Last week I dropped a little “bomb” at AAAIM’s Building Bridges conference at the beautiful St. Regis in San Francisco. But more on that later.
The well-organized and increasingly popular annual event (great job Brenda Chia) was riddled with hobnobs from the investment community, including Ambassador Linda Tsao Yang, Dr. Ta-lin Hsu (Chairman of H&Q Asia Pacific, $2.6B), Christopher Ailman (CIO of CalSTRS, $130B), Joseph Dear (CIO of CalPERS, $200B), Clark Cheng (HSBC, $55B), Larry Schloss (CIO New York City Employees’ Retirement System, $105B) as well as representatives from the government including Ginger Lew (Whitehouse Economic Council), Don Graves (US Department of the Treasury), Sean Greene (Small Business Administration, $1.2B upped to $3B) and Ann Yerger (Council of Institutional Investors).
For those unfamiliar, these people represent the mostly public money that is dispersed through a variety of asset classes (investment sectors and models) to money managers with expert knowledge of a specific domain. In the Venture sector they represent the Limited Partners (LPs) who then invest their money directly or through Fund-of-funds to Venture Capitalists, the latter who in the marriage between the assets of Limited Partners (money) and the assets of entrepreneurs (ideas) are supposed to produce outlier returns.
The reason why I participate in this event (and have sponsored AAAIM with advertising for about two years) is to get a solid understanding of what the Venture Capital spin-doctors tell their Limited Partners that makes them re-up in Venture without instilling more structural investment discipline.
But life of the investment managers with Billions of assets-under-management is not easy; they personally make little money, they are forced to deal with the rigidity of consensus driven decision-making, they are heavily constrained by government and they are competing with their wealthy and more nimble private investment counter parts. A big reason to cut them some slack and a reason why I make myself available as “the voice of reason” in Venture for them.
Top investment themes
Clearer than ever before investing today is a global “game” that requires feet on the street local knowledge. In many cases, stated Dr. Ta-lin Hsu, successful investing in current times requires an attachment to Social Economic Value (a topic we talked about previously) that drives dramatic financial value. Old fashioned principles like honor and reputation beat flash-in-the-pan investment strategies, especially in Asian countries where reputation is the life-blood. China is described as a highly valuable investment petri dish, if the local culture and governmental restrictions are well understood, as it will soon have its own Fortune 500 companies, supported by investments, for the first time. Asia also sees real opportunities to “prop up” Silicon Valley.
Pension funds struggle
Pension funds still appear to struggle to produce viable performance (8% average return target, realistically now at 5.5%), not surprising considering the state of the macro-economy. Each of the Chief Investment Officers (CIOs) appear surprised that the conventional wisdom, driven by risk models has failed. That few of the diversification models that were supposed to alleviate risk in certain sectors actually produced and worse, the models appeared to be duct taped together. Missing benchmarks, made up numbers, too long-term focused while losing sight of short-term reality all require CIOs to be more tactical and force them to invest in different people and processes to support the investment strategy moving forward. Many pension funds grapple for better tools, both quantitative and qualitative, to manage the most important dimension of risk: volatility. Nimble requirements for organizations generally known for the opposite.
The Venture Capital “bomb”
Venture returns over the last ten years have produced a negative 3.7 IRR (Internal Rate of Return). LPs in the investment community who have not read my blog yet continue to allow (Venture Capital) General Partners to use easy excuses (we debunked) such as their inability to influence external factors and some even stunningly increased their allocation in Venture. A bad thing considering that structurally unchanged an increase in Venture allocation means more proliferation of subprime VC by default, and therefore more disappointment down the road and a further loss of trust in the viability of the asset class.
So, I went up to Joseph Dear, CIO of $200 Billion CalPERS again and asked him a simple question (not dissimilar to the points I made to him in Sacramento earlier this year, and the year before):
Why do we believe an asset-class with 10 levels of bottom-heavy diversification will produce consistent outlier returns?
His hasty and befuddled “what do you mean?” answer on his way out made me drop this bomb also on the Venture Capital emerging market focused segment where Fund-of-funds Hamilton Lane, Invesco, Centinela Capital Partners, Baird Capital Partners who all evaluate Venture Capital firms, struggled similarly in providing any satisfactory answers, as the room quickly went quiet. Even more surprising to me was how seemingly anemic these “masters” of Venture Capital asset allocation appear to be. Congratulated afterwards by the moderator for a great question, only Invesco was intrigued enough to approach and discuss the topic with me in more detail.
The problem in Venture is not the purported lack of opportunity associated with the massive 80% greenfield of the underlying asset (our ability to innovate) but lies in the redundant complexity of the structure of the financial systems we put on top.
Endless diversification by default harbors mediocrity and turns one-time successes in fat and happy residents with their own (sometimes personal) diversification tactics and political clout hard to dethrone from their cushy yet steadily deflating position.
So, Limited Partners should not waste their time discussing ways to produce viable alpha (portfolio returns) by jumping from one financial asset to another, but instead focus on why a financial asset does not trail the performance of its underlying production. It should follow the money-trail to where it reaches the actual assets they (indirectly) invest in, and flatten its deployment in order to tap into its massive opportunity (in technology Venture at least). It requires from Limited Partners the knowledge of how their risk is currently deployed, how their money is fragmented, and how the economic model they currently deploy is systemically unable to discover the outliers of innovation.
The real source of financial instability in our country is a financial system eleven times the size of production, the real source of the financial underperformance in Venture is the complexity of its investment pyramid (see The State of Venture Capital). In both cases it means we have become a nation of gamblers rather than a producer of social economic value the public can trust. And in this day and age, surely the public does not want to gamble on its future anymore.
So why do we keep asking for public trust if we don’t spend the time building the discipline needed to earn that trust?