Equities in a given sector, whether public or private, tend to be highly correlated, but external observers just don't really get the full picture unless they dig into the specifics of the situation.
IME, private marks in aggregate are less volatile than equivalent public performance for a wide range of reasons, but that doesn't mean that a private manager can liquidate a portfolio company at an optimistic mark in a downcycle any more than the manager wouldn't be able to get a better price than the last mark in an upswing.
I think it's also worth clarifying for other readers that the risk you're talking about is volatility and has nothing to do with the actual fundamental risks of a given investment. Private equity (broadly defined) managers look to minimize risks in their investments, but they're talking about business and financing risks. I don't think I've ever heard a private equity manager ever talk about minimizing volatility and I'm ok with that.
I disagree on the choice of benchmarks as they're not really comparable. A more comparable benchmark for angel investments in Internet / SW startups would be a broad-based ETF that covers those. Picking a couple of the larger ones, I looked at the same periods (2012-2019 and 2016-2019) for each of them:
Not much different than QQQ's 3.04x, but SPY is not a good benchmark due to big differences in underlying constituents.
I'd want to get a better handle on the timing of investments as well to make the benchmark more comparable - e.g., if 50% of the capital was deployed in 2012 (hypothetically) and 10% in each of the following 5 years then I'd weight my benchmark performance in the same fashion.
Finally, I would want to discount the angel investment portfolio for lack of control and liquidity. Much depends on the specifics of the recent fundraising - is the valuation using the pref figure or is it a reasonable approximation of the valuation of the seed paper (adjusting for structural differences)?
Personally, I'd rather have a well-diversified liquid ETF return of X than a portfolio of illiquid minority stakes that are marked to 1.2X. At 2X, I'd be happy with the restrictions.
Please don't misinterpret this as dumping on the result - IMO I believe this to be an above-average outcome and I congratulate the author on their success. Angel is harder than most if the top-few % of investments are not in a portfolio.
I am also curious how many hours this individual put into the investing. I put about two or three hours a year into my investments in VTSAX and VTIAX -- just rebalancing. I would expect given the nature of angel investing that this person put in a good deal more work.
Let's say the per company deal size is $100k, and the excess risk adjusted returns are 2%. That means the deal would be worth about $2k extra to you, annually. (I'm counting your baseline investing effort as epsilon, so the deal gets no credit for returns matching my mutual funds.) Suppose your daily rate is $2k/day. You'd want to spend no more than a work day on this deal, per year, over the life of the investment.
If the amounts are smaller, or the excess risk adjusted returns are lower, then you'd want to spend less time per deal. This calculus also only applies if you have enough money to roll the dice enough times for the risk to even out. If you only have a million to invest, you'd only be able to do ten deals this size. Perhaps your hourly rate is lower, so you haven't accumulated as much of a warchest. In that kind of situation, you might be willing to work more for the same absolute amount of excess returns, but your risk would also be higher. So your risk-adjusted excess returns might shrink to a negative value.
Of course, you can tweak all the variables as suits you, and also there's the possibility that you are person who just enjoys angel investing, the feeling of importance that comes with hob-nobbing with the who's-who, etc. If that's so, then you could view the work as the price of entry, to the extent that it underperforms ordinary investments.
QQQ is also up 50% in the past 12 months, which skews the benchmark. TQQ is up 120% and if you called the bull run in 2012, TQQ would have you up 46x.
That and anybody with ~$1000 can buy into an ETF. Angel investing not only requires more capital but social connections and the prestige of something like a big Facebook exit. There are some funds and things like Forge Global where you can get access without a nice headshot, but otherwise you have to play golf with the founders and/or other investors.
So the SPY/QQQ benchmark does not realistically model the opportunity cost. It's not like angel investing is another tab in the Vanguard fund list where you can see where $10,000 will take you. Angel investing requires you to adopt a lifestyle.
So even if an average angel investor produces higher average returns than SPY, they might still have a lower Sharpe ratio, meaning the angel is taking on much more risk for only slightly higher returns.
For most investors it's hard to beat a broad market ETF for risk-adjusted returns.
Also the article doesn't calculate SPY total return.
Dividends-reinvested SPY is very different over long periods of time, I get ~3.46 (versus their 3.01) for the from-2012 calculation, which is a substantial improvement (and over only 8 years!).
Pure financial gains are only one aspect of angel investing though. The status and influence of being an angel investor does have its own value. Although I am not sure how you can capture that.
Good explanation. I'll nudge it even more with a Scenario C to further illustrate that ignoring non-cash comp leads to an distorted picture.
Scenario C: Company hires an engineer with zero base salary and $200k/year worth of stock that gets paid monthly with the correct number of shares to get $16.7k in value. The shares can immediately be sold back to the company for the full value.
The engineer clearly receives $200k of economic value. Whether the stock is sold or not has no effect on the value transfer.
Does this hypothetical company have 1) a 100% profit margin, or 2) is it losing money?
If you picked 1), let's say the engineer quits and for whatever reason the company needs to pay the replacement $200k/year in cash. To do so, the company sells $16.7k of shares to an investor each month. Is it still a 100% margin company?
1. It's important to distinguish between liquidity risk and solvency risk. Liquidity risk is needing to sell an asset that is fundamentally sound and not being able to get a fair price, or any price at all (as happened in 2008/2009 - no/few buyers and many sellers). Solvency risk is the asset goes bad and there's a permanent impairment.
Simplistically:
liquidity risk = broken leg (painful and needs immediate treatment, but recovery over time likely)
solvency risk = horrible cancer
2. CLOs are made up of bank loans, which are generally the most senior obligation of a company, and are the least risky. Bonds, preferred equity and common equity get hit before the loans are impaired. During the period from 1998 through 2016, defaulting loans recovered 66% of their value while bonds recovered 40%. [0]
3. CLOs generally made it through 2008/2009 without any major issues. The structures held up as designed, but prices fell along with other structured products since there were few buyers and many sellers.
If you were able to hold, you did reasonably well. Over the 20 year period from 1994 through 2013, there were 6141 CLO tranches, of which 0.41% defaulted (no AAA or AA defaults) and had a 0.04% loss rate. [1]
4. What has changed since 2008 is that loans are becoming a larger portion of the total value of the business (loan-to-value). This means that if the business goes bad, there's less of a cushion for the loan and recovery rates will be lower.
I don't know how much lower, but some of the junior tranches in a CLO could be impaired in a severe downturn. It's hard to really know, but I _think_ things would need to be worse than 2008 (or the same level of crisis, for a longer period) for AAA tranches in general to be permanently impaired.
5. Accounting plays a role here. If you are required to mark-to-market, then the market clearing price is what the asset is worth, regardless of fundamentals. If there's a panic, you may be a forced seller if you don't have sufficient reserves to get through the disruption and your mark-to-market loss becomes a permanent loss. This applies to any asset class, not just structured products.
6. I don't understand why the article brings up CDS gaming. It's a real issue, and one that is being worked on, but it's not even a rounding error compared to the size of the corporate debt universe. [2]
quote from the FT article:
"Isda’s method of “fixing” CDS has always been akin to “patching” software after hackers exposed weak points. When one window closes, traders simply find a new one."
[0] "JPMorgan Default Monitor 4Q16"
[1] “Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”
These are good points. I would add that generally there's not a problem with having lots of risky debt in the system, as long as it's held by investors who are aware of and can handle the risk. The reason that CDOs led to the financial crisis, was that there was lots of risky debt being packaged as AAA and held by investors (i.e. systemically important banks and insurance companies) who couldn't handle losses on it. So the big questions about CLOs should be: who's buying the AAA debt, is it being mis-rated, and if so, can the holders handle losses on it. In general, I think the rating companies reacted to their vast and obvious failings in 2008 by tightening rating criteria across the board, even in structures such as CLOs which did okay during the crisis. Is it possible they're still being too optimistic? The thing about the rating models is that they're very sensitive to correlation assumptions that are difficult to observe empirically. Also, they tend to have a blind spot about things like fraud. Is it possible that junk-rated corporate defaults could end up being much more highly correlated than the models assume? There are transmission mechanisms that can cause high correlation. For example, an uptick in defaults in one sector could lead to a tightening of credit standards across the board that could lead to rollover risk. (Most of these companies are highly dependent on being able to rollover maturing debt.) Or fraud in underwriting standards could be much more pervasive than assumed. (This one seems unlikely, but who knows.)
Suggest that readers look at cloud revenue from a business model perspective, not a technology one.
Cloud revenues between Amazon and MS are comparable from an investment point-of-view:
- sticky (unless something bad happens, if you're a paying customer in month 1, you're probably still a paying customer in month 2)
- service delivered "in the cloud" (neither vendor needs a local brick/mortar storefront)
- fixed cost: data centers, variable cost: "things" in data centers
- for enterprise accounts: high-touch salesforce and dedicated contacts
- for end-user / SMB accounts: primarily self-service via online tools
Yes, one of them gets more revenue from IaaS and the other from SaaS. Each of these, and the specific submarkets that the two of them play in, will have different growth rates and potential and affect their respective valuation.
Still, from an investment standpoint, based on the above characteristics, I'd feel reasonably good about comparing the two of them on financial and valuation metrics for the "cloud" parts of their respective businesses.
This an insightful post -- but I think there's one key characteristic missing that Wall Street cares about still more, and that's growth.
Traditional products like Office 365 may be sold as a subscription, but the market is largely saturated. Its growth is primarily dependent on productivity device growth. "True" cloud products, whether serverless or lift and shift of existing workloads, have much higher growth potential since a large percentage of the attachable market is still unreached.
That's why it's a little disingenuous for Microsoft to claim products like Office 365 and Dynamics 365 as cloud revenue. For many years before the cloud was a thing, they earned that revenue in the form of Enterprise Agreements: which are essentially three-year subscriptions for the same products.
The "crash" wasn't a day-long, week-long, or even month-long stock pricing event, but lasted 6+ months from the first tech sector to the last going through the crash.
The first stocks to get hit were the web 1.0 properties in Q1'00 (use Amazon (ticker: AMZN) or Yahoo (YHOO) as a proxy as there aren't many left standing that are easy to find historical prices for) and amongst the last were the comm equipment companies which didn't peak until 6-9 months later (e.g., Cisco (CSCO) or Ciena(CIEN)).
All of this is completely separate from whether any of these companies had viable business models. Some did, like the telecoms, their suppliers, semiconductors, enterprise software. Some did not, like pets.com.
A very small number of dot-coms survived, and ultimately thrived after the crash (AMZN). Though you would have had to have enormous foresight to properly select your investments during the boom to not lose a ton of money if you bought in this frothy period.
All of the company fundamentals were well known at the time. It's not like the enormous cash burns of certain types of businesses was hidden from view. It was a badge of honor at the time (also true today in a few places). Some of that cash made it into other businesses that had been around for almost 100 years, like HP or Lucent, but juiced them, and they suffered withdrawal symptoms when their customers stopped spending (or even paying their bills).
To a fundamental investor, the perplexing thing about the whole era was looking at one of many not particularly unique companies that was trading at 25x annual sales, growing 50% a year, and losing money (which is a ludicrous valuation for a public company). Yet you'd find it at 40x three months later.
To get back to your question, having been close to the situation, I can't point to a specific event that started the cascade, but once it started, there was no stopping it. To a fundamental investor in early 2000, the outcome was perceived as being inevitable, but impossible to predict when it would happen. If you'd asked them at the time, they would have told you that the tech market had detached from fundamental behavior back in 1997/98 earlier with no signs of slowing down.
As an aside, if you were willing to look outside tech, it was an amazing buying opportunity in pretty much every other sector of the stock market. Industrials, energy, commodities, real estate, and so on were trading at discount prices even in the midst of this enormous bull market in tech/telecom and related stocks. Unfortunately that is not the case today and it's hard to find any sector that could be considered cheap.
Consider other historical antitrust battles. It's often not about dominance in one niche, but leveraging that dominance into other areas and limiting innovation there.
By your assertion, you would be happy to have had IE tightly integrated into Windows since the early 00s and make it extremely difficult for typical users to install another browser. Competing browsers would also be at a technical disadvantage to IE since they don't control the underlying OS. After all, Windows is popular, why shouldn't they...
You make a very good point and I certainly don't think that IE being tightly coupled to the underlying OS would be good for browser competition. At the same time couldn't I argue that a company such as Apple having so much power over their suppliers due to their market position, and profitability, is also not good for overall competition?
It's certainly going to be difficult if not impossible for a new entrant in the smartphone world to out compete an incumbent like Apple when negotiating contracts with Foxconn.
As I said in my other comment in this thread, I'm having a hard time understanding why certain behaviors get labeled anticompetitive while other behaviors, that ultimately may be just as detrimental to competition, don't.
I admittedly don't have a very deep understanding of these issues and I am perfectly willing to admit I might be completely wrong but I would love to hear your and other readers' thoughts.
It can be spiral-like locally without it necessarily being so nationally or globally. Ask your average roughneck or metal bender in Texas or North Dakota about layoffs, salary cuts or personal spending trends and you'll find all of the spiral characteristics.
If you're investing on a longer-term horizon (a year or more), the monthly futures roll where the USO fund sells the current month's oil contracts (because it doesn't want the actual oil to be delivered) and buys the following month's oil futures (normally at a higher price than what it sold the current month's at) will eat into any returns you get from price appreciation.
To put some numbers to the example, let's say the fund has 100 barrels of oil, and the current month's price is $20, and next month is $21. When it rolls the contracts, it sells 100 barrels for $2000, and buys 95 barrels, with $5 left over.
Fast forward a month. Prices have gone up by $1 for all months oil. It will sell 95 barrels for $22 ($2090, plus the prior month's leftover $5) and buy 91 barrels for $23, with $2 left over.
Fast forward another month. Let's say you owned the entire fund and decided to liquidate it. Prices for your contract have gone up another $1, so you sell your 91 barrels for $24, receiving $2184, and adding the extra $2 in cash you had gives you $2186. That's a 9.3% return in two months.
Compare that to the price of oil as reported in the news - it's the front month contract, so on the face of it, oil has gone from $20 to $24 (20% increase) while you've only made 9.3%.
The numbers are somewhat exaggerated here, and it can work the other way (current month more expensive than forward month) but is uncommon. This is why USO has historically been a bad long-term proxy for the price of oil.
Nearly all cruise ships currently charge for Internet access by the minute, not the bit, and throughput can vary widely. Typical prices start around $1/minute and with bulk minute purchases, may get down to $0.30/min.
This is starting to change, with some now offering unlimited connectivity for ~$15-30/day.
IME, private marks in aggregate are less volatile than equivalent public performance for a wide range of reasons, but that doesn't mean that a private manager can liquidate a portfolio company at an optimistic mark in a downcycle any more than the manager wouldn't be able to get a better price than the last mark in an upswing.
I think it's also worth clarifying for other readers that the risk you're talking about is volatility and has nothing to do with the actual fundamental risks of a given investment. Private equity (broadly defined) managers look to minimize risks in their investments, but they're talking about business and financing risks. I don't think I've ever heard a private equity manager ever talk about minimizing volatility and I'm ok with that.