Archive for March, 2007

Installing RMagick on OS X with Fink

Thursday, March 29th, 2007

Hold on: I’m not sure that the below works right. Don’t use it yet.

There are lots of instructions out there for installing RMagick, which is a graphics manipulation library used by many Ruby-istas for things like thumbnailing, resizing, etc. I wanted to use it for an internal database I’m building in Rails.

Some of the sites offering instructions:

  • The RMagick site itself. This one is tilted toward using Darwin Ports (the BSD-ish way to do third party package management on your mac; I prefer the Debian-ish “Fink”).
  • Hivelogic. This one involves manual downloads of tarballs and configure; make; make install type loving. I don’t like this way of going about it because you lose the package management features.

But nobody seemed to have a Fink-friendly way to do this.

If you naively try to install with gem install rmagick, you’ll get something like:

configure: error: Can't install RMagick. Can't find libMagick or one of the dependent libraries. Check the config.log file for more detailed information.

My solution:

1. Install the needed dependencies from binaries using Fink. 2. Use gem install to install RMagick (the Ruby bit) itself.

The dependencies include (as best I can tell):

freetype freetype-shlibs imagemagick imagemagick-dev imagemagick-shlibs ghostscript ghostscript-fonts gv libpng-shlibs libjpeg libjpeg-bin libjpeg-shlibs lcms lcms-bin lcms-shlibs libtiff libtiff-bin libtiff-shlibs

Therefore, you should probably be able to install simply by doing:

sudo apt-get install freetype freetype-shlibs imagemagick imagemagick-dev imagemagick-shlibs ghostscript ghostscript-fonts gv libpng-shlibs libjpeg libjpeg-bin libjpeg-shlibs lcms lcms-bin lcms-shlibs libtiff libtiff-bin libtiff-shlibs

sudo gem install rmagick

(I realize that this is probably overkill and that you don’t actually need all those packages above. If you figure out the minimal subset, why don’t you post a similar blog entry of your own?)

Good luck!

VC Essential Tensions: Momentum vs. Contrarianism

Wednesday, March 21st, 2007

It is my intention to begin a series of entries dealing with “essential tensions” in investing in general and VC in particular. This is the first of the series.

Venture capital as an industry deals with momentum investing. Paul Kedrosky has argued on his Infectious Greed blog that VC is a “bubble business,” and that venture returns, when they’re good, come from momentum-fueled exit events. This is an argument where the counterexamples are the exception that proves the rule: Google’s IPO (unimpeachably a deal that stands on its own merits rather than a momentum exit) stands out for having decisively ended the exit drought that had plagued the industry since 2001. Indeed, GOOG going out kicked off the recent positive-momentum exit cascade that gathered steam throughout 2006.

Likewise, on the “entry” side of new financings, momentum tends to rule the day (especially when exit momentum “spills over” into fundraising and new financing activity). See, for example, the cavalcade of YouTubettes that have been trotted out, freshly funded and hoping to hit warp 10 and slingshot off the perceived stellar performance of online video and user-generated content. (Indeed, it would take some backwards time-travel for most of these to capture any fraction of the value in that particular space.)

It is easy self-righteously to laugh at the absurdity of funding 30 YouTubes. But if we accept whole-heartedly the ad absurdum version of Kedrosky’s argument, we can’t blame VCs for believing in momentum. After all: if folks today are buying online video companies, then the savvy VC better have one to sell.

But investing is not a game played alone, and contrary to the bluff and bluster of some VCs, no deal is “binary.” Every deal is implicitly an auction, with a bid and an ask, and the formula for investment return is ancient and venerable: buy low, sell high. Momentum helps with the latter, but crushes our ability to do the former. Apart from the occasionally perverse incentives provided by large, fixed fund sizes, pricing going in is even more leveraged in ROI than pricing coming out. Getting into a good deal at an attractive price — and hence, the longer lever on ROI — depends on a virtue diametrically opposed to momentum, namely, contrarianism.

The contrarian looks for undervalued purchasing opportunities by ignoring or subverting the prevailing wisdom of the day. He makes it his job to call the tops or bottoms of markets, and sometimes is the one declaiming the emperor’s nudity. An occupational hazard of this is that sometimes, the market has a ways to go yet, and occasionally the emperor still has flesh-colored tights on — and early is the same as wrong when timing markets.

Certainly, if there is a mythical hero of venture capitalism, it is the steel-nerved visionary contrarian who makes what looks like a long-shot bet, boldly doubling down when others are fearful, and propelling forward great companies and great technologies that nobody else dared touch (and hence, that he invested in on the cheap). Where else do we get the nerve lionizing our asset class as “venture?”

So, we are faced with a contradiction between the mythology of our industry and the harsh reality. You don’t get to be both the visionary contrarian and still have the online video portfolio company. Why do so many venture firms seem to choose momentum in this tradeoff?

I have two theories. One is that, although entry price has more theoretical leverage over ROI than does exit value, exits are so much more visible that they dominate the consciousness of most VCs. That is, given the implicit opportunity to make a 8x ROI on, say, a $60 M exit, or to make a 2.5x on a $500 M exit, and assuming that the probabilities and amounts are adjusted to keep other comp and performance measures ceteris paribus, I bet that VC decision processes are strongly skewed to the big dollar, highly visible exit. Half-billion IPOs are much better bragging fodder at the VC confabs than mid-market M&As, even though the latter may well pay off better. This would be a great master’s or Ph.D. thesis if one could substantiate and measure the value of this skew.

The second theory is a general theory for understanding why contrarianism, itself, is “meta-contrarian” (that is, why contrarianism is selected against as an investing style). I call this the “rich friends theory.” I use it to explain why, despite all rationality, U.S. investors tend to overweight U.S. equities in their portfolios. In a nutshell the theory is this: it sucks far worse to miss out on an investment opportunity that all your friends have scored on, than it does to miss out on an equally profitable opportunity that everyone else missed, too. Put another way, it’s awesome to get richer than your friends, but it’s way worse to get much poorer than them. Thinking of this “peer-relative risk aversion” helps to understand a lot of bubble / momentum dynamics. This, too, would be fascinating to measure, although I can reasonably set a lower bound here of 0.7% skew toward the crowd, which is the “rich friends tax” you pay in incremental house edge at craps by playing the pass line (the “do’s,” where most players play, has a house edge of 1.41%) vs. the don’t pass line (the”don’ts,” almost diametrically opposed to the do’s, where winning earns you enmity and losing earns you jeers from your fellow punters, has a house edge of 1.40%).

There’s also a case to be made that emerging managers hew more closely to the herd because it could be an existential crisis to a firm for its first fund to be a “fourth quartile” performer. Much better for a new firm to post median returns and live to raise more funds, than for it to risk lagging returns on a series of contrarian bets (better, that is, for the firm, if not for its investors, who may in fact be better served by the longer-shot odds). This is, of course part of the “tyranny of IRR,” about which I have another blog entry under preparation.

I wish I could say that understanding, or even measuring, these effects gives you some kind of instant edge in investing. But, alas, this is a perfect example of the occasional frustrating impotence of mere understanding. (I do have some ideas for exploiting this particular case, but those obviously aren’t public.)

The Washington State 529 Program (GET) Offers an Overlay

Monday, March 12th, 2007

Important update:

This was my take on things back in 2007, when it was published.  As of 2010, both my opinion and the math have sharply changed.  I revisit the issue in a new post.

State-administered “529 plans” for education savings are another in the series of tax dodges doled out by the Bush administration (thereby further and regressively lowering the effective rate of taxation on the higher-income people most likely to avail themselves of such dodges). (Sticklers will observe that 529s predate Bush; true, but their extra tax favorability is a post-2001 invention.) On the bright side, they offer quite a good deal if you can find an investment that keeps pace with college tuition (and you don’t need to worry about also beating the tax rake, since 529 gains are tax free when used for qualifying tuition etc.). You do have to nominate a beneficiary when you set one up, but you as the controlling owner can change the nominee at any time to any blood relation (and it can even be yourself).

There are two types of 529 plans: one is like a 401k plan and involves picking a retail investment or mix of assets; I’m sure someone, somewhere has done the analysis to pick out correlates of tuition costs, so if you can find that, maybe you should look at the first form. The second 529 plan is somewhat more interesting. In the second form, the 529 plan is actually selling you “prepaid tuition.” This kind of thing is normally a terrible deal: fronting money for something way in the future is generally a sucker bet, one made against the collected wisdom of armies of actuaries by not-sophisticated-enough retail investors with both informational and scale disadvantages. But I have a few reasons for believing that the Washington State 529 plan (known as the GET: see their web site) offers an overlay in certain circumstances.

1. Each state may offer either or both types of 529 plans to its residents. As it happens, a couple of states that have offered guaranteed tuition programs have run into trouble with the plans being underfunded and unable to meet obligations, according to this article. Although this might raise an alarm in some folks’ minds, to me it says that tuition costs have been rising faster than can be achieved by even the professional money managers hired by state 529 plans specifically to meet that hurdle rate. Therefore, I see it as a sign that tuition is in general an expensive thing to guarantee and that if you can get a reliable guarantee (see below), you are getting the best of it (until or unless a mean reversion on tuition growth rates vs. inflation occurs).

2. Washington’s GET program is (ostensibly) backed by the full faith and credit of the State, unlike other states’ 529 guarantees. In my mind, combined with the evidence of other states’ underfunding difficulties, that means the WA GET is a good bet to get bailed out by the State at some point in the future. (In general, any time you see something other than a plain vanilla bond backed by the full faith and credit of an American government, someone in the government got snookered or corrupted, and the public purse is about to make its counterparties rich: see e.g. the PBGC, the S&Ls, the Federal Housing Enterprises, etc.)

3. The index for the GET tuition price is the most expensive state university in Washington, invariably the University of Washington, located in Seattle, a thriving and growing metropolis which is well positioned to weather many economic threats and therefore in which prices and incomes are likely to remain high enough to induce the University to charge steadily increasing sums for tuition. (Although I certainly don’t think that the outlook for Seattle is monotonically ever rosier, it seems a much better bet than somewhere like e.g. Montana or Idaho, where relatively small disturbances to nondiversified industrial bases could result in stagnation at all state universities.) The University also has competition in town from a number of private schools charging full freight to their students, therefore establishing the viability of increased tuition at UW.

5. The WA GET program has a scam built into its marketing strategy: rich people can buy the tuition units at the “buy-in price” (see below), but they try to sign up poor people for a payment plan where they charge them 7.5% interest on top of the buy-in price. Whether this is morally appropriate or not is a separate issue; the fact that we can spot the fish (and we ain’t it) is good for us.

6. The big catch to the WA GET is the difference between the buy-in price and the pay-out value (the bid-ask spread, if you will). For the past few years, that has looked like so:

Year Purchase $ Purchase YOY % Purchase CAGR
1999 $35.00 NA NA
2000 $38.00 8.57% 8.57%
2001 $41.00 7.89% 8.23%
2002 $42.00 2.44% 6.27%
2003 $52.00 23.81% 10.40%
2004 $57.00 9.62% 10.25%
2005 $61.00 7.02% 9.70%
2006 $66.00 8.20% 9.48%
2007 $70.00 6.06% 9.05%
Year Payout $ Payout YOY % Payout CAGR
1999 $33.75 NA NA
2000 $35.19 4.27% 4.27%
2001 $36.42 3.50% 3.88%
2002 $38.64 6.10% 4.61%
2003 $45.31 17.26% 7.64%
2004 $48.63 7.33% 7.58%
2005 $51.81 6.54% 7.40%
2006 $55.05 6.25% 7.24%
2007 $58.80 6.81% 7.19%
Year Purchase $ Payout $ Payout Ratio
1999 $35.00 $33.75 96.43%
2000 $38.00 $35.19 92.61%
2001 $41.00 $36.42 88.83%
2002 $42.00 $38.64 92.00%
2003 $52.00 $45.31 87.13%
$57.00 $48.63 85.32%
2005 $61.00 $51.81 84.93%
2006 $66.00 $55.05 83.41%
2007 $70.00 $58.80 84.00%

Observations on these numbers:

  • 2003 saw a big bump in tuition and hence in both purchase price and payout values. This jibes with 2002 news reports of the same.
  • The payout ratio (payout $ / purchase $) has been declining steadily, but has recently hovered around 84%.
  • That said, WA GET is raising the price of purchase by 9% annually, while tuition has been increasing at 6-7% annually. If these two don’t converge, the payout ratio will get worse.
  • This supports a 6-7% tuition increase rate, especially because that makes the 7.5% interest on the payment plans accretive to GET’s situation.

7. The time-lag spread between purchase and payout makes sense only if you assume that college costs rise faster than the rate of return you can make elsewhere, adjusted for tax treatment. Assuming a fairly conservative 5.25% risk free rate and a 28% tax rate, the line crosses with 7% annual rising educational costs after about 6 years:

Years Held After-tax return risk free GET Return GET to risk-free %
0 $70.00 $58.88 84.11%
1 $72.65 $63.00 86.72%
2 $75.43 $67.41 89.37%
3 $78.36 $72.13 92.05%
4 $81.45 $77.18 94.76%
5 $84.69 $82.58 97.51%
6 $88.11 $88.36 100.29%
7 $91.71 $94.55 103.10%
8 $95.49 $101.17 105.94%
9 $99.48 $108.25 108.82%
10 $103.67 $115.83 111.72%
11 $108.09 $123.93 114.66%
12 $112.73 $132.61 117.63%
13 $117.62 $141.89 120.63%
14 $122.77 $151.82 123.67%
15 $128.18 $162.45 126.73%
16 $133.88 $173.82 129.83%

As you can see, given these numbers, it doesn’t make any sense to buy units for a teenager. You’re just going to get hammered down by the time-lag spread if you hold less than 6 years before redemption. Of course, it gets a lot worse if risk-free interest rates rise a lot compared to college tuitions, or if you’re paying more than 28% in tax.

However, if you think that college tuitions will maintain their higher growth rate relative to the risk rate, and if you can hold for well over 6 years, then you should strongly consider buying tuition in the GET. Why do this if you can get a higher return in a normal 529 in, say, the stock market? Well, remember that you need to beat UW’s tuition growth rate, and do so without a great deal of volatility. I’d be surprised if normal 529 plans let you use sophisticated tools like options to hedge against volatility.

I, like numerous others, believe that we’re entering a period of increased market volatility, and that if you can offload the risk of matching investment returns that are linked to a tax-free, inflating expenditure requirement to a full-faith-and-credit backed State obligation, you should seriously consider it.

Serious risks in this strategy include the possibility that Washington state politics will result in tuition increases that do not track inflation. Also, general mean reversion in higher education could threaten this strategy. I don’t think that there’s a lot of risk from falling behind a big run-up in equity prices that sustains for 15 years without a concomitant rise in inflation and tuition, but if equity returns beat my expectation and whoop up on tuition increases, you could stand to lose relative to a more traditional asset allocation. Also, waiting is not advisable; the bigger the gap between the purchase price and payout value, the longer you have to spend invested to catch up to risk-free.

Of course, remember that WA GET isn’t something you invest in for strict performance; it’s a way to cover a known expenditure requirement with lower risk. As far as I can tell, for periods well over 6 years (and ideally ~ 18 years, since you can purchase GET units naming yourself as a beneficiary and then transfer them later to your as-yet-unborn children), WA GET makes good sense.

VCs Are Not Your Channel (But They Might Be Your Friends)

Monday, March 12th, 2007

Occasionally I get calls from folks who get the bright idea that, since VCs have a bunch of portfolio companies under influence, they can leverage selling their stuff by talking to me instead of pounding the pavement to the whole portfolio.

If you’re thinking of doing this, remember that we (VCs) are not your personal sales channel into our portfolios! Consider:

  • VCs generally take a board seat at most; we influence our portfolios, not control them, and we do so at a fairly high and abstract level.
  • Most VCs abandoned the “incubator” model after the ’90s bubble; we prefer that our portfolio companies seek the best service providers for their particular needs rather than establish some sort of Gleichschaltung.
  • We ain’t in it for charity! We’re trying not only to build and sell our portfolio companies, but to seek out new deals, with new capitalizations, and to boldly go where no man has gone before! (er, sorry.) Star Trek aside, this takes up our time, so even if your shiny new product (or dreary old service) is really groovy for a portfolio company, unless it gets them to an exit or gets us a new deal, it’s probably best dealt via a different contact.

Now, all that said, there are some cases where using VCs for leverage into their portfolios does make some sense.

  • You have some particular specialized characteristics that suit one VC’s portfolio well. This could be a mix of geography, stage, domain expertise, etc., like, say, a life sciences IP law firm that caters to early stage firms in Botswana might find affinity with a VC with that same focus.
  • Your sale is at the board level. C-level recruiters come to mind (although this is emphatically not guidance for recruiters to start badgering VC board members).
  • You have some referenceability within the world of VC-funded startups. These people talk to each other, go to work for each other, and start companies over and over with each other. Your sales into big companies (even tech) or lifestyle businesses (even small “startups”) are not representative of what the experience with a VC-funded firm will be, and won’t necessarily reference well among such firms.
  • Your offering will almost certainly speed a company to exit at an excellent valuation (hint: you can’t, or else you’d be a champion VC yourself).

What should you do if you decide to make the pitch?

  • Do your homework — it’s fairly trivial in most cases to discover a VC’s portfolio and the specific investors (partner) on each board.
  • Use your homework — figure out which portfolio companies you have a great deal for, and make your pitch to the specific investor affiliated with that company.
  • Reference successes and, ideally, get referred in. Find other venture-backed companies that you did an amazing job for, and, if possible, get the CEO or VC board member from that company to recommend you. This would be the holy grail introduction.

I personally try to be helpful to decent and courteous sales / biz dev folks, but I think that reading and acting on the above is a bare minimum level of courtesy for sales / biz dev people talking to VCs.

More Evidence That Your Old-Ass Values No Longer Hold Sway

Saturday, March 3rd, 2007

I read last week in the Durham (NC) Herald-Sun this AP story, which unfortunately I now find linked only at the ghastly FOX News:

Today’s college students are more narcissistic and self-centered than their predecessors, according to a comprehensive new study by five psychologists who worry that the trend could be harmful to personal relationships and American society.

Of course, we can hardly see this without warning bells that it is a salvo in the ever-more-boring-by-the-day Culture Wars. But interpreted another way — freed from its pettily polemical underpinnings — it is yet more evidence that the Myspace values have taken over from the old-school ones that persons of so venerable an age as my own (27) may yet hold. Self-promotion is no longer vice, but virtue. Narcissism, manifested through incessant working on of one’s own profile and pictures, is not the domain of a few egotist introverts but is every barista’s and coed’s pastime.

Reflecting on this shift during a week in Key West reading some of Papa’s value-challenging works on the Lost Generation was interesting. (I will not say enlightening, as the mind-addling effects of the State of Florida tend to preclude enlightenment while in the Sunshine State.)