Paul Singer, the billionaire activist investor, recently announced that Elliot Management has taken a 20% stake in Masayoshi Son’s Softbank Group Corp. What should we make of Singer’s initiative?
The simple answer is that Singer is going to pressure Softbank to take steps to narrow the discount by adopting best practice investment principles (activist investors make a living out of forcing efficiencies on inefficiently run companies - and while Softbank is a legend in VC-land, it trades at a 50% discount to NAV.) But Masayoshi Son is a superstar, the VC investor that every VC investor wants to be – in VC-land, he is doing nothing wrong: this is how VC operates. Singer and Softbank are shaping for a Titanic clash of – well – Titans.
Modern Portfolio Theory (MPT) has forced major changes on the investment portfolios of institutions and individuals. Index funds never existed 50 years ago, but they now make up more than 50% of the market. In the 1950s, investors were all stock-pickers, stitching together portfolios of 50-odd stocks or buying 20 of the 30 constituents in the Dow Jones Industrial and Transportation Indices. JPMorgan’s ‘Nifty-Fifty’ was the staple investment for US Corporate Pension Funds back then and the investments were ‘actively’ managed. Indexing had not been thought of.
Modern Portfolio Theory made two important observations that has shaped portfolios ever since the field emerged in the 1960’s:
- Every security return can expressed as the sum of its market exposure (its beta) and a company component (its alpha). The beta : alpha mix for a listed security is about 30% : 70%
- Passively managed Index funds outperform the average active investment portfolio
These two simple observations are related. From 1, since every security contains a market exposure and a company specific return, a portfolio of securities builds up its exposure to the market and a collection of ‘alphas’. By 2, the only way to beat the index is for the collection of ‘alphas’ to sum to something that is greater than zero (after transaction costs and fees).
The result of this thinking turned portfolio management on its head. Previously, portfolio managers had constructed portfolios by starting with a collection of stocks that they liked and the return that they received was a mixture of market and alphas. Today, the modern approach is to start with the market return and then step out into individual securities that appear cheap (ie have a positive alpha).
The difference is subtle but completely transformed the investment industry. The starting point for an investor is to buy the market where possible and to only concentrate in individual securities when you have a good reason to. For most investors, the likes of institutions and individuals, there is never a good reason to take bets on stocks – markets are informationally efficient and the likes of Paul Singer are all over those opportunities when they arise…
So what does all this mean for VC? Just as there are undiscovered tribes in the Brazilian Amazon and the Mountains of Papua that have yet to be touched by civilisation, VC is one of the last bastions of investment management that has yet to be touched by Modern Portfolio Theory. Having only recently been exposed to the practices of VC-land, I am appalled at the near-absence of science with which investors and managers alike approach this market.
The typical VC investment portfolio holds 20 or fewer companies, risk-control is driven by draconian rules of thumb (“…we only invest in series A or later…”) rather than portfolio diversification principles and qualitative instincts drive decisions rather than quantitative objectivity. This is all the more surprising when it is recognised that VC returns are almost 100% alpha driven as opposed to the 70% alpha exposure for listed equities. The volatility of the sector is gut-wrenching, highly skewed toward complete failure (95% of startups lose 100% of their capital), and informationally asymmetric.
That said, the VC sector as a whole has delivered some eye-popping returns with the Thomson-Reuters VC Index delivering 22% pa since 1996. Investors are increasingly attracted to these returns. However, the industry is so antiquated that the only way to get exposure is through old style stock picking, which is expensive, unnecessarily risky and a shark tank for the uninitiated.
The Singer-Son clash may change the VC dynamic. Effectively arbitraging the 50% discount of Softbank to its Net Asset Value requires Softbank to (i) liquidate some of its investments and pay out the proceeds to shareholders, or (ii) open-end the fund thereby allowing for subscriptions and redemptions at NAV, or (iii) buying Softbank and hedging its components by shorting the underlying. The Singer-Son clash, however, may get the VC market thinking about how to deliver VC returns in the Modern way. That is, finding a way to deliver diversified market index type returns to investors who want VC beta and then specialising in stock picking to generate alpha.
There are very few diversified VC funds offering beta exposure. We are proud to be associated with the Hatcher+ fund - a fund that is designed to deliver beta for startup tech VC by investing in 1,300 startups over the next few years. Traditional VC investors see this as a ‘radical’ approach to their market and are either intrigued or skeptical. The truth is that the Modern Portfolio Theory train is heading toward VC-land - so either you jump aboard or it will run you down.
Note: The above article was originally published on the The First Degree View.