetry existed? Because hedge fund managers ask for it. If a manager wants a quarterly payout, they have to live by quarterly reporting and performance measurement. Period. And if they complain that their investment horizon is long-term and that they shouldn't be judged on short-term results, then they shouldn't get paid that way, either. In a perfect world, managers would collect fees to run the business and attract and retain talent (management fees), but would have both performance fees paid and lock-ups match their investment horizon. So, if a manager had a three-year investment horizon on their thematic portfolio, they should get paid on positions in the book on a rolling three year cycle. This would result in a true melding of the hedge fund and private equity models, where performance fees are paid upon realization, not on period mark-to-market values, and capital is committed for long time periods. The same thing can be said for quantitative managers: stat arbs and other high-frequency strategies with short-term signal horizons should get paid out quarterly - but they should have redemptions quarterly as well. This is akin to the CTA business, and quite frankly it makes a lot of sense.

I believe this is a sensible, rational, and fair way to align manager and investor interests and to let the long-term fundamental manager do what they do best - invest, not trade. People would once again get paid for alpha generation and not simply asset gathering, and portfolio managers would probably have far fewer ulcers. Long portfolio manager health, short Tums.

The KKR/SUNW Deal Telegraphed Today's PE Environment

The KKR/SUNW convertible preferred PIPEs deal, an oddity in the private equity world up to that point, in retrospect looks like the harbinger of things to come. When I wrote about the deal in March 2007, I saw the following as being the principal reasons for such an investment:

• KKR knows that deal sourcing is going to get increasingly difficult. They are seeking to build a track record in the PIPEs space and to gain experience with the management of these types of investments. This is very, very different than the stuff they're used to. And they are acutely aware of this. The hope is that by being successful and by working well with Managements and Boards of Directors, that they'll ensure a steady source of deal flow tomorrow and beyond.

• KKR knows that deal return risk is increasing. You know those Blackstone guys? They see the same thing. KKR's approach (though an IPO is possible) is to put less risky assets into their portfolios to prepare for rainy days ahead. From a portfolio management perspective, this is smart.

• KKR, besides putting on an implicit portfolio hedge by booking a convertible debt structure versus straight common equity, is putting on a management and performance fee hedge. If KKR is moving down the risk/return continuum by shooting for lower risk, 10-12% total returns versus higher risk, 30-40% total returns, they are betting that shellshocked investors won't be offended by paying premium fees for stable, low double-digit returns. And they're probably right.

• KKR knows that private equity is coming under increasingly regulatory and PR scrutiny, and wants to be the firm wearing the white hat. By supporting company management's in PIPE deals, they burnish their image as a concerned corporate citizen that is a supporter and not a raider of industry. No asset stripping. No debt-funded dividends 3 months after taking a company private. Only good, wholesome, long-term investment. This isn't your father's KKR, my friends.

And look at what we've been seeing recently. TPG/Washington Mutual. Corsair et al/National City. Couple this with Carlyle's David Rubenstein's recent thoughts on the matter:

The co-founder and chief executive of private equity giant Carlyle Group said on Monday that struggling financial institutions are the "single biggest opportunity" for investment in the U.S.

Speaking during a conference of the Society of Business Editors and Writers here, David Rubenstein said financial institutions have enormous balance sheet holes in them and the amount of capital that is needed is more than has been publicly announced. While large, big-name institutions have made headlines, he noted that there are many lesser-known financial institutions around the country that need help.

Please note that due to regulatory restrictions, these investments are, by necessity in most locales, minority shareholdings. So at the end of the day the deals will look a lot like the Washington Mutual and National City deals. Very un-private equity-like. Highly unlikely to generate the kinds of returns private equity investors have gotten accustomed to.

I recently posted about my fears that fund size is leading to bad risk/reward decision-making on the part of leading private equity firms, and the two bank deals mentioned above were the marquee examples in my post:

And I know that these private equity firms and the SWFs say that they are getting quality assets on the cheap. But I worry about the conflict between the ability and desire to write a big check and the best time to write such a check.

Because it seems to me that some funds are a little trigger-happy, pushing money out the door while they can in order to justify their existence and to spend time managing dollars instead of deploying them. And if I am right, this is a very worrisome trend, indeed.

Equity Private recently weighed in on the topic, arriving at a conclusion similar to mine, which is not entirely surprising since she and I tend to be pretty blunt, sarcastic, cynical and generally rational:

What do you do when your private equity returns are dwindling because you have billions of idle cash sitting around and no deals to invest in? Invest in public equities, of course. Well, "of course," is sort of strong, particularly when your core competency isn't public equity analysis.

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I would say I'd be selling my Blackstone shares, if I owned any. I'd say short Blackstone, but, well, it's probably a bit late for that.

Funny, yet accurate stuff. Bottom line, my thesis of thirteen months ago is playing out pretty much as expected. It should be a very interesting (read: crappy) few years for the private equity industry. Gigantic asset pools that need to be deployed. Broken credit markets making leverage prohibitively expensive or unavailable. Existing portfolio companies in dire need of fixing (read: de-levering). So what's a survival-oriented PE banker to do? Put tens of billions in lower risk, lower return deals in public companies, or to massively step-up the foreign investing activities which frequently have smaller ticket sizes. In short, those pension funds that have been the largest backers of the top PE firms are going to see their returns go down, down, down. There is nowhere else for them to go. Because I don't care how good a PE banker you are: you can't fight gravity.

I'm Not a "Linkfest" Kind of Guy, But...

Here are some articles I've seen over the last few days that warrant a read:

1. Bagehot's Lessons For The Fed, Wall Street Journal, 4/25/2008. Stanford University's Ronald McKinnon shares some pearls of wisdom from the legendary UK economist and scholar Walter Bagehot's  body of work.

Bagehot called a seizing up of internal markets "a domestic drain" (of gold), and the flight of capital abroad "an external drain." He wrote that "The two maladies – an external drain and an internal – often attack the money market at once." And what, he asked, should be done when this happens?

"We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm. . . . And at the rate of interest so raised, the holders – one or more – of the final bank reserve must lend freely.

"Very large (domestic) loans at very high rates," Bagehot advised, "are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness. But though the rule is clear, the greatest delicacy, the finest and best skilled judgment, are needed to deal at once with such great and contrary evils."

The punch line:

To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right.

Here was a lead-in to a post I had written back in December of last year:

I've been one of those on the stagflation bandwagon, deeply concerned about the weakness of the dollar, the likelihood of the Fed continuing to reduce rates in the face of locked-up credit markets, rising food and energy prices and persistent and rising deficits. This is a toxic macroeconomic cocktail I've written about and which has been the source of much worry.

I'm firmly in Walt's camp. We'll see if the Fed and the Treasury are listening.

2. Horatio Alger Multiplied by 1.3 Billion, New York Times, 4/26/2008. Joe Nocera penned a very interesting and informative article about the spirit of entrepreneurship that has been released in China, chronicling the rapidity of its impact on both China and the world. It reminded me a bit of yesterday's post on entrepreneurship in the U.S. These are the words of a very successful Chinese entrepreneur who started with $31 and now runs a large consumer electronics company:

“My mother and father went through the Cultural Revolution,” Mr. Feng said. “They had no chance.”

He continued: “When I was in grammar school, the Cultural Revolution ended. When I graduated from university in 1992, that was the year of real reform. Deng Xiaoping encouraged students to go into business and become entrepreneurs. Before then, if you wanted to be an entrepreneur, you would sink like a stone. But after that, anyone could be an entrepreneur.”

Joe made the following observation during his recent trip to China:

But look at what else happened: motivated by the prospect of wealth, people started companies. And as those companies succeeded, millions of new jobs were created. In Shanghai — a place with more entrepreneurial energy than any place I’ve ever visited, including Silicon Valley in the 1990s and Houston during the 1980s oil boom — you can practically see wealth being created before your very eyes. If Shanghai doesn’t make you a believer in the power of capitalism to improve lives, nothing will.

We are just at the beginning of a massive, global entrepreneurial wave. And amidst all of the fear, confusion and uncertainty, the prospects are bright for a better world created by the passionate, the driven, the risk-taking entrepreneurs in every corner of the globe.

3. The Best Game Ever, Sports Illustrated, 4/25/2008 issue. This is an excerpt from a new book by Mark Bowden of the same title. While the book is a chronicle of the great 1958 Super Bowl championship game between the Colts and the Giants, there is a powerful vignette about one of the stars of the game, Raymond Berry. It is a story of passion, raw intensity, brutal focus, self-motivation and unparalleled drive in the face of huge obstacles that ultimately culminates in legendary success. It is an inspirational tale for anyone who thinks they aren't good enough, big enough, fast enough or something else that others deem as important. It is about the refusal to accept one's perceived limitations. It is really a story about succeeding, regardless of context. Trying out for a team, interviewing with a company, building a start-up; anyone pursuing these goals would benefit from the lessons of Raymond Berry. I think I'll have my son's read this one.

Enjoy.

The Halcyon Days of Entrepreneurship

The economy isn't so hot. The credit crisis has caused mass layoffs across Wall Street and related industries. Mortgage defaults are skyrocketing, causing panic in many communities across the U.S. The geopolitical environment hasn't been this lousy in a generation. All pretty depressing stuff. But I see a silver lining in all this chaos: the rise of entrepreneurship, a wave that can help spur innovation, solve seemingly intractable problems and help energize the economy both today and tomorrow.

Here are a list of catalysts that I see contributing to the entrepreneurial phenomenon:

• The boredom of big companies. Whether one is talking about Ford, IBM, P&G or even Google, big companies eventually stunt the entrepreneurial growth of many talented people. If you have an idea, a really good idea that you want to own and run with, there precious few companies where you can do this without a whole lot of b.s. that makes the whole experience unsatisfying. So if you are successful, self-confident, have a network of smart people and the drive to do your own thing, leaving the mother ship to pursue your passion is both a rational and a logical thing to do. I can't tell you how many people I personally know that have left Google, AOL, every major media company and Wall Street firm to do something entrepreneurial, whether it is to become an angel investor or to start their own company. This is a powerful catalyst for change that will drive great ideas and companies for a generation - or more.

• The mass layoffs across Corporate America. Lots of smart, mature professionals are finding themselves without jobs, and without good prospects for finding similar jobs in other companies or industries. This doesn't mean these people aren't good, only that they were left standing when the music stopped playing. I personally know several people this has happened to that are - yes - taking some of their capital and all of their creative energies to develop business ideas they've had but never had the time to pursue. And these people have lots of practical experience that can be used to either start companies of their own or to take operational roles within young companies that can benefit from their knowledge. Hundreds of thousands of professionals are going to have to re-invent themselves. There is no choice. But these are not the types of people who curl up in a ball and wish things were different. They'll feel compelled to figure it out. And that can only inure to the benefit of the small, rapidly growing companies in need of such skills and wisdom.

• The asymptotic nature of technology costs. As technology costs approach zero, barriers to starting a company are simply fading away. If the talent and a little operating capital is there, what is stopping anyone from pursuing their idea? Not much, except guts. It has never been cheaper to hack together an alpha prototype and test the market. I'd argue that while costs will continue to fall, they've already fallen to such a low level that they really don't represent much of an obstacle any more. Get started and get to market early and often. Because now you can.

• The availability of both angel and venture capital. Even if the corporate refugees don't have as much operating capital as they need to completely self-fund a start-up, there is plenty of angel capital around to help bridge the gap between personal monies and an institutional round (if needed). There simply aren't any excuses. It is hard to walk into a Starbucks in any major city and order your venti skim latte without bumping into someone who does angel investing. We're everywhere. There is no place to hide. So unless you are living under a rock or so inept that you can't find a nearby business accelerator, angel group or high net worth individual who likes seed investing, hacking together a little money for a really good idea should not be viewed as a mountain to be scaled. It is doable and it is done ever single day.

• The presence of clear problems that need solutions. There are so many things I see in my own life that could be done better it is truly mind-boggling, whether they are on the macro level (clean fuel technology, water purification) or the micro level (job search, ad targeting, basically all that stuff I invest in). I buy into the Peter Lynch ethos - "Invest in what you know" -  but applied to early-stage investing and entrepreneurship: put money in stuff/start companies that addresses a problem or need you have. So I don't see a dearth of opportunities for smart, entrepreneurial people to come up with commercially compelling, bankable ideas. You only need look as far as our own life for investment ideas. Not everyone needs to start a nanotech, biotechnology or social networking company. But if you feel like you have an edge, go for it.

New business ideas and experienced management for helping young companies are two clear positives coming out of the current business and economic environment. High-impact start-ups is an area where the U.S. has long excelled. Now we have an opportunity to leverage all those highly knowledgeable, experienced, displaced professionals into both new and young, rapid-growth businesses. Maybe local groups of professionals in transition can be established to brainstorm around new business ideas (see Meetup.com), and to bring in successful entrepreneurs and venture capitalists to provide guidance on how to turn their ideas into real businesses. It could be a win-win by helping entrepreneurs identify possible senior talent for their companies, and helping the venture guys source new business ideas and entrepreneurs to fund. All I know is that we can turn what looks like a negative into a big positive by thinking outside-the-box, providing some education and support and presenting both start-up and small business opportunities to those used to thinking only about big companies. What they may find is a life and a challenge that is different, challenging and possibly even more rewarding than what they've gotten accustomed to. Now that is what I call a silver lining.

Growing Older is Hard

This is not a post about vanity, the loss of hair, the newly-formed wrinkles, the sore muscles, the need for a mid-day siesta. It is about the loss of life and of love, the passing of an era. A few night ago my wife's grandmother died, the last of our grandparents to go. She was a tough, feisty, bright woman, an independent and free spirit who was ahead of her time. She traveled abroad as a young woman, falling in love with France in general and Paris in particular. This ultimately led her to become a French teacher, speaking the language that became her favorite tongue until the end. We always thought that if she cognitively lost it and resorted to a single language, French would be the language she'd speak.

I met her in France when I connected with my then-girlfriend during a trip with a couple of my college buddies after graduation from Michigan. My now-wife was on a trip to France and Israel with her "petit grand mere," diminutive in stature but large in spirit, for a little grandmother/granddaughter bonding. I took a four day diversion to spend time with my new girlfriend, and had the pleasure of spending some time with her beloved grammy while in Paris. I brought grammy flowers at her hotel, had lunch together in the Jardin de Luxembourg and dinner together at a wonderful restaurant called Le Petit Zinc. Though this was over 20 years ago it feels like it was yesterday.

Grammy's speech at our engagement dinner over 15 years ago was very memorable, a time at which she said such beautiful things about my then-fiancee it made me smile a mile wide. She also really loved me, which was a special gift since I never had that kind of a relationship with my grandparents. She doted on my wife, providing her with another source of love and emotional support beyond her parents. It was a beautiful thing to see, the mutual love between my wife and her grandmother. Such a special, priceless gift.

She was 91 when she finally gave up. The last years of her life weren't particularly pleasant, being confined to a wheelchair and losing the mobility and active lifestyle that characterized the lion's share of her full and rich life. In my mind's eye I don't see her in the nursing home but sitting at the piano, playing silly songs at Thanksgiving that had all the grandchildren, both by blood and by marriage, dancing around and acting like little kids. I see her playing Trivial Pursuit and Scrabble with the family and with my sons, displaying her powerful memory and language skills for all to see. To be sure she was far from perfect; everybody is. But she had an array of positive qualities that left a strong imprint on me, my wife and my children. And I will always be thankful that she had a place in our life. This is the first relative that my children have lost in their lives, and it will not be the last. I wish I could be more at peace with the passage of time and its consequences, but it is very, very hard.

Is Fund Size Leading to Perverse Decision-Making?

The $7 billion TPG-led recapitalization of Washington Mutual. The $5-8 billion Corsair-led syndicate to support the ailing National City. The tens of billions invested by sovereign wealth funds (SWFs) in Citigroup, Merrill Lynch, Morgan Stanley and UBS. These are stunning numbers for firms that are in a lot of trouble. Now being a contrarian, I applaud the guts-of-steel necessary to invest in the face of financial panic. The problem is, I just don't see the panic reflected in the U.S. stock market, notwithstanding all the issues with the global credit markets. And I know that these private equity firms and the SWFs say that they are getting quality assets on the cheap. But I worry about the conflict between the ability and desire to write a big check and the best time to write such a check.

Because it seems to me that some funds are a little trigger-happy, pushing money out the door while they can in order to justify their existence and to spend time managing dollars instead of deploying them. And if I am right, this is a very worrisome trend, indeed.

Mega-funds, be they of the hedge, private equity or SWF variety, face pressures of scale. It is necessarily difficult to invest such massive sums, and it takes incomprehensible amounts of discipline to let ok deals (from a risk/return perspective) go by in order to wait for the truly great deals with solid margins of safety to present themselves.  Because it can get pretty embarrassing sitting on $10 billion (or in the case of SWFs, $100 billion or more) of commitments, getting paid management fees and not putting money to work. There is a natural pressure to pull the trigger, because it may be more painful waiting for the right deal to come along than doing a deal that ends up being mediocre but being busy in the process. And it certainly is impossible to raise a fund V, VIII or XII if one can't even get past 50% of committed capital for the current fund. This would bring the whole asset gathering operation to a screeching halt. And we can't have that, can we?

Why am I picking on these deals? Because the dollars are so large and the sector being mined so troubled. I get the argument about the value of WaMu and NatCity's core deposits and branch networks; I was once a Financial Institutions M&A specialist and spent lots of time looking at such things. But so much of the value of these deals turns on asset side of the balance sheet and the massive mortgage and commercial lending books. In my opinion we are early in the credit down-cycle, and even if one doesn't agree with my assessment, I think it is hard to argue that things will be rosy any time soon. And further, there is much uncertainty about the depth, breadth and timing of the credit downturn. With all of these unknowns, clearly the investors in these deals are looking at the price they're paying and saying "This is my margin of safety; I'm buying cheap." But does anyone really have enough information yet to make such an assessment? Is buying at a 30% discount to market the right number? Is fair value really 20%? Or is it 50%? I certainly don't know. Maybe they do, and they could be right. But the risk/reward calculus seems kind of skewed at the present time.

If the deal sizes weren't so large I'm not sure I'd raise my eyebrows quite as high. It's just that the pressures of size are so great that I can see it adversely impacting rational decision-making. I'll be keeping careful watch on these deals. And I'll be interested to see the next series of mega-ticket deals getting  done for exactly the same reasons.

Super-Angel Networks: Seed Capital 3.0

It seems as if everywhere I turn there is yet another article about a slowdown in venture capital investing. This from today's Wall Street Journal:

Facing an uncertain economic environment, venture capitalists showed restraint with their wallets in the first quarter.

These investors sank $6.8 billion into U.S. companies across 603 deals in the period, according to data from Ernst & Young and VentureSource, a division of Dow Jones & Co., publisher of The Wall Street Journal. The deal total is the lowest since the first quarter of 2005, while the investment level is down 8% from the $7.4 billion recorded in the year-ago quarter and 9% in the fourth quarter of 2007.

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Many venture investors say they aren't overly concerned by short-term economic factors, instead looking for the next big company that will emerge as a mainstream hit in two to four years.

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Still, investors are telling their portfolio companies to conserve cash and are looking especially closely at potential new companies to make sure they have clear and strong revenue channels.

The prism through which I view the venture capital environment is quite different. I am looking primarily at the seed stage, and the volume and quality of deal flow I've witnessed has never been higher. Further, I'm aware of more people like me funding these companies, people and small groups with previous start-up experience and sometimes large-company experience. Sometimes these people invest in the context of a small seed fund; other times they invest directly with their own money. But these new friends and business acquaintances of mine have eight common characteristics:

1. Love of new technologies and business models
2. Experience leveraging internet-enabled platforms
3. Groups of friends with expertise across an array of domains that can be tapped when needed
4. The desire to be part of a syndicate of like-minded investors
5. A healthy rolodex of entrepreneurs, corporate executives and venture capitalists
6. The willingness and interest in helping managements make their companies successful
7. A focus on building a portfolio of start-up investments
8. A wad of cash that can be deployed in building out this portfolio

I call these entities "Super Angels." As Kim Rachmeler said during CI Foo camp back in February, "The network knows what the nodes know not." Translation: by leveraging networks, you can learn stuff that you yourself cannot through an insular, go-it-alone approach. Now any VC will tell you "Oh yeah, I speak to firm X, Y, Z, and expert A, B and C." But the issue is that there are always conflicted motives. Are the VCs really going to get straight, honest answers from their peers? Come on. It's a big dance, they all know some pretty girls and they want to make sure they're dancing with as many as they possibly can. Super Angels, conversely, truly value  the expertise, complementary skills and expanded networks offered by other Super Angels. They are not so much in competition with one another as they are wanting to do good deals and to de-risk them through a combination of capital and top-notch, value-added investors. But the difference between this loose confederation of Super Angels and the common angel networks is that both the nodes and the networks among the Super Angels are often far stronger. At least this is way it seems to me.

Kind of like the Internet, I think the Super Angel phenomenon is only in the first inning of an extra-inning contest, and that their impact will increasingly be felt over the ensuing years. But let me be clear - I don't see Super Angels as the death-knell of VCs. Quite the contrary: I think they can become a more efficient farm team for the best VCs than the VCs themselves can ever think of building. Where the real impact will come is with VCs who have strayed from doing traditional seed by doing larger Series B and C rounds, and want to get back to their roots. Too late. And too much brain damage in dealing with such firms. I think Super Angels have the chance to own the seed stage business, and are the best-positioned parties to prosecute this class of investments because:

1. Many have been entrepreneurs
2. Many have been buyers of the types of companies they are funding
3. Many lack LPs and don't have to nit pick as much around terms
4. Many have the skills and contacts to make a success a self-fulfilling prophecy by getting involved
5. Many have the rolodex to get the right VCs involved in the right ventures at the right time
6. Many have the money along with their networks to do both seed stage and A round deals
7. Many entrepreneurs would much rather deal with a Super Angel than a VC any day of the week

I really do think this is a megatrend, one which will become increasingly important if both the broad market and the VC market continues to tighten. A smart, helpful, highly networked source of low brain-damage capital is a valuable thing. And this is where the Super Angels are going to rock it.

Where is the Hedge Fund Industry Going, 2 Years Later?

In one of my first posts I made some projections concerning the future of the hedge fund industry:

1. The number of hedge funds, higher or lower? - Answer: LOWER
2. The "shape of the hedge fund industry?" - Answer: BARBELL
3. Will fund-of-funds continue to be relevant? - Answer: YES, BUT LESS SO OVER TIME

A recent commenter asked the following: Roger, have your view changed since your original post? I think it is high time I revisited my earlier predictions to see if anything has, in fact, changed my views.

Number of hedge funds

My bottom line on this issue back in July 2006 was:

All of this points to an industry which will grow smaller by number of constituents but be made up of the super-big and the super-small, each geared towards a specific pocket of investors.

To be honest, I don't see things any differently. The big have clearly gotten bigger, whether you are talking about Fortress, Och-Ziff, Lone Pine or Citadel. Large, sophisticated investors have placed increasing value on the institutionalization of the largest players, offering stability of management, infrastructure, reporting, risk management and a control environment worthy of larger investment dollars. Part of this trend has slowed the small fund launches, notwithstanding the rise of the seeder programs. There has also been a continued trend towards multi-strategy funds, giving the managers the ability to allocate capital to those strategies best suited to current market conditions. Also, there has been a shake-out over the past two years, driving the marginal players out as the smart money has either gravitated towards the large, established players or the high-profile new fund launches by successful portfolio managers. I think it is increasingly hard to sustain a single-strategy effort in the face of competitive pressures from the multi-strategy behemoths. So net net, I still see the number of hedge funds as being on a slight downtrend before it plateaus. And I believe the market is getting more efficient at picking the great from the good, creating a healthy, purging cycle that will also force consolidation across the hedge fund universe.

Shape of the hedge fund industry

My view two years ago:

...you have a group of large, global players populating the upper end of the spectrum with a churning, roiling lower end where some simply die off while others make it happen and jump to the big leagues after putting up serious numbers over a 2-3 year period. At the  end of the day, you end up with an industry that has the characteristic shape of a barbell.

I am more confident in my view today than I was in July 2006. The "great squeeze" of the middle that was happening  two years ago is alive and well today. The big have gotten bigger. The middle have either made the jump to the big leagues or are in an increasingly tenuous position. And the small is an amalgam of new starts, falling stars and a small group of single-strategy managers with laser focus who are happy with their business. And as the costs of entry I'd argue have gone up, not down, this serves to reinforce the barbell shape of the industry. Why have costs gone up? Even in the face of rapidly declining technology costs, the infrastructure necessary to run institutional money has gone up, up, up, in terms of people, systems and the time it takes to administer such an organization. Further, as the largest firms move into every market and asset class, it has created an arms race that makes it increasingly difficult for smaller funds to compete. I believe this is an inexorable trend that shows no signs of abating.

The relevance of fund-of-funds

Roger, circa mid-2006:

While I believe there will always be a group of institutions that will simply want the added protection of having a professional fund-of-funds manager when they report back to their boards, this group will, without question, shrink over time and place ever greater downward pressure on fees for providing these services.

This is an interesting one. I'd say that I got the theme right but the timing wrong. Why? Four words: Amaranth. Sowood. Bear Stearns. If there is anything that can shake the confidence of an institutional investor it is a colossal blow-up, and these are just three of the many we have witnessed since my original post. And the big beneficiary of this waning confidence in one's due diligence ability? Fund-of-funds. These institutional investors still need to generate returns, and they're not running away from the asset class. But many would rather pay away some fees and get the imprimatur of a top fund-of-funds than go it alone and risk personal and professional ruin. I'm not saying this is rational, but it is what it is. Plenty of fund-of-funds got smoked in these three high-profile explosions, but the mere perception of greater stability and security offered by fund-of-funds is enough to make the marginally-confident institutional investor sign up. But as a trend, I believe that alternative asset allocations will continue to rise, and that many will reach a cross-over point between hiring a fund-of-funds and building an in-house due diligence and risk management team. Eventually, both economics and control will dictate the construction of these in-house efforts, leaving fund-of-funds to a more marginal role in the investment landscape. That said, in light of the jittery markets and high-profile instances of hedge fund failures, this trend will take longer to play out than I had originally anticipated.

I guess two out of three ain't bad.

Buddy Media: $6.5MM and Off to the Races

It was just announced that one of my portfolio companies, Buddy Media, raised a $6.5 million Series B round led by my friends at Softbank Capital. Sometimes in the life of an investor things just feel right, and this company, its business model and its partners feel just right. From the time I got involved with Mike Lazerow and the Buddy Media team I've been impressed with their combination of vision, a bias towards action and cold-nosed pragmatism. And I've had the privilege of being in the midst of all this excitement from my seat on the Board. From the time we completed the Series A round it has been a whirlwind, closing strategic deals with applications developers, commercial deals with marquee advertisers and ad agencies and recruiting top people to accelerate growth. These were heady times.

Then it became clear the Buddy Media should pick one of two paths: do a strategic deal with a large media company or raise another round of capital, build out the ad network and blow things out. Over a six-week period the company received two offers and five term sheets from great firms. And after much deliberation, Mike and the Board all agreed that raising the additional capital, building the business and executing against the vision was the right way to go. We were fortunate enough to have gotten the interest and support of two great venture firms, Softbank and Greycroft Partners, in addition to myself and 13 of my fellow Series A investors who decided to re-up for the Series B. Quite frankly, it was a no-brainer. Further, two of my friends from Softbank, Eric Hippeau and Karin Klein, will be joining Mike and I on the Board. It should make for some exciting, productive Board meetings.

Buddy Media serves an important purpose: helping advertisers and their agencies best access, activate and monetize the communities on social networks. And with Acebucks as a rapidly-growing loyalty program, we look forward to driving value to our clients while building the ubiquity of Acebucks. The market has spoken loud and clear during Buddy Media's relatively short life: it is creating lots of value for its clients. And as long as we never lose sight of this goal, Mike's vision of Buddy Media's future will become reality.

On A New Path to Liquidity

Fred Wilson just put up a very provocative and interesting post concerning how successful start-up companies might garner liquidity for their owners. IPOs are great, but the market has largely been weak since the bubble burst in 2000 and is only available to companies of a certain scale. Fred and many of those commenting on the post also noted the big-company M&A option, but one that has often crushed the dynamism and the spirit of the company being acquired. Sometimes later-stage venture firms and private equity firms can also provide an exit, but these deals are few and far between. So is there a new way, a better way, of providing liquidity without the barriers of the public IPO market or the value-destroying tendencies of many M&A deals?

Fred cited the relatively new private exchanges, GSTrUE and OPUS-5, for example, as being a possible solution. This is a realm I know pretty well and have written about quite a bit. As currently structured and positioned with investors, these private exchanges are really just a proxy for going public, with the same types of revenue and earnings thresholds and scale requirements as companies listing on the NYSE. In fact, it is arguable that the barriers are even higher, since the disclosure requirements under the private exchanges are significantly less onerous than the public alternatives, requiring even greater comfort on the part of investors. Neither of these facts play well given what Fred is hoping to accomplish. But as Fred's first commenter noted, some out-of-the-box thinking might be called for to deliver the benefits of liquidity to companies for whom the conventional paths are either unavailable or unpalatable. This assumes, of course, that the owners care about continuing to grow and develop the business as opposed to selling it in whole to a Goliath that may treat it as an afterthought once purchased.

What I have in mind is a private exchange for accredited investors that is not subject to some of the current restrictions plaguing unregistered vehicles, like the 500-investor limit. Here are some issues that a new structure might need to address:

1. The 500-investor limit

This makes an exchange where anyone other than large institutions can play completely unworkable: there is both the tracking issue ("When exactly did we trip up on this?") and the sharply limited amount of capital that could be raised from non-institutional accredited investors. In order to create a liquid, robust market in companies that are either too small to go public, don't want the hassles of being public or wish to avoid selling out to a big company but want some liquidity plus capital for growth, the 500 investor rule simply needs to go away. Why not, right? It is just a number.

2. The definition of "accredited investor"

My idea also calls for a re-visit of what exactly constitutes an "accredited investor." Current rules are both archaic and backward: they are principally geared towards the ability to withstand loss, not investor sophistication. I once posted about hedge funds and externalities, and discussed the definition of accredited investors. One of my commenters, Jack Doueck of Stillwater Capital, made the very point I am making now. Those who have the knowledge and experience to invest in unregulated products should have the ability to do so, whether or not they have $1 million or meet the income tests. Plenty of people lacking both experience and ability have $1 million and shouldn't invest in single stocks much less lightly-regulated private placements, yet they can do so under the current regime. This is an asymmetry that should be snuffed out by the regulators tomorrow.

3. The specialist function

if such an exchange is to be successful, it can't simply be like a crossing network. There needs to be specialists providing liquidity in the market and finding the right price at which to clear the market. Especially early on in the exchange's life, both liquidity and price discovery will likely be inadequate. This is where the specialist comes in. Over time, as the market becomes more efficient perhaps it could migrate more towards a Liquidnet model, where bids, offers and lot sizes are posted electronically and investors can trade anonymously without the need for an intermediary. But this is a ways down the road; the investment banks doing the initial placement should also stand behind their names and provide liquidity in the market.

The Benefits

A private exchange in this model would provide funds for both founders and investors to take some money off the table, raise capital for growth and afford entrepreneurs the chance to execute their business plans without either the burden of being public or the cultural issues of being acquired. Investors would likely be smart, savvy individuals or perhaps mid- and late-stage venture funds that want exposure to a particular business after it has been de-risked through earlier financing rounds. It could also serve as a feeder to the public markets, as companies deliver results and grow to a scale where they have the ability (and the desire) to do an IPO. It could also provide large companies with the chance of getting exposure to interesting tools and technologies that they might not be aware of, in a much lighter-weight, less committed manner than investing at an earlier stage or buying a company outright. And it would provide sophisticated individuals and institutions with access to a whole new asset class, one that is in many ways VC-like but with liquidity and entry/exit opportunities completely different than venture investing.

There is much more to say and do on this topic but Fred got the ball rolling and I wanted to share a few thoughts as well.