Capital markets commentary « discourse and notes

There are three ways to fit a square peg into a round hole. The peg may be circled, or the hole may be squared, or both the peg and the hole may be reshaped in some other way to fit with one another. A fourth tactic, that of brute force, whereby the peg is plowed through with a heavy hammer, is in actuality the same as any of the three listed alternatives, from which there is no escaping. Though none of this is news, I bring it all up now because of developments in venture capital and the startup scene.

To clarify the analogy before proceeding to developments, the conceptual misfit is this: Startups are high-risk undertakings (perhaps the highest-risk there is) and these have been financed within a highly illiquid asset class. A volatile operation is thus supported by rigid funding parameters. The issue is not only one of duration – as has been discussed in this space before – but also capital efficiency. That is to say, funds should flow to their most optimal uses in an environment where those best able to assess and mitigate risk most efficiently price it. In an environment in which the nature of the risk is fluid, the funding mechanism should ideally be liquid.

The puzzling over inconsistent venture returns in the past two decades of digitally fueled innovation can (to a large extent) be put to rest when the environment is framed in this fashion. The only time when the segment (as a whole) produced returns commensurate with its risk was the time when market liquidity – rightly or wrongly – supported the concept. That the support happened to be in a late-90s bubble is only pertinent to present discussion in that the bubble’s rupture caused liquidity to disappear. But liquidity does not only happen in bubbles, and is not always necessarily financial. We are beginning now to observe certain trends which bode well for the venture investing climate. In addition to financial liquidity enhanced by new markets and new information mechanisms, we now begin to also see operating fluidity, which is just as interesting.

As the round hole, in other words, is getting squarer with improved liquidity in a previously illiquid market, the peg that passes through is becoming rounder through a mechanism commonly known – and increasingly accepted – as the pivot. For those uninitiated in entrepreneurial lingo, to pivot is to change the direction or even the very nature of one’s business undertaking, sometimes (but not necessarily) leveraging technology or other assets created to that point. Because of the relatively low cost of building a web-enabled technology platform nowadays, and because of the relatively high density of ideas and inspiration sources, one may change course, as it were and almost literally, on a dime.

The effect of the phenomenon – observed all throughout the continuum from the earliest seedlings to the highest-profile sensations and back – is that in essence the liquidity of a venture investment is now determined as much by external as internal dynamics. When the business you buy today becomes another business entirely next month, it is as if you only owned the first business for a month before exchanging your investment for another. This, to repeat the point, is a new form of financial liquidity, and it may be in some ways as real as the more conventional kind of selling the position outright. (Cash does not change hands, true enough, but the optionality is extended, maybe enhanced, and cash is at least in theory an accounting entry only – it gets used, it is spent, converted or invested, it rarely just is.)

All else equal, the depicted landscape should serve to improve venture returns or, at the very least, the opportunity to achieve these. But all is never equal, and all is also a function of what is priced into valuations and how far ahead of or behind fairness these might move. As fairness is mainly a matter of interpretation, perception, and academic study, the market – which contains all of that and more – will give its guidance surely enough. Until then, we bear witness to a changing equilibrium of uses and sources that now complement one another with something that approaches elegance.

A fellow once wrote this: “We are what we pretend to be, so we must be careful about what we pretend to be.” He was a clever fellow, prolific, argumentative, a blogger in his way, (but who isn’t?). He died, alas, before this medium really took off, and anyway, he was probably more of the typewriter variety. So it goes. The cited wisdom could be applied to many a context, some of which may have been imagined by the author, but for some reason it currently makes me think of the media sector, which nowadays comprises many things, (more below).

I am thinking that media, as a general category of industry, is uniquely positioned to report upon and conduct its own assessment. A sector populated (and even defined) by carriers of the message – bloggers, analysts, researchers, marketers, advertisers, publicists, podcasters, broadcasters, journalists, tweeters – can shape the message and define itself with few checks and balances. Any such controls would necessarily also come from within, from other carriers of the message. The situation is a little bit analogous to, for instance, Michael Jordan calling his own fouls. Some secretly suspect that this happened all the time. So too with media: A sector that gets to call its own game. What luck.

But not really. One could argue, in fact, that this is a misfortune. To illustrate, let’s take a scenario of a different type from that of an arbitrary calling of shots. Take for example, software code. Putting aside qualitative aspects like programming efficiency and elegance, in a very fundamental way the code either works or doesn’t. This is a binary condition that cuts to the truth of the case very precisely, so that a syntax error could throw the whole thing off. In one way of looking at it, and as painful as such a process may appear, this binary precision is its very beauty and is the trait that gives it lasting value. On the other hand, when one gets to define one’s own reality freely, that is where true anxiety lies. (The concept of anxiety and freedom is not new, “we are what we pretend to be, so we must be careful about what we pretend to be.”)

Now, media is a vast universe and getting vaster. Not only is this true in the sense of new technologies and modes that have entered the domain and continue to enter – mobility, interactivity, data and its assortment of branches, security, artificial intelligence, and others – but also in terms of enriched applications. As has been contemplated in previous articles here, the segment also comprises capital markets – perhaps this was always so (the example one likes to use is Bloomberg, media or financial technology company?), but now maybe more obviously than ever – and this is where the notion of self-reporting takes on a more than philosophical turn. We see, for instance, Facebook preparing for an IPO and we assess the opportunity on the basis of opinions and analysis often disseminated through… Facebook.

The circularity is wonderful, and so is the snowball effect that sometimes perpetuates. In certain instances the snowball becomes a bubble that pops, and sometimes it grows like any rolling snowball. Sometimes, as well, observers get swept up by the rolling mass and cycle through it actively, perpetuating whatever fashion the sector’s trend-setters-cum-trend-reporters lead. When in rare instances an industry observer is able to step out of the cycle and look upon the scene with a fresh and distant perspective – such as, for example, Peter Thiel in his current lecture series – the experience is refreshing to the point of being almost hypnotic. (Perhaps this is so because of the nearly mathematical logic and clarity of Thiel’s overviews, and the feeling one gets that maybe he isn’t even “talking his book.”)

But precisely because of expediency and improved efficiencies enabled by the technologies now residing in the media domain - mobility, interactivity, data and its assortment of branches, security, artificial intelligence, and others – we should not have to rely on rare instances of individual vision. Because of digital technology and its binary sophistication, in short, because of coding, we should be able to diminish the anxiety of the free flow. In other words, the opportunity exists, in capital markets and in media – which have become increasingly synonymous - for information flow to be optimized, scrubbed clean, and made useful. That, ultimately, will be the dominant and lasting value-proposition of our evolving field, and it is the direction in which the sector is heading.

I miss the old-fashioned investor. Long ago, when I was newly minted, I catered to a retail clientele. A market-leading mutual funds organization, when this market was still small, saw fit to hire me and round out a class of youngsters staffing up its service center. I sort of knew how to brush my teeth, was then experimenting with my shoelaces, dabbled in some other stuff, mildly incidental to the job. This résumé was acceptable enough. The risk that came with it was diminished by the product being mutual funds, and by a branch manager who hovered like a cloud.

We had a regular guest back then, I don’t remember his name but let’s call him Mr. Blenderbonder, a retiree. Once every week or two Mr. Blenderbonder walked in to check on his portfolio and ask us what was “hot” that day. To be clear, these were mutual funds; as many of us now know, mutual funds are diversified portfolios of securities, designed specifically to not become hot or cold, but to be diversified. So we used to tell Mr. Blenderbonder about whatever fund of ours was receiving the most press attention or brochures from the marketing department, really for lack of a suitable response. “Put me in!” he used to say. (I can never forget that: “Put me in!”)

The manager would talk to Mr. Blenderbonder, and probe to see if he really thought it a good idea. Sometimes Mr. Blenderbonder changed his mind, other times not. Sometimes he lucked out – his account value tweaking up a notch – and sometimes he did not. He would come back to transfer the money into some other “hot fund” – Put me in! – which sometimes we talked him out of but were at other times unable to – the man insisted. I don’t think Mr. Blenderbonder cared about the actual performance, truth be told, as much as he did about the activity, about sitting down with us to dissect the market and his most current perspectives. And by the same token, Mr. Blenderbonder was shrewder than we (youngsters) realized. He knew what he was doing and he knew his limits. His swashbuckling gambits rarely took him out beyond some no-load bond fund or another.

But this was a very long time ago. This was before LTC and sub-prime and Bear and Lehman and the inexplicable flash crash; before hedge funds and high-frequency trading; before, in short, the sophisticates took over. Mr. Blenderbonder, according to reports, has gracefully bowed out, alienated in many ways from the investing ecosystem. The structures and the mechanisms are too complex to suit the retail fancy now, and the pace of flow is too enormous for him or her to fathom. This is speaking figuratively, of course, Mr. Blenderbonder does not in actuality exist. But there is a category of investors out there – I know there is – who would participate constructively in the market if they could comprehend and trust it more. There is a category of investors who would simply like to deal with finance on a human level, and whose renewed participation would make the market more efficient.

There have been many reasons offered for the recent pickup in activity and valuations in the angel and seed-stage investing field. For the most part, these explanations have had to do with diminished entry costs, quicker exits, and flashy exit values. Some of these explanations are more valid than others, but none of these takes into account the human factor: The angel markets (and venture capital) are among the last remaining bastions of purely human interaction in financial capital. These are fields in which investor and investee can still be old-fashioned and deal with each other like people rather than volatile data. One meets with another directly, says “put me in!” and comes back a week or two later to see how things have been going. One gets to posture, spin, digress, and all such things for which people are beloved.

So while it is true that cost and exit economics have played a role in this private finance realm, perhaps these are not so much root cause as fortuitous circumstance in an evolution that runs parallel to an otherwise mechanized and increasingly concentrated institutional landscape. The JOBS Act, in this way of looking at matters, is not so much a catalyst as a natural reaction. And those who are worried about risks to the “small investor,” as he or she dabbles in venture-stage platforms, need not be overly concerned: Remember that Mr. Blenderbonder was savvier than he got credit; and the fat finger, after all, belonged to someone else.

Employment, partnership and investment are all variations on a theme, each blending elements of the other in varying proportion. To clarify the point, investment does not refer to trading, just as the notion of employment in this generalization doesn’t take economic terms into account. But even factoring such caveats into the discussion, we really are dealing in matters of degree, and one way or another these roads all take us to forms of partnership, more or less loosely defined. Not all partnerships are the same, not all have equal durations, not all are based on similar principles, but generally there is a theme of codependency. Employment, partnership and investment are all variations on this theme, (more or less loosely defined).

In matters of finance and markets, there is no better laboratory in which to observe the described notions than the world of entrepreneurship and the sources of capital that support startups through their maturation. In matters of codependency and partnership, this is a frame of reference from which all other samples (at least in finance and markets) may be judged. But for this very reason, because the bond of partnership (good or bad) is so strong in these private-capital instances, these are transactional scenarios that must be looked at through a different lens from, say, the mere purchase of shares – even if in a large block, even if in the outright acquisition of a company. In public trade, the “partnership” can be dissolved with the click of a button, and in buyouts the acquiring entity assumes control. Codependency, in the sense intended for purposes of this discussion, is in its purest state in venture capital as it relates to entrepreneurs.

In this universe of activity, spheres of influence combine to add value to the whole, or otherwise diminish the same. Strategy, direction, good or bad, are shaped as a result of such combinations. Even in scenarios in which investors are entirely passive, this too sets an important tone and drives a certain course when a new enterprise is groping its way through volatility. In other words, matters of chemistry in this universe of activity take on more than academic stature, and the success or failure of ventures is not independent of the compounds thrown into the mix. More, the way in which elements combine takes on an added level of importance in financially illiquid asset classes – recent developments in secondary markets notwithstanding – where the principals have often to climb or sink together, and it may take some time to arrive.

These subjects came to mind on reading some of the back-and-forth the other day between venture capitalists on the subject of venture capital scalability. I had already been set up to think about these things several days before, when on one hand a very large venture group was profiled in an article about the host of services it offers to its entrepreneurial targets, and on the other a prominent seed fund described new efforts to build and launch its own new businesses (rather than merely fund others to do so). All of these angles considered, in addition to the previously described assortment, one begins to see that early-stage private capital is not financial but rather strategic capital, defined by elements of partnership that are no different from most such forms.

In this way of seeing the world, it isn’t only the business idea and the quality of the entrepreneurial team that determines success or failure of new ventures, and it isn’t merely the funds raised to support execution of the same, but rather all of that and one thing in addition: Hitting on the just-right catalyst in the codependency that is formed between the parties, which may or may not be a matter of luck. In any case, thoughtfulness and planning (on both sides) will certainly not hurt the odds.

Information asymmetry is a slippery subject. Pinning down information and its meanings is as difficult sometimes as determining the correct placement of the line between symmetry and asymmetry. These are complex and heady debates, and where years might be spent in chatter and Nobel PrizeÂ grantings, markets tend to settle issues more gracefully. This is why we love markets so very dearly, among other reasons: There is brevity and insight in markets that are as elegant as any minimalist design.

But even if markets in whole are thus, the quality is based on an aggregation of points more or less “with it” than others. An analogy could be drawn to a large ensemble – thousands of voices in unison, creating harmonies and effects – reduced to grotesquery when the singing stops but for a handful of tone-deaf dudes who haven’t finished their notes. The underlying mess exposed, we have to reconsider the music. But we shouldn’t, because the performance was complete and unified enough. So too with markets, even when they appear to break.

There is no better laboratory in which to observe the described themes than the market presently shaping to facilitate secondary private trade: A market built around asymmetry, where sellers possess information that buyers may or may not have. When a leading platform in this field is forced to substantially reduce staff because one position (out of dozens) is being passed off to another exchange – where, as it happens, information flows more efficiently – this makes us consider the method of markets and wonder. Seeing one piece of a much bigger whole, we are also witnessing an organism in action, where capital flows into its most efficient channels.

With organized secondary private markets, an attempt had been made to bring efficiency to an otherwise illiquid frontier. The emphasis, as this was initially coming together, was on capital formation and the accumulation of sources into a new arena for minority stock positions. We’ve learned, however, that this is a tall order when dealing in uneven information, and volume patterns in these private fields have gravitated to the one crumb of knowledge around – the prospects for an IPO – which is a path to efficiency, liquidity, and a more symmetrical direction.

More than any academic analysis, markets are thus teaching lessons (that we probably already knew): Capital and information follow one another in harmony, and both tend to flow to where the stream runs deepest. And if recent events, as described, are highlighting any one thing in particular, it may be that in the duality of capital and knowledge it is the latter, more than the former, that leads. If so, then capital markets are and have always been segments within media and telecom, which is a point suggested in this space before.

There is a double misconception that financial bubbles are bad and that these are caused by naive excess. In the first case, it isn’t the bubble per se that is devastating, but its eruption. Recall that we didn’t mind it in 1999 and 2006 so much, but we refer to these eras derisively after the fact. Note also that eruptions may sometimes happen even in the absence of bubbles – reflecting on 1987 and 1989, for instance – and maybe there were bubbles we just don’t think about, or were not aware of along the way of market history, undetected in the absence of a burst.

The second misconception (naive excess) is caused by a flawed emphasis. The way up and the way down are both fueled by excess, at least with hindsight, but it isn’t necessarily an issue of naÃ¯vetÃ©. The capital going in and coming out of markets during bubbles and bursts is very largely sophisticated, at least this was the case in the most recent bubble that erupted. Such capital is not easily hoodwinked, but it is highly concentrated and sometimes the various pockets move in concert. It is an excess of herd, perhaps, of fear of missing out, maybe, but this is notÂ naÃ¯vetÃ©, this is more like turning a blind eye.

Whether we speak about dot-com public stocks, subprime real estate, or seed finance for startups, the technical definition of a bubble would be a financial environment in which market values far exceed economic fundamentals. The air in between one and the other is the bubble; but really, who is to say? Fundamentals are so hard to estimate in isolation, and the calculation can be deceptively circular. In a liquid market, capital costs decline and customers spend – both fundamental value drivers that fully reverse course when bubbles pop. Causality is fickle.

So rather than speak about bubbles and bursts, let’s think of the described phenomena as market irregularities, and rather than speak of excess, let’s think instead about concentration. When you get down to brass tacks, as the saying goes, the described phenomena go hand in glove with market inefficiency. What some of us learned when we were little financiers in the schoolyard, feisty and bright-eyed, playing schoolyard games of portfolio theory, weighted average capital cost, discounted cash flow, option pricing, and the like, were fundamentals based on a more or less efficient marketplace… whichÂ presupposes diversity: It presupposes a large universe of willing buyers and sellers with a multitude of opinions and risk tolerances and conclusions drawn. It is a mosaic rather than a homogenous mass. When the mosaic is diminished, when fragmentation is replaced by concentration, market efficiency suffers, and one potential consequence is that which is referred to as a bubble, with hindsight, because it has burst.

Now, this is all looking back, and we have reason to look forward. The market is smart, and while one might lose faith in this organism from one day to the next, one shouldn’t do so for the longer term (loosely defined). As parts of the market were moving towards concentration, with the consequences described, other parts have been conspiring towards an offsetting effect: Technology, consumer habits, and now also the regulatory regime, have almost in tandem progressed towards a democratized flow of information and capital, made possible by social networks and the evolution of transactional media.

The importance of this evolution cannot be overstated, and even as many have correctly flagged increased risks of fraud and bad decisions in a more open environment, the remedy for such concerns is in significant ways already built in. If knowledge is a gating variable that stands between sound and unsound decisions, the suggested progress, based as it is on information access, should bring down barriers that stand between “sophisticated and unsophisticated” investors.Â Some of these themes, and others, are illustrated in a new CoRise overview aboutÂ democratization of markets and the convergence of finance and media. It’s a market trend that bears watching.

A buyer is offered two items: an armchair and a formula. The armchair is used for sitting, storage, cushion, obstruction, place-holding and decor. The formula may be applied to some of these things. It might never be useful at all. It may be used destructively, but that isn’t fully established. There will be experimental uses, retroactive uses, multidimensional uses, limited and unlimited uses, and so on, and one day the formula may even become an object with cushions and other practical nicknacks. Maybe one day the formula will turn into the most valuable armchair in the world. Whereas the actual armchair, the one that is offered, will never be that, or if it is, its price reflects this special status.

In digital media – and all media is digital now, even the media that isn’t – there are many formulas and few armchairs. Even the armchairs are formulaic on inspection, which is to say, these may turn into something else before long, or may become extinct. Without putting too fine a point on the notion, in this volatile and transformative segment most value is option value. That’s an exaggeration, but we are speaking relatively. Take Google, for instance: Is it farfetched to consider that its search mechanism may not be favored by the world in perpetuity? Is it possible even that search as we know it will change in a matter of years? Can we say with precision that Google will always be a search platform foremost? Google, in this manner of speaking, is more formula than armchair, its ample cushions notwithstanding.

And that’s Google, one of the world’s dominant. Think of the wannabes, Twitter for instance. But that isn’t even the best example, that one is sitting pretty, all things considered. Think of the startups trying to goÂ where Twitter is, and maybe someday Google (in its prime). And think of the poor buyers and investors as they look into this hodgepodge of formulas and no armchairs. When I say poor, I don’t mean this in the literal sense, there is more dough in the petty-cash box than there are hashtagged tweets out of Austin. And that is a lot, that’s enough to buy every platform in attendance at #SXSW plus every idea dreamed up there in moments of enthusiasm, at a premium to satisfy every liquidation preference several times over. They call it cash hoarding, you know, for a reason.

But when somebody evaluates a formula for purchase, the evaluation can’t be like when we are buying furniture. One can’t sit on a formula, bounce into positions, unzip a cushion or two. When buying formulas, it’s the idea that matters, the way that it fits in the context of others, the ways in which context evolves with time. There is strategy to consider, there is changing circumstance, there is competitive response and new competition, all manner of predictable and unpredictable variations. When price is heavily predicated on option value, evaluation is hard for the buyer, hard for the investor, and hard for everyone in between. Armchairs are easy, is what I’m saying, but armchairs are a thing of the past.

These observations, like so many others, are traceable back to capital and its behavior. When volatility is high, so is option value, but costs are best held in check: Thus, note the cost control emphasis in the new business paradigm. When the landscape is fluid, so is opportunity: Note the expanding entrepreneurship motif in the broader economy. When the environment is constantly transformed, it is best to monitor and study, and to treat investment with greater discipline and care: Note, thus, the previously mentioned cash hoarding; note also theÂ diminished average acquisition-size in key digital and technology sectors. When traveling as though on waves in choppy water, it’s best to know how to adapt and maneuver, how to avoid riding a single wave down to the ocean bottom.

In short, the most efficient capital in present circumstance may be intellectual capital. This requires work, and it is never-ending. The armchair metaphor was picked here for a reason: It’s best these days not to sit around much; one may find oneself relaxing on a formula, thinking it might be a cushion.

Match-funding was the subject here in the previous entry. The idea was proposed that the matching of an asset’s life-expectancy with a funding source of similar duration is as applicable in technology investing as in, say, inventory finance or plant and equipment. It was suggested, however, that different technology types have different life-expectancy, while institutional funding sources for these – at least in the early stages – are fairly uniform in their term. For purposes of this discussion, technology refers to digital media and related software, hardware, applications and services; and funding sources are venture capital and its derivatives. The issue is one of technology obsolescence, innovation and evolution that happens at different rates, more or less rapid, and the mismatch this might cause for funding sources based on standard multi-year horizons.

This was all heading in the direction of explaining low venture capital returns in the past decade (as a general category) in terms of more than over-supply of capital – a quantitative discussion – by also introducing qualitative aspects.Â Increasingly as I consider these themes, I arrive at one of two places. Given that long-term hold-periods are most appropriate for long-term assets (match-funded), in digital media this lends itself best to networks and network-related businesses. As discussed in previous postsÂ here and there,Â these have shown great resiliency, even as circumstances changed (and continue to). These businesses have been the ecosystem in which new modes may or may not thrive, while networks themselves survive (in one way or another) the technical transformation. Perhaps not surprisingly, the venture funds with the top returns have been those highly weighted in these categories (thus match-funded).

Conversely, shorter-lived technologies should be matched up with shorter-duration capital. Perhaps this is a function of exit timing, but not all exits are the same. Businesses most likely to be independent – and in a fast-paced innovation environment this also means those most likely to transform and readapt with time – make more appropriate IPO candidates (or candidates for other secondary market exits). The others should be sold to a portfolio aggregator – which is to say, a strategic acquirer that is best suited to combine and diversify platforms – realizing that certain technologies will withstand the test of time for longer periods than others and accepting the risk in a portfolio system. Such acquirers, given their size and resources, will also be best suited to evolve with changing technology trends, and the acquired platform might thus be best positioned to optimize its value.

Regardless of the profile and alternative, however – and the complexity of issues and options far exceeds the summary presented – the idea of matching asset life-expectancy in technology with its proper financing model is an idea that warrants much further consideration. It isn’t clear that the startup ecosystem is as evolved in this regard as its more mature corporate finance counterparts, but the basic tenets of corporate finance apply to startups as much as mature companies. This is especially the case in an environment in which the distinction between one and the other is blurry at best, and arbitrary at least. As I wrapped up the prior post: Not all early-stage businesses are equally early, not all mid-stage ventures are equally in the middle, and not all exits are mature. By the same token, not all multi-year commitments are equally appropriate.

All the innovation in the world doesn’t change fundamental corporate finance. We may not value some assets the way we once did, we may not always have revenue to compare or cash flow to multiply, but assets are still governed by asset rules. We just have to look at it that way, which is to say, we have to remember that we are dealing with assets. For instance, assets have finite lives – it’s only a question of how finite – and between now and then assets depreciate, amortize, or deplete. Further, assets are funded with liabilities, and it is best for the two sides to overlap. Back in the day when corporate finance precepts were based on a greater vocabulary than Series A and IPO, there was the notion of match-funding. This had to do with the term of liabilities (not to be taken literally as debt only, but any financing) as corresponding with the life of a given asset. The two went hand in hand back then, and theoretically still do. We only have to look at it that way.

To transport these old-fashioned concepts from the era of leveraged buyouts and inventory cycles and working capital management to the new era of innovation and Series A rounds, we should begin by thinking of apps and technology solutions and websites as the new inventory and working capital and so on. Like inventory, like property and plant and equipment, like accounts receivable, the new apps and sites and technology solutions are assets with finite lives. For instance: the mainframe, the disk, or the walkman, or for that matter the physical book, the TV network, the web portal. In some cases the asset manager, as it were, has been able to reinvent or introduce new assets – IBM being an example – and in other cases this is less so. (Because of technical obsolescence in particular, such assets have typically been funded with equity, the murkiest and least rigid of the liability classes, where liquidity is a matter of secondary sale rather than repayment.)

From this synopsis, which is limited although extensive enough to get us going, we derive several themes: Different types of technology solutions and apps and sites have different (expected) lives; some owners and operators are able to extend the lives of some assets, and others are not; some owners and operators manage a better portfolio than others, knowing how (and when) to acquire, exit, reinvent, transform and such things for which Apple is a good case study; and the match-funding of assets is, at least theoretically, based on a liquid equity profile that is as long- or short-lived as a given situation warrants. From these ideal roots to the reality of actual branches – characterized by frenzied innovation, funded privately and not necessarily efficiently – there are a few disconnects and rough patches worth noting. Here are some, just to get going:

Entrepreneurs and their funding sources alike often talk about differences between products, features and businesses – in the context of startups and the prospects of these – but not so much about life expectancy. In this regard, there are substantial differences in profile. Some technologies – security software, for example, which gets hacked over or otherwise rendered old fairly quickly – might have a limited term to maturity, as it were, while a network asset – even MySpace or Aol’s dial-up service – is likely to linger around and sustain repeated beatings. It isn’t that these networks will survive into perpetuity – we see now that cable systems are even at risk of cord cutting – but there is a resilience to networks that mere technologies don’t possess. And in between, there are variations, permutations, and combinations, which can cause (expected) lives to vary along an extensive continuum.

… While on the other side of the ledger, at least in the early stages of development – from birth to infancy and into adolescence at the very least – the funding of these assets is, as a rule, uniform in term. The sequence is usually one of seed finance to a variety of venture capital series, all (or most) of which are private and marked by uneven liquidity options. Institutional participants in these financings typically strive for five- to ten-year capital commitments, and this is a general rule of (financial) asset-class that doesn’t seem to differentiate between (operating) asset-life profiles, as noted.Â In short, there is an absence of match-funding, or if there is some of it, this is in many cases haphazard and not necessarily ruled by fundamental corporate finance analysis.

A lot has been said about sub-standard returns in venture capital in the past several years, especially as the effect of the late-90s bubble has been processed out of the ten-year calculation. The discussion has for the most part honed in on issues of amount and an excess of capital supply. Correctly, this is an angle driven by ever-diminishing startup costs in the technology segment. But in the past decade another phenomenon has emerged, which is a quickening of maturation cycles for these businesses. It is no longer standard fare that maturation is a multi-year process, and by extension neither is life-expectancy insulated by such a cushion. As life terms have been exposed, in a manner of speaking, and are now a purer function of technology type, as discussed, we should begin to see the funding discourse also evolve. Match-funding – which is a qualitative trait – should start to play a much more prominent part alongside quantity in the financing analysis. Not all assets are equally young or old, and not all should be financed or un-financed in the same way.

Disintermediation is in the eye of the beholder. Although the subject – especially in finance – seems to some like a foregone conclusion, it should not be, and is only so in relation to norms that are in flux, redefinition, or various stages of antiquity. I feel as though the year ahead will give rise to disruptive changes in the market, and these will not all be about economic events and central banks. Information technology, the regulatory environment, and consumer trends are finally at a point where true disintermediation might actually occur, and this may present the first trueÂ innovation in finance since, well, arguably,Â Bloomberg, whose founder (maybe not by coincidence) has been busy placing the finance capital of the world on the map of leading-edge technology.

When market watchers have referred to disintermediation in finance, usually this has been to describe themes of abbreviation and access. For example, an issuer “going direct” to a venture fund or other capital source is as much a disintermediation, in this way of seeing things, as an individual placing trades online and without assistance from a “full-service” broker. These themes (and others of a similar ilk) are real and have become pervasive, made possible by a transference of expertise beyond the core of a select few. But just as Groupon has disintermediated the ad network by going to the consumer with an offer directly, these themes are not so much about disintermediation per se, as a transference of the account to a different go-between.

To wit: venture funds, private equity funds, hedge funds, are all intermediaries also. More precisely their managers are; and “going directly” to these is in a sense like driving head-on to a new agent. The fund manager’s decision authority is significant, to be sure, but when LPs (capital sources)Â pull back or push forward, we are reminded about who ultimately calls the shots – as we were, for instance, around the time of Sequoia’s RIP slides. (That the “principal’s” economic formula – a management fee and a commission (we refer to it as “carried interest”) – mirrors a standard compensation package in the same agency model that such funds had allegedly disintermediated, this also gives us reason to question the allegation. ItÂ is at most false, or at least a misnomer: There hasn’t been an elimination of the middleman, but rather a replacement.)

But the story gets even more interesting, in fact, noting that the money intermediated by banking and shadow banking go-betweens, as described, is sourced from capital pools that are themselves intermediated.Â Insurance companies, family offices, pension funds, (other banks), are all variations on a similar motif. So rather than disintermediation, which suggests fragmented democratization, one might even make a case that in actuality we have experienced quite the opposite phenomenon: a concentration and growth of intermediation and its participants. (Among other things this might also explain the homogenous market patterns that many analysts in this past year have puzzled over.)

When Bloomberg introduced its information terminal some 30 years ago, this was a major disruption to information management in finance, and it paved the way for a more fragmented market with higher individual participation and an equalized playing field that, arguably, resulted in greater efficiency. The elements are falling into place for similar trends to occur now, possibly serving to fragment and democratize a financial market that has become excessively concentrated. Social networks are enabling the sharing of information like never before, while the Internet is giving rise to higher-quality information access all the time. Online transactional platforms – and related security and electronic payment solutions – are spreading rapidly, and mobile communication is increasing the immediacy of information and individual reactions concurrently.

For these and many other reasons, I feel as though the time may be ripe for finance disruption to occur, and because capital markets are driven by information, I feel that digital media will play a central role in the disruption. Just as Bloomberg began as an information technology and evolved into an integrated media organization, so too the broader distinction between finance and media is likely to fade in years ahead. And just as media has become fragmented and democratized and made universally accessible with new technologies, perhaps so too will financial markets. If so, we can look forward to a truer diminution of market intermediation, and this should facilitate efficiency for both issuers and investors in equal parts.

discourse and notes

Category Archives: Capital markets commentary

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