Is FB the next BX?

The euphoria surrounding the upcoming Facebook IPO is reaching untold levels. Retail brokers have stopped taking orders. The offering price range has been sharply increased. And the amount of stock that sophisticated investors and insiders are offering has jumped dramatically. So what should one think about this in light of the upcoming IPO? I’ll tell you - buyer beware.

The market dynamic reminds me a lot of how investors were lining up to buy the Blackstone IPO back in 2007. The firm was on a roll. Private equity was scorching hot, supported by cheap debt that made almost any highly leveraged deal look good. And there was immense scarcity value as none of Blackstone’s peers had yet gone public (while certain specific vehicles of KKR and Apollo had floated shares, they did not represent shares in the parent company). And the firm was headed by the most visible figure in the industry, Steve Schwarzman, who commanded the respect of both public and private investors alike. Current operating executives such as Schwarzman and Tony James were selling large amounts of stock. Taken together this indicated to me that private equity in general and Blackstone in particular were on an unsustainable roll, and that the people who knew their business best - Messrs. Schwarzman and James - were sellers. Forget about asset allocation and estate planning; these gentlemen took home tens of millions to hundreds of millions of dollars a year in pay. So to say that liquidity was a primary motivator makes no sense: it was simply about buying low and selling high. That’s what these people do for a living. 

So how did the story end? It started its public life trading under the ticker symbol BX. The stock popped from $31 to over $35 on offering day and has been worse than dead money ever since. It has oscillated in the $10-$20 range for the better part of four years, and currently trades at around $12. In short, while Schwarzman, James, Tom HIll, Pete Peterson et al sold shares at $31, IPO investors have gotten shellacked. This should come as no surprise given a stock that was priced for perfection and a savvy management team that was smart and motivated to hedge their personal exposure.

So what about Facebook? Like Blackstone, a great company and a leader in its field. Also a beneficiary of scarcity value given that there isn’t a public company quite like it that represents an opportunity for institutional or retail investors. And while its principals might not be the market-driven sharks like those running Blackstone, their investors firmly fall into this category. And while its business is indisputably powerful, the multiples being applied to its revenues and cash flows stress the imagination. Might it grow into its IPO price? Certainly. Are there significant risks to achieving this? Absolutely.

My Financial Times Op-ed concerning the Blackstone IPO was written over five years ago, yet a re-reading leaves me feeling as if I’m seeing the same movie five years later - except the company is called Facebook.

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LTCM. Amaranth. JP Morgan?

Will Jamie Dimon go down in history as the John Meriwether of this generation? Or perhaps the Nick Maounis of our time? Either metaphor can’t make the current CEO of JP Morgan feel very good about his legacy. And if I understand the trade properly, the end of the story is nowhere near being written. 

Banks hedge risks. This is what they are supposed to do. And when they don’t, the results have been disastrous (see: the failure of the S&Ls when their long-dated mortgage books were suddenly funded with short term, de-regulated deposits in the sharply rising rate environment of the 1970s). The best way to hedge is always through the cash markets, e.g., I loan out money for a period of time and assume credit risk, interest rate risk, liquidity risk and timing risk, but match fund the loan and mitigate three of the four risks (with only credit risk remaining, the precise thing that banks should get paid to do). The problem is, with the scale of banks and the increasing range and complexity of both business and retail products, match funding is a thing of the past. This risk gap is generally managed using derivatives. There is nothing inherently wrong with this.

However, problems arise when hedging strategies become excessively complex in their attempt to be as close to costless as possible and overly precise. As a long-time risk manager, the goal should be to mitigate risk to an acceptable level but to place a premium on hedge liquidity, transparency and simplicity. While a hedge might effectively hedge “delta” but not “gamma,” the best way to address this is to simply take on less gamma, not try to construct a sickeningly complex and illiquid hedge that models out beautifully but is essentially a custom suit on a person whose weight fluctuates wildly. Sometimes the suit fits, sometimes it looks like crap. And in JP Morgan’s case, they are sporting one of the ugliest suits we’ve seen in quite some time.

It actually reminds me a lot of LTCM. Super smart team. Could likely have put a man on the moon all by themselves. However, the bridge between theory and practice broke down in such a way that the global financial system was clearly at risk. Over a trillion dollars of notional risk supported by less than $5 billion of capital. And the strategies broke down in spectacular fashion because of what? Lack of liquidity and rising correlations. Hmm, lack of liquidity and rising correlations…that sounds a lot like what JP Morgan is facing at this very minute. And there is one other dimension that hastened LTCM’s decline and why the JP Morgan story isn’t close to being done - market knowledge. Once the market knew that LTCM was in trouble, the leaned hard against their positions until they cracked. Now LTCM’s capital base is a tiny fraction of JP Morgan’s, but what if $2 billion turned into $5 billion? Or $10 billion? Every sophisticated market participant is causing JP Morgan maximum pain, and it is simply a question of high-stakes poker. But let me assure you, JP Morgan is not holding many cards right now. 

The JP Morgan debacle also reminds me of Amaranth. While Nick Maounis didn’t run the firm-destroying natural gas trade (a trader named Brian Hunter did), he certainly must have known about it and if he didn’t, he should have known about it. There was a total breakdown of communication, risk management and accountability. Regardless of whether the Managing Partner made the trades, what does it say about their culture that a trader was allowed to put a bet-the-shop position on of that magnitude that blew through billions of dollars of LP capital? One could say the same thing about JP Morgan, Jamie Dimon and the CIO’s office. While the transactions in question may have been for hedging purposes, the risk rebalancing exercise rapidly grew to a scale that placed the firm’s capital position at risk. That this was allowed to continue in the face of rising market awareness (which serves to exacerbate the problem) is incomprehensible, at least to this former Wall Streeter.

I understand why Dimon continues to lobby against the strictest elements of the Volcker Rule, because banks should be allowed and, in fact, have to be allowed, to hedge their books. But when bank managements’ lose sight of the hedging mission and risk management and common sense discipline break down, they shouldn’t be allowed to lead. This is what the Volcker Rule should really be getting at.

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Building the perfect machine

If the goal is to do something exceptional, nothing is more important than building a great team. It is very rare that success is a truly individual discipline. Whether one is talking about world-class researchers, top-tier tennis players or sought-after start-up founders, stellar results are the outgrowth of carefully coordinated and chemically-balanced team efforts. I had the benefit of witnessing this first-hand during my Wall Street career and subsequently in my time as an angel and venture investor. The best leaders consistently attract and retain the best teams. But doing this requires a level of self-awareness and humility that is hard to find in nature. 

Team-building is hard because it is partly a function of filling in gaps, not only in bandwidth but also in ability and skills. And for super motivated, opinionated, stubborn, high-performing individuals, it isn’t always easy to say “I suck at this: I really need to get someone who is much better than me and from whom I can learn.” But the best find a way to do this. And this isn’t just about Mark and Sheryl or Larry, Sergey and Eric, but about every start-up, every large corporation, and every focused unit where there is a concrete mission and a need for diverse skills and perspectives to achieve the mission. Running a bake sale. A Little League. A product team. It doesn’t matter: the requirements are the same.

My experience in constructing the IA Ventures team is a microcosm of the team-building challenge. When I first conceived of the firm, I recognized that to fulfill my vision of being the go-to seed stage venture partner for all things data I needed several elements, many of which I did not possess:

• Deep technical and product knowledge, Ph.D-level depth plus years of practical experience, that could be used to both assess and advise companies on technical issues such as scaling, managing the release cycle and bridging the gap between technology and product. This is a skill set and range of experiences I definitely did not have.

• Operational start-up experience, as one who has started a company, built the infrastructure, models and controls, yet has the skill sets of a financial manager that can help advise seed stage companies on modeling, budgeting and tactical decision-making. My experiences touch these areas but don’t represent the ways in which I can personally be most valuable as an investor, adviser, mentor, strategist and partner.

• Higher-order financial modeling skills together with a voracious appetite and aptitude for understanding markets, analyzing the competitive landscape and constantly asking questions to keep our firm’s thinking rational and pure. This is an essential part of the connective tissue that keeps everything humming among the firm, the portfolio and the market.

To this end I went out and was able to lasso Brad and Ben, and subsequently Justin and now Jesse. They are all awesome but they are awesome not merely as individuals but because of the separate yet distinct roles they play on the team. Brad sits on a handful of Boards but has helped most if not all of IA Ventures portfolio companies as a sounding board on technical issues, tech recruiting, product roadmap and myriad other topics. Ben also has his complement of Board seats but has certainly helped the majority of IA Ventures’ companies with their budgeting, staffing and financing strategies. And Jesse is a gem of a resource that has literally helped several companies rebuild their financial models, perform very targeted research and stay on top of market developments. And I lead several investments while assisting all companies in our portfolio with financing strategy, business development, recruiting and ensuring that our portfolio company teams know each other and ways in which they might help each other. Rather than feel threatened that I have teammates and partners who are better than me at a bunch of stuff, I am so thankful that our team - the machine - is working well for the benefit of our company partners, our LPs and our firm. It was a very deliberate process and it has been the single most important thing I’ve done since starting IA Ventures. Without all elements of the team we wouldn’t be where we are today.

For the last 25 years I’ve been in pursuit of the perfect machine, that just-right group of people with whom to pursue a shared mission. Sounds a lot like the challenges of our founders, no? It is. Team first. Because with a great team, achieving even big, honking, seemingly insane and audacious goals are comfortably within reach.

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Play your game

I’ve written a lot about the importance of focus among start-up teams. This is a very closely held belief. Develop a hypothesis. Test the hypothesis. If proven, move forward and add gas. If disproven stop, take stock, and determine whether or not to gin up a new hypothesis or go home.

The same is true for investors. All the noise around crowdfunding, party deals and all-angel rounds changing the face of the venture industry doesn’t resonate with me. What it does say is that there is more seed stage capital available from a broader array of sources that will give more chances to more people to start companies. All I have to say is: Bravo!

But to be clear, I don’t perceive this as a threat to early stage venture for many reasons. As a venture investor who is comfortable with the way I and my partners do business, I am confident that teams which see the value in working with us will choose to work with us regardless of the other options out there. Also, more interesting businesses seeded by others provides us with additional data concerning product/market fit, adoption and engagement that can go into our decision-making and relationship-building process. Nothing scary here.

Also, I’ve found that many seed stage start-ups actually want a heavier-weight, more engaged lead investor than a more diffuse group of awesome investors but where no single investor has a deep commitment to the company’s success. I completely acknowledge that lots of start-ups don’t feel they want or need this at the seed stage, and that’s totally ok. But those often aren’t the start-ups that we’re investing in. It’s just not our game.

But the bottom line is that for us it isn’t necessarily about leading or following, small investment or larger check. It is much more about team fit and excitement for the mission. Because when there is great chemistry and trust between ourselves and our founder partners, the relationship tends to work itself out in ways that benefit both parties. We might want to buy up in the company, and the team is psyched to get us more involved and more economically aligned with them. And when this happens it is an incredibly exciting and fulfilling thing.

But the key message is: know what you’re about, forget about what other people are doing and be comfortable in your own skin. Successful venture investing is a long time scale business, and the results of investment decisions will stay with you for years. So be confident. Be comfortable. And by all means do not simply follow the pack because it’s popular. Make no mistake, it’s hard to stay strong against the trend when others seem really successful and are getting all the kudos. But don’t fall prey to this dynamic. Just play your game.

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Some thoughts on JPM

With the web afire with criticism over JP Morgan’s recently announced (and unexpected) $2 billion trading loss, a few “life lessons” came to mind as to how Jamie Dimon - and his PR department - bungled this badly:

Know the facts before taking a stand. When news of a “London Whale” came to light a month ago, and this trader was linked to JP Morgan, Dimon issued a strenuous denial that his was a big deal. According to the Wall Street Journal, and I’d tend to agree with them, Dimon didn’t understand the true extent of his trader’s activities or the risks it posed to the firm. Fast-forward to today: he looks like a terrible leader, one who allowed a trader one of the biggest risk books on the planet without knowing how it was impacting the firm’s financial position. Why on earth would he make a statement about this trader’s activities without truly understanding their impact in depth? His typical bravado backfired in this case. He should have heard the rumblings, did a deep forensic dive into the facts, developed a view and then communicated to the media. He chose not to follow this approach and got absolutely skewered. And deservedly so. He failed Crisis Management 101. Perhaps he should have learned from J&J’s handling of the Tylenol scare. Lives may not be at risk here, but given how far out on a limb he had gone in denying any problem (and now knowledge of the problem) his PR morass is pretty hairy.

Avoid taking self-righteous positions. For all the skill and opportunism with which Dimon navigated JP Morgan through the financial crisis, he has long touted his emphasis on risk management and on prudent risk-taking. He specifically sought to paint his firm as distinctly different than those “cowboys” at Bear Stearns, Lehman and the other investment banks. Better diversification. Greater breadth. Better risk controls. These were the hallmarks of JP Morgan as a world-beater, largely immune to the troubles of its bulge bracket peers. Both the communication breakdown and lack of risk controls giving rise to this massive loss are completely at odds with his characterization of the firm. If you put yourself on the top of Mt. Olympus, you are always prone to a nasty fall if messaging and reality are found to be mis-aligned - as they are in this case.

Stop thinking that VaR has any linkage with reality. While Dimon himself may not have been aware of the magnitude of the Whale’s risk position, certainly his risk managers were. And if they were using VaR, they should be skewered as should Dimon. Have we learned nothing? I was musing about problems with VaR and Sharpe Ratio six years ago, and in between we’ve seen the 2008 crisis and myriad mini-crises in between, and the fact that VaR is still a bedrock of financial disclosure - and financial risk management - is chilling. But hey, we’re still in a world where there are huge arguments over the imposition of true mark-to-market accounting rules, enabling financial firms to present something less than a true picture of how assets and liabilities are valued on a liquidation basis. We should isolate long-term assets and liabilities - those that are truly match-funded on a duration adjusted basis. Then we should look at those short-term assets and liabilities and look at the costs for hedging out the residual risks, understanding the market’s assessment of the true mark-to-market exposure. Why this isn’t current best practice for disclosure is beyond me, but at the very least these tools should be employed within all financial firms, not only the JP Morgan’s of the world (though given their systemic importance they should be mandated by both regulators and the FASB). 

Acknowledge that the SEC will forever be playing catch-up. The metaphors that come to mind are Network Security Specialists vs. Black Hat Hackers. Or WADA (the world anti-doping authority) vs. Steroid Using Cheaters. It is a classic good guys vs. bad guys conflict (though I am operating on the assumption that the SEC are the “good guys” - I believe they are trying, just failing). They are out-manned. Out-paid. Out-incentivized. Out of luck. The fact that Mary Schapiro just uttered “I think it’s safe to say that all the regulators are focused on this” is akin to the fire department showing up after the house has burned down. The system is broken. The accounting rules are flawed. Risk analysis and disclosure is flawed. And the regulatory framework is broken as well. Losses of this nature should not come as a surprise. They have and will continue to occur in the absence of common sense disclosure and elimination of all the obfuscation that has been allowed to pervade balance sheets for generations. It’s just that the ante has risen given the magnitude of the risks being borne, the inter-connectedness of the major players in the financial system and the complexity of the tools being used to take risk. It’s not your father’s bond and risk arbitrage portfolios any more: it’s derivatives of all shapes, sizes and liquidity. Until rigorous mark-to-market rules are enacted that facilitate the transparency required to regulate properly, the SEC is fighting a losing battle. All good things stem from transparency. But a broken SEC is good for shareholder-funded speculators. The longer it stays broken, the longer they get to continue making asymmetric bets in their favor (heads I win - tails you lose).

While to many the JP Morgan trading revelations might have been shocking, they should’t have been. The system for deeply understanding financial institutions’ risk is flawed, both inside and outside the house. Until this fundamental weakness is addressed, it doesn’t really matter what the SEC does. Our banks have more than enough latitude to get themselves - and our financial system - in trouble.

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