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Lopsided Barbell of bank credit

At a fascinating macro talk this morning by a Goldman Sachs strategist, he mentioned a “lopsided barbell” of credit.

To the biggest firms with the best ratings — think IBM or MSFT — money is basically free, with coupon yields at sub-2%.

But to middle-market (say, $100M – $500M sales) and lower-end of middle market (let’s say $20M – $100M) companies, bank credit is simply not available at any price.

Interestingly, this week at a discussion with some regional commercial bankers, my partner Andy Sack heard gripes from the loan officers about extraordinarily tight credit conditions for single-digit-millions size facilities. (Of course, loan officers always gripe when “the credit guys” say no, but it’s worse now than usual, and importantly, not much better than 2008).

So: until or unless the big banks stop getting money for “free,” they’ll be quite content to sit on it and/or plow it for nearly-free into premium credits in large deals.  Don’t expect small business credit to loosen up until, paradoxically, rates have risen somewhat.

(Don’t expect us to have that problem over at RevenueLoan.  We’re funded by private equity investors specifically to prove out the royalty/revenue-based financing model, so A. our money costs us “private equity rates” and B. we’re on a mission to fund small businesses!)

RevenueLoan meets Disneyland, capitalism, America, and God.

A family trip caused me to end up at Disneyland, the old-school Anaheim original, on the day of a Disney-sponsored half-marathon. (The surreality of that event, with its mouse-ear-bedecked joggers and tutu-clad princesses, could merit its own blog post.) But what got me thinking the most was a sight from after the race, and it made me realize just what an awesome opportunity our team has at my new startup, RevenueLoan.

Our party of runners (not me!) and fans stopped for some post-run hydration, and I happened to stand in front of a racing wheelchair owned by one of the rolling half-marathoners. As I looked it over, it was almost unrecognizable as what the word “wheelchair” brings to mind: this beaut was customized, with super-narrow
aerodynamic form, racing bicycle-style brakes, and sharply tilted, carbon-fiber mag wheels sporting slicks. What’s more, various of these clearly purpose-built parts, including and especially the specialty, high-end components like the carbon fiber wheels, sported the brand names and logos of their manufacturers.

Seeing the brand logos of these specialty components, a single thought, immediately and unbidden, came to mind: “what a shitty, small market; there can’t be more than a few tens of thousands of these units to be sold worldwide.”

A second thought followed almost immediately, as my conscious mind caught up to my knee-jerk initial thought: “What the hell are you thinking, Randall?  That’s a shitty and broken way to think about markets, business, and the world.”

Let me be clear: there is nothing shitty, or small, or unworthy, about a business that makes a great and unique product, that generates customer love, and that manages to turn a profit. No. Hell, no! In fact, I would venture to say that such a business — regardless of total market size, with a lower bound of recouping its owner’s living costs — is the very telos of the free market system, the raison d’être of capitalism.

I’ll say it again: the very reason why capitalism is justifiable, good, and to be maintained is precisely because it brings us miracles like self-sustaining inventors and producers of wheelchair racing components.

My knee-jerk “small market size” dismissal is a pathology easily traced to the years I spent in traditional venture capital. While I’m proud of several of the companies I worked with, and many of the people I knew, in the VC industry, I’m downright ashamed at the conditioning effect my work there has had on my thinking.

It’s not necessarily a conscious moral failing of the VCs: any industry or business that valorizes one category inevitably does rhetorical violence to those outside that category. Salesmen have “deadbeats” who never close, doctors have “GOMERs” (Get Out of My ER) whose symptoms don’t merit further treatment, and pit bosses have the “small fry” of the low-stakes bettors. The more self-actualized VCs might protest that they see and recognize the need for small-market-size businesses, but the plain fact is that if you spend 50+ hours a week rejecting those businesses, you are training and wiring your neurons for disdain at a deep level.

No, it’s not a moral failing, but an arithmetic one: Fred Wilson has expounded on VC Math, and my former Voyager colleague, Dan Ahn, is fond of noting that he is being paid by his investors to make 10x home runs, not 3x bunts and 2x walks. Fred and Dan are right; VC as an asset class, as it’s been run, is a necessary part of well-functioning entrepreneurial finance markets, but it demands a certain immutable probabilistic rubric: bigger returns, infrequently realized.The gap, then, that VCs leave below their market-size threshold, and that banks are loathe to touch without hard collateral and personal guarantees, is a gaping void. This is the void of financing for non-venture, non-brick-and-mortar businesses that stares back at some of the best and brightest of American capitalism (and convinces many to turn away). Pace, Geoffrey Moore and colleagues, this is the new “chasm” of the 21st century, and if I may have license to be so bold, it is the challenge of capitalism’s next chapter in America. And it is this segment of businesses — the “tweeners,” beloved by customers but shunned by financiers — that my team at RevenueLoan has the unique opportunity to embrace and to serve.

Lloyd Blankfein, take a hike: it’s RevenueLoan, not Goldman, who’s really doing God’s work for the businesses that are America’s promise and future.

(Wow. Over-the-top, God-and-America talk aren’t my usual style; cynicism, punnery, and Steely Dan are my usual stock-in-trade. But I guess this is what happens when my observations, my passions, and yes, my personal financial interests, align.)

But seriously. Once upon a time, we needed our creative obsessives, our ambitious organizers, our painstaking engineers, and our masters of persuasion to pull together in only the largest of endeavors. Anything less than a well-funded corporation, with capital in the eight-to-nine figures couldn’t possibly build a railroad, a refinery, a department-store chain, or a sophisticated manufacturing operation. In short: twentieth century entrepreneurialism was enabled by, and shaped itself to the demands of, nineteenth-century capital.

Today, though, we live in an economy driven by choice. We’re (ostensibly) wealthier for it. That choice, that variety, is a function of more flowers blooming and more companies thriving, not of more capital pumped into the same few firms. We must not let the promise of capitalism in the twenty-first century be enslaved to the death-throes of the models of money-management of the twentieth. In fact, the smaller overall capital requirements for launch and success mark a shift in kind of investable company, even from the 1980s-1990s model of “minicorp” to a true “microcorp” model (hint: imagine that finance is 30-40 years behind the computing industry, which it probably is, and consider that the merchant-bank to VC change is the parallel of the mainframe to minicomputer shift of three decades prior).

The naysayers whose only refrain is “Made in America!” ignore the fact: Lenovo buying ThinkPad from IBM was not the end of American export manufacturing, but a shift in what we create for export: America now invents IP, brands, and reputations. And to keep up with it, the answer isn’t to throw in the towel on education, and demand that we artificially keep a manufacturing underclass on subsistence wages in domestic maquilladoras, the way that some (I suspect disingenuous) progressives seem to want. No, the answer is that we as a nation and a people must step up to the standard of living we have chosen, and we must better ourselves, an individual and a family at a time.

Economically, this is by serving the wants and needs of our fellow man, tabulated and calculated as best we know, via the free market. And it should not be limited to serving the imperatives of inflexible, legacy forms of concentrated capital that blindly chase scale and eschew invention.

I’ll say it: a slightly cheaper T-shirt does not improve the world.  Just-in-time manufacturing is a gimmick. Raping a city’s tax revenues to subsidize yet another bread-and-circus stadium is theft or worse. “Better” derivative trading of interest rate swaptions or forex futures does fuck-all for peoples’ lives.

But having racing wheelchair parts means a hell of a lot for athletes in wheelchairs.

And it means a hell of a lot to the guy who makes ’em and sells ’em.

And if NYSE, NADSAQ, VC, PE, BofA, and “C” can’t help them — then who will?

That, my friends, and my patient readers, is why RevenueLoan is important. We get to make it happen. And we will.

The Secret Trick of Portfolio Effect Dominance

Smart-as-a-whip VC Sim Simeonov did some math and some simulations and came up with the conclusion that a large “portfolio effect” has a major, almost overwhelming, effect on the financial returns of e.g. angel and seed VC portfolios.

English translation: make a LOT of small bets in order to win. (Even if most of those bets are losers.)

Now, this sounds somewhat counter-intuitive to a lot of folks who have been trained to “think like investors:” after all, the more deals you do, the less of a special snowflake you must be, right? (And we all know, Private Equity Professionals are the Specialest Snowflakes of All.) Furthermore, doing more and more “losers” in order to scrape together more winners (rather than trying to avoid losers altogether) just grates the wrong way at the investor mindset.

Well, Sim Simeonov has rejected that mindset with his Simeonov sim. (Forgive me.) But the point of my post isn’t just an emulation of Sim’s simulation. It’s that he’s right despite his simulation math. Rational VCs should be doing as many deals as possible, true, but it’s not due to portfolio IRR; it’s in spite of IRR.

No, the real reason that rational VCs should be doing as many deals as possible is that, to a large extent, VC firm survival has been dependent more on appearance than on financial reality. Specifically, assume two similar firms on their 2nd or 3rd funds, and assume they both, 5 years in, go out to raise funds with a 20% IRR. However, Firm A has earned that IRR through a risk-averse, lower-beta type strategy, while Firm B earned that IRR with a much larger “shotgun” portfolio chock-full of duds, but with a tiny sliver of a Google or similar mega-hit. Which firm is going to be able to raise the next fund with more certainty?

How things have worked to date is that LPs fall in love with great stories, and so it’s more important (in general) that you have one great story in the portfolio (even if it’s for a small investment) than that you have a bunch of sleepy, boring stories that average out to the same return.

Now, I’d love to see what savvy upstream investors like the Super LP, for example, think of this theory: it’s certainly not very flattering to the LP community if you suggest that they make investments solely on “stories” and not on “math.” In the LPs’ defense, I don’t think they’re being lazy or stupid; on the contrary, for the first several decades of the VC industry’s life, the market was so inefficient, and the data were so very sparse, that “stories” were the only reasonable data to look at.

However, we now have a VC (and super-angel, and micro-VC, etc.) industry that is chock-full of history, overflowing with data, and crowded with participants in the marketplace who will (relatively) quickly compete for new niches (especially as the squeeze of a denominator effect and general anti-VC enantiodromia are felt). I no longer feel as strongly as I once did that we’d soon have algorithmic VC decisions, and I doubt that we’ll see a “robot uprising in venture capital.” But I do hope and believe that we will see a more disciplined industry, and one where VCs’ incentives get rearranged to align better with actual financial returns (rather than with “stories” that drive fundraising).

(I do happen to know that there are institutional investors who realize the “great story bias” and are seeking to exploit the inefficiency it creates… let’s just say that if you were going to exploit it, you might look quite hard at Revenue-Based Finance as the way to do so 😉