Cutting Through The Noise

The Times, They Are A-Changin'

Public versus private markets | A conversation with Jason Portnoy

CUTTING THROUGH THE NOISE, A FINANCIAL BLOG BY BILL MARTIN CFA

This year we have seen the impact of the unstoppable force, named global systems (global trade, central bank policies, currency management, ect.) run smack into the immovable object, named local politics….both here in the US and abroad. The results have been a pendulum swing back in the direction of protectionism and isolationism, at least at face value and on the margin.  I suggest, speaking ONLY for the markets and avoiding all social/political discussion, that the results of the most recent election could be considered a mixed bag. There are economic policies that are currently being put forth, which could only be considered “pro-business” (tax cuts, cash repatriation, de-regulation and infrastructure spending) and others, such as tariffs, that could be considered harmful to the deficit, inflation and to global trade.  I will not go further than to say that uncertainty has increased in many respects... markets typically do not like UNcertainty.   

Indeed, the times, they are a changin’ but not just in reference to political maneuvers and their outcomes. Rather, the times are changing in the way public markets are viewed vis-a-vis private markets (private equity and venture capital).  You didn’t see that coming, did ya?  Sorry, but I recently had the pleasure of seeing Bob Dylan perform in concert the evening following his Nobel Prize announcement.  Hence, the title for this blog was chosen prior to the election, so I had to weave it in somehow : )

The private markets have long been viewed as the “wild west” with little understanding of pricing mechanisms, while public markets had what were believed to be open and transparent price discovery mechanisms.  Keeping politics out of this discussion, it is not difficult to see how governmental organizations have moved to make public markets less transparent and perhaps more managed.  Is it now possible that the private markets provide more sanity and less systemic risk?  

The private markets have long been viewed as the “wild west” with little understanding of pricing mechanisms, while public markets had what were believed to be open and transparent price discovery mechanisms.
— Bill Martin

Much of the focus of earlier blogs was on the stagnant global economy.  The reasons for this stagnation are varied, political, and not necessarily straight-forward.  However, there is some consensus that one factor contributing to stagnation seems to be too much capacity.  Too much capacity discourages productivity enhancing investment on the margin.  A possible cause for too much capacity is posited to be too much “easy” money available due to central bank activities, which helped to keep sick companies on life support.  I don’t want to stir up old wounds about the role of the Fed with such little time, but will point out that private markets have not benefited from easy money policies to nearly the scale as public markets.  As such, they compete tooth and nail for every available investable dollar.  If growth opportunities dry up, so does the capital and life support.  At a high level, this is a model that has thus far worked and continued to create growth rates that are more in line with what we expect from the broader economy.

I am super excited to explore this public/private paradigm and new arc that has developed between them with successful entrepreneur and venture capitalist, Jason Portnoy.  

Jason Portnoy has spent his career contributing to some of Silicon Valley’s most impactful technology companies.  After first earning an engineering degree at the University of Colorado, he joined PayPal as employee number 34 while still a graduate student at Stanford University. As a Vice President on PayPal’s finance team, he helped support the company through its hyper-growth, Initial Public Offering (IPO) and subsequent $1.5bn acquisition by eBay in 2002.

Jason next gained privileged insight into the formation and rapid growth of two highly influential asset management firms. He was part of the founding team of Clarium Capital, which grew to over $3bn under management during his tenure. He later helped launch the Founders Fund whose early investments included Facebook and Palantir Technologies.  He was the first Chief Financial Officer at Palantir Technologies and later served that same role at Practice Fusion. In both cases, Jason helped guide the company’s early culture, fundraising strategies and industry leadership positioning.  

Jason honed his investment philosophies through angel investments in several ground-breaking companies including Facebook, Palantir Technologies, Yammer and Stemcentrix.  Today, Jason applies his many years of experience through the framework of Oakhouse Partners, a firm whose mission underscores his deep commitment to discovering and supporting talented entrepreneurs pursuing important challenges.

Jason is also a Kauffman Fellow, and a member of the famed and fabled PayPal Mafia whose membership includes icons like Elon Musk, Reid Hoffman, Peter Thiel, Max Levchin and Roelof Botha.

Bill:         Welcome Jason, it is great to have you here, especially during these uncertain times. Before we get into the topic at hand, I need to ask about what is on everyone’s mind...do you have any thoughts about the election and how this plays out in relation to the economy and the markets?

Jason:      Great to be here Bill, I really enjoy reading your blogs and have been looking forward to contributing.  As you know I am not a public markets person, but do have views on deploying risk capital.  I would also like to mention that I go to lengths to stay apolitical and am not willing to comment on social issues in this forum.  That said, following the morning-after hangover from a contentious campaign season, I am excited about the possibilities from a business perspective.  I believe the election results threw a lot of risk into the equation and this could either pay-off well or end in disaster.  But as a risk-seeker and risk taker, this feels good.  If we are re-entering a period of risk taking as a nation, I feel good in knowing that Silicon Valley will have a role.  Risk-taking is something Silicon Valley does very well.

Risk-taking is something Silicon Valley does very well.
— Jason Portnoy

Bill:          It is interesting that you focus the discussion on risk taking and not risk reduction, like most of my public market colleagues.  Do you see any parallels between how the public markets have gotten to where they are relative to the private markets within that risk framework?

Jason:      Absolutely, and I think you touch on some of that in your introduction.  Over the last few decades, most investors in the public markets have been looking for less risk, so public companies have responded by engaging in risk (aka volatility) reduction efforts like outsourcing their research & development (R&D) to the broader venture capital ecosystem and using financial engineering (e.g. stock buybacks using leverage) to deliver predictable returns on equity.  In fact, since the tech bubble burst in the early 2000’s, we have seen an explicit attempt by large tech and telecom companies to cut R&D spending in a desire to cut risk and increase cash flow.  These large, slower growing companies are using small start-ups as their R&D labs and then look to add these innovations through merger & acquisition (M&A) activity so they can leverage the growth opportunities over their larger platforms.  In any event, the net effect of outsourcing the R&D activity seems to segregate the consistent and lower risk cash flow businesses of a large public company from the high risk/high growth profile of a venture capital company.  

Bill:          That is so interesting, I saw the same “outsourcing” paradigm take place in the gold mining industry in the late 1990’s.  When the price of gold traded below the cost of production, the large mining companies reacted by cutting their exploration teams who identify “green field” growth opportunities. This was an attempt to cut budgets and risk, while increasing short term cash flow.  These exploration teams re-formed as mining start-ups (so to speak), and they are the ones who knew where the good gold deposits lay.  Those same mining start-ups then went to the Canadian capital markets to get cheap financing in order to drill out the properties and “prove up” the gold reserves.  This system continues to this day, where “wildcat” exploration teams find the gold and are then acquired by the larger, short-term focused, growth starved major producing companies. To your point, Jason, risk reduction by some leads to greater risk taking opportunities for others.

Bill:          And how has this dichotomy in risk translated to returns?

Jason:      As a result of the lower underlying risk, investors in public equities have been rewarded with commensurately lower returns.  I don’t see this happening in the private markets.  I’ll focus on venture capital for now since that is the area with which I’m most familiar.  If you look at the Cambridge Associates data below, you see that private market investors, who are comfortable taking risk over long time horizons, are rewarded with much higher returns than those available in the public markets.

US Venture Capital Index
...private market investors, who are comfortable taking risk over long time horizons, are rewarded with much higher returns than those available in the public markets.
— Jason Portnoy

Bill:          Those data are very compelling, Jason.  I’ll attempt to put those returns in perspective.   First, Warren Buffet returned 19.8% over his entire 50 year investing career (through 2015).  He has returned only ~14% over the past 25 years, while the Venture index has returned over 22%. Much of Warren Buffet’s tremendous growth occurred back when he was pursuing aggressive, small-cap opportunities along with private companies...similar to the venture capitalist of today.  It is tough to compare different investment era’s, but Mr Buffet achieved an approximate 30% compounded annualized growth rate over his first 25 years of investing, because his then smaller asset size allowed him to invest with a riskier profile.

Lastly, from a different dimension on this return comparison point, I would argue that the public markets have benefitted more than venture capital investments from the Fed’s aggressive monetary policy activities over the past 5-8 years.  These activities have likely had the effect of making the more recent returns even closer than they would have been.   

Bill:          So Jason, why do you think this bi-furcation in risk has occurred?  

Jason:         I’ve had friends say things like “Chicken or egg.  Lack of risk appetite or lack of opportunities?”, but I disagree.  There is no shortage of opportunities out there to take risk and invest in the future of our civilization.  I think a lot of it goes back to government and central bank intervention conspiring at every turn to try to reduce risk in our publicly accessible financial systems.  Forest fires are healthy, they clear out the dead brush.  Financial markets should be allowed to go through that same regenerative process.  When markets are allowed to self correct, capital and labor are freed up for more productive uses in the economy.  In the private markets, this dynamic still works quite well, so some investors are responding by seeking out investments in private companies.  A recent economist article shows that the fraction of total US equity enterprise value that is held in private companies has grown significantly over the years.

Bill:          This shift over just the 13 year period cited in the report is dramatic.  I’m sure with the growth of some of our ‘unicorns’ that shift toward privately backed companies has only accelerated.  I mentioned the surprising move toward fewer companies on the listed exchanges in a prior blog, but this really helps highlight what has been occurring.  I’m sure a part of this shift is simply growth of venture backed companies, as well as private equity acquisitions of companies that had previously been public, ala Dell.  Lastly, the private markets have just performed better and attracted more institutional money in response.  It all ties.

Bain & Company Private Equity chart

Bill:          And what has been the response to this bi-furcation of risk?

Jason:      Primarily, we’re seeing a corresponding bi-frucation in our capital markets.  Previously, companies had to go to the public markets to find the capital they needed to grow and scale their businesses.  More recently, if you are a risk-taking CEO focused on a very long time horizon, it’s been much harder for you to find like-minded public market investors to finance your vision.  Enter the private market investors, most of whom are hungry for growth, are willing to tolerate volatility and illiquidity, and have long time horizons.  These investors are now finding like-minded CEOs with whom to partner in the private markets..  On the other hand, investors who prefer predictability and liquidity continue to partner with like-minded CEOs in the public markets.  Neither one is right or wrong- if the right buyers (investors) and sellers (CEOs) are transacting with each other then that is a sign of a healthy market dynamic.  I believe it is only a matter of time before a private stock market works alongside the public stock market.

Bill:         I agree that the public markets have traditionally offered more predictability and definitely more liquidity.  However, I sense that with an artificially suppressed yield curve due to central bank activity, some of that “predictability” and transparency has been altered.  Investors just seem more uncertain about how the market operates and how they can benefit.  If I may, their returns seem more subject to be “Blowin’ in the Wind”.   

Jason:         Yes, it does indeed feel like participants in the public markets have to spend a lot of energy thinking about how government tinkering (either through the Fed, tax policy, etc.) is going to impact their investments, whereas we don’t tend to worry about those things in the context of most venture capital investments.  

Bill:         To what do you attribute private market success?  Is it just this uninhibited regeneration process?

Jason:      No, there is more to it than that.  In addition to the ability to regenerate, I believe private market investors benefit from having a very long term time horizon which allows them to tolerate more volatility.  They tolerate more risk-taking by the companies in which they are invested, and are generally rewarded for it.  

Bill:          Is there a way for retail investors to participate.  Should they start thinking longer term for the risk appetite portion of their portfolio?

Jason:         Yes, I believe they should.  They can learn from what large institutional investors have learned over the previous decades.  I’ll reference Cambridge Associates again.  They recently published a report that characterized the performance of foundation and endowment investors by how much they allocated to private market investments.  There is definitely positive correlation between their allocation to privates and their returns.   The table below shows how institutional investors begin to see outsized excess returns (mean = 4.0%) in their portfolios when they allocate greater than 15% of their capital to private investments.

Cambridge Associates research

I believe retail investors should follow suit.  At a high level, I would encourage them (and their financial advisors) to stop thinking of private company exposure as purely an “alternative investment”.  As we saw earlier, privates are becoming a much larger fraction of total equity enterprise value, so if you leave them out of a portfolio you are starting to leave a big hole.  In addition, the hole that is left is exactly the growth story that many retail investors crave.  Think of it this way: It has always been the case that some companies are growing and some are stagnating (or potentially being displaced altogether).  Now that private capital markets are increasingly more developed than in the past, and growth stage private companies wait much longer to go public, one can make the case that the private market represents a bigger fraction of growing companies, while the public market represents an increasing fraction of stagnating or soon to be displaced companies.  If true, then a portfolio that only includes public market equities is less exposed to growth than it was in the past, and that’s a problem.

...stop thinking of private company exposure as purely an “alternative investment”.
— Jason Portnoy

Bill:         That is an awesome point, Jason.  You brought up companies taking longer to issue an initial public offering (IPO).  Can you comment on the liquidity cycle in the private markets.  It is no secret that the IPO market has dried up.  Is that more from a supply/demand standpoint, and is it impacting the venture world?  Just as the public markets have perhaps had too much capital chasing too few good opportunities, is it possible the private markets have not gotten the good re-cycle of cash?  

Jason:      I have a couple thoughts on that.  First, successful companies have not gone public because they don’t have to, as I mentioned before.  They don’t want all the legal baggage and distraction that that goes along with being a public company, and they are finding great private market investors to finance their growth.  On the other hand, for a company where a good chunk of the employee compensation is in the form of equity ownership, an IPO still feels like the most efficient way to distribute the value to the employees who helped create it.  I’ve wrestled with the IPO issue for a number of years - I even wrote a blog piece about it called “IPO is not a Four Letter Word”.

In short, yes, the fact that companies are waiting longer to go public (if they ever do at all) is definitely having an impact on the venture ecosystem, although I would argue that it is a net positive.  In the late 1990s we saw too many companies go public because they could, even though their business models were not quite ready for it. That capital was quickly liberated, which may have led to excessive cash recycling and the first famous tech bubble of the late 1990s ensued.  I don’t think we’re seeing the same phenomenon this time around because so much of the capital is still held in private companies like Uber, AirBNB, etc.  That may be what is forcing VCs to be more disciplined than they were in that first internet bubble.

I believe we are living through a one-time shift in this regard - like a meal moving through a snake’s belly.  Let’s imagine companies went public in year 5 and now are waiting until year 8 or 10.  That means we’ll have a period of 3-5 years of very few IPOs, but then at some point all of the companies who would have gone public at year 5 will start going public, and the cohorts behind them will similarly.  The resulting pace will reach a new steady state.  As a venture capital investor it is OK for this liquidity shift to happen... as long LPs (the investors in those funds) are comfortable with it and believe they will be compensated for the wait.  Let me add that IPO has almost always represented the minority of liquidity events for venture backed private companies, with acquisitions making up the majority.  In recent years the M&A market has been fairly robust, so venture capital investors get liquidity this way as well.

I believe we are living through a one-time shift ... like a meal moving through a snake’s belly.
— Jason Portnoy

Bill:         Going back to the retail investor; how should they actually incorporate private equity exposure into their portfolio?

Jason:         Unless they are an expert in investing in private companies, they should invest in a fund, FULL STOP.  Whether it is private equity or venture capital, they should look for a great fund manager and allocate that way.  I’ll focus on venture capital since that is where I spend all of my time.  I see a lot of high net worth individuals go out and start making angel investments, only to watch the capital disappear in short order.  Private company investing, especially at the very early stages, where most high net worth (HNW) individuals get access to investments , is extremely risky.  In a portfolio of 20 companies you will have one or two (three if you are lucky) that drive all of the returns.  There will be a few investments that generate modest returns, and the rest will be a loss.  This was the case in my angel portfolio: the big gains were all driven by Facebook, Palantir Technologies, Yammer, and Stemcentrx.  I had about 35 angel investments in that portfolio and those four outcomes drove the entirety of the returns.  

So I recommend working with a professional.  You probably wouldn’t try to represent yourself in court or perform surgery on yourself.  Pay a professional to help you navigate the venture ecosystem.  Also, investing in early stage private companies is not just about picking companies - it is about post investment support.  That support does two things (ideally): 1) it helps improve the company’s chance of success, and 2) it gives the VC investor incredible amounts of data that help them assess if they should continue investing in that company.  Most venture capital gains are made by investing follow-on amounts in the best companies.  You can’t do that if you aren’t working on it full time and getting intimately connected to each company in the portfolio.  You don’t have the data and, perhaps more importantly, you don’t have the relationship to do it.  In the best companies the CEOs have the pick of who they want as investors, and they are going to pick investors with whom they like to work.  Without those relationships you won’t be able to invest in the best companies, and you will have an adverse selection problem on your hands.  

A further benefit of investing in a VC fund is that in many cases the fund will offer opportunities for you to co-invest with the fund down the road in the fund’s most promising companies.  Now you have a *proverse* selection situation, and that is a recipe for success.

Without those relationships you won’t be able to invest in the best companies, and you will have an adverse selection problem on your hands.
— Jason Portnoy

Bill:          Proverse selection.  I don’t think I’ve heard many investors use that term.  Can you tell me more about that?

Jason:         Well in that prior statement I was simply referring to the fact that if you are co-investing with a fund in later rounds of a company’s financing, you may have the opportunity to cherry-pick the best investments from that fund, which gives you great odds from the start that the investment has a chance at a nice return.  But more generally I refer to proverse selection as the phenomenon that exists, somewhat uniquely in venture capital, where great portfolio company outcomes (and fund returns) build up the brand of a VC firm, which then attracts a higher quality of company to seek out that firm for investment, and that then leads to more great investment returns.  It’s a positive reinforcing cycle, and it goes a long way toward explaining why certain venture capital funds consistently deliver the best returns.  I’ve written about this in the past in an article titled “The Secret Law Every Successful LP Understands”.

Bill:          Lastly, are there specific sectors that you believe offer tremendous growth opportunities?  Better yet, how would you suggest investors learn to identify some of these opportunities on their own?  

Jason:      Healthcare, finance, and robotics are all areas that I’m very excited about right now.  The first two have been popular for some time, but both industries are so big that there is still a lot of innovation coming which VC investors can help finance.  Robotics is in its early days because the commoditization of sensors and hardware that resulted from the proliferation of smartphones is still gaining speed.  As this continues and hardware costs continue to come down, robotics begins to look a lot like software, and that’s when innovation can start happening even faster.  There is a lot of discussion about artificial intelligence and blockchain, but I personally tend to focus on how those underlying technologies are going to disrupt various industries, and then look for investments in those industries (versus in the underlying technology itself).  

There is a lot of discussion about artificial intelligence and blockchain, but I personally tend to focus on how those underlying technologies are going to disrupt various industries, and then look for investments in those industries.
— Jason Portnoy

For investors to find these opportunities on their own, there is no good substitute for getting out and talking directly with entrepreneurs.  Or better yet, listening to them.  If you listen closely to enough conversations you start to stitch together an idea of where these new technologies are heading and which parts of an industry they will disrupt. That’s where you start doing your research.  

Bill:          That was fun, Jason.  Thanks for allowing us to “listen” in.  You speak as eloquently about risk as Dylan waxes about change - poetic.  It has been fascinating to hear you share your views and outlook for our Silicon Valley growth ecosystem and beyond.  No surprise, you also brought up a whole host of other questions. I hope you will come back next year and let us hear your thoughts on the long-term impact of disruptive industries on the broader economy.  

Have a Happy Thanksgiving!