The Alternative Asset Management Industry: Inexorable Forces for Change

Hedge funds (HFs), private equity firms (PEs) and venture capital funds (VCs) are facing historic challenges, many of which are of their own doing. It is easy to point to difficult market conditions and conclude that their problems are largely due to the environment. This would be a convenient, but less than truthful, explanation. The fact is that the top tier of HFs, PEs and VCs are no longer style pure; the are all institutional asset management firms, motivated by ever-increasing assets under management and the sticky management fees that come along with it. And structural issues brought about by fees schemes and scale  have been the source of other bad behaviors.

In the hedge fund realm, the incentive fee structure is designed to motivate managers to swing for the fences when markets are against them. Big management fees. Quarterly incentive fee payouts. High water marks. These three features have caused many "top" managers to lose their senses and drop prodigious amounts of capital, risk management principles be damned. Many recent mega-losses aren't the case of simply taking the long view and getting stung by short-term volatility; this is getting carried out because of either too much leverage (the most prevalent cause of failure) or too much concentration. I had always thought that hedge funds were supposed to hedge, and were designed to generate attractive absolute returns regardless of market conditions. Such thinking is clearly a remnant of bygone days for much of the industry, where managers want the best of all worlds: stable management fees, quarterly performance fees, and the ability to suspend redemptions. There just aren't that many Steinhardts and Robertsons any more. And this is too bad for the industry and its investors.

Private equity and venture capital firms have a different set of issues. The largest shops have become fund-raising machines, coming out with Funds XIII and IX before generating returns on Funds III and IV. Cumulative management fees on the whole lot, with only modest absolute returns relative to the massive amount of capital committed by LPs. These funds have traded on early successes when assets were small, built a brand, and have been living off that brand ever since. Again, not really what investors had in mind. But LPs have made their own bed, constantly re-upping for new funds before getting paid out on prior funds. "If you don't get in on this fund you won't get in on the next one" is the constant threat. But LPs are starting to push back. Oh yes, and I predict this will show no signs of abating for a long, long time. The model is broken, and the market will fix it. But it won't be that painful for the incumbents with big brands but little absolute performance. They have already made so much money off management fees, they're sitting pretty no matter what. But this is another reason why true seed stage investing, real venture capital investing, has been deserted by the biggest names in the business. They just can't be bothered putting $1-$2 million in companies when they are investing out of an $800 million or $2 billion fund. They need to put $50 million, $100 million to work over the life of a deal. Series C and D. Not seed, A and B. The industry needs to get back to its roots. And it will. The market is pushing it there as we speak.

Today there is a historic chance for LPs to help re-shape these segments of the alternative asset management industry, and to bring them back to their original missions and risk and return profiles. But LPs need to vote with their wallets. They have been so caught up in the big brands as insurance against looking stupid for so long that many have forgotten why they got into alternative assets in the first place. Because at massive scale, the alternative asset world kind of starts to look like the traditional asset world. The world of relative returns. Not what the pioneers of and late-comers into alternative asset investing had in mind.

A Country Divided

During my more than three decades of political and cultural awareness, I have never experienced the United States in such turmoil. Questions such as "Who are we?" and "What have we become?" as a people, as a country, are on the minds of so many. And it isn't simply a question of political affiliation, gender, race or religion: it goes much deeper than that.  I remember the gas lines of the 1970s; the Iran hostage crisis; the stark political shift from Carter to Reagan; the 1980s leveraged buy-out boom and the Crash of 1987; the real estate crisis of the early 1990s; Rodney King trial; the Presidential election vote count irregularities of 2000; and so many more high-impact events. While these events may have shocked, scared or angered us, they didn't appear to shake us to our core, to question the very foundations of our nation. What, then, makes the present different than the past?

The 21st century has caused our nation to deal with new challenges and threats, ranging from the tragedy of September 11th; the rapid globalization and the offshoring of millions of jobs; the rise of China and India as superpowers; and the resurrection of Russia as an economic and political force with a military agenda. And the list goes on. But even these threats pale in comparison to the threat posed by a country divided, a schism that will only become clearer by the choices offered in the upcoming Presidential race. It clearly has gotten to the point in Presidential politics - specifically Republican Presidential politics -  where it's not about crafting the right ticket, one where the two parts complement one another in skills, experiences and world-views, but in presenting a slate that appears to only provide the best chance of winning. Alaska Governor Sarah Palin was a coldly calculated, carefully analyzed choice by Senator McCain and his advisers. Grab the Christian Right, maybe some women on the fence, plug those gaps in McCain's voting record. McCain as a maverick? Hardly. This isn't patriotism. This isn't demonstrating love of country. This is playing on people's deepest fears, and upping the ante such that the only result can be bad, regardless of the outcome. Robert Reich has a great take on this, and several others have highlighted different facets of the matter. My question is: is this what our country has come to, and what does it mean in how we view the Constitution?

We now have a person running for office, who is potentially a heartbeat away from becoming President of the United States, who could potentially send us straight back to medieval times. She stated in a televised debate that she supports the teaching of creationism in schools; she does not believe global warming is due to man-made causes; she opposes state health benefits for same-sex couples; and she is not only firmly pro-life, but opposes abortions for women pregnant either due to rape or incest. Anti-separation of Church and State (that concept, first put forth by Thomas Jefferson, is immortalized in the First Amendment of U.S. Constitution otherwise known as the Establishment Clause); anti-science; anti-equality. These are not the characteristics of someone who can bring people together, but someone who can push them apart. Regardless of one's political views, I find it hard to believe the the majority of this country support the candidacy of a person with such narrow-minded, backward-looking beliefs. Divisiveness is not what we need at this critical point in the evolution of our society and of the world, especially when challenges to the status quo haven't been higher in generations. Do you think China, India and Russia are moving light-years backwards in their science programs to teach creationism? Do you really think we can continue to be competitive on an increasingly challenging global stage when science is something you learn from the Bible, and not from scholarly texts in biology, anthropology, chemistry and physics? I shudder to think what will happen to our knowledge economy in such a scenario.

I have been reading a fascinating book about Intel's Andy Grove by Richard Tedlow. It traces Mr. Grove's childhood and eventual escape from Hungary in 1956, and the remarkable life he has built since his move to the U.S. Mr. Grove is a man of science, of determination, of massive intellect and is a lifelong learner. He has used his powers to fight both prostate cancer and Parkinson's disease, and was employee #3 and the architect of growth at arguably the most important company to bring us into the PC generation and out towards the Internet generation. I wonder what Governor Palin would think of Mr. Grove's life story and the role of science in his personal and professional development? It is hard to imagine this self-proclaimed "hockey mom" being impressed. Rest assured, I am.

When I see the U.S. through my prism - being whatever you want to be if you work hard enough, inclusive, edgy, aggressive about ensuing our personal freedoms, innovative, caring, focused and fierce under duress, willing to change but without compromising the spirit of our Constitution - it saddens me to see where we find ourselves. Eight years of a fractious, troubled Administration, with the possibility of not more of the same, but perhaps much, much worse. It angers and scares me that Mr. McCain would choose someone like Governor Palin as his running mate. We are, without question, the laughing-stock of the world, which will come even more into focus if Senator McCain and Governor Palin actually win. It is almost as if the election has become merely a game to him. Let me assure you, Senator McCain, this is no game. And if I am right and there are millions of others who are just as angered and as scared as I am by your actions, this is not a game you'll be able to pursue after November 4th.

Lehman: Following Good Bank/Bad Bank to Redemption

Lehman Brothers recently announced that they are taking a Good Bank/Bad Bank approach to tens of billions of dollars of illiquid real estate assets, hiving them off from the rest of the firm. Nice to see someone is listening. As previously discussed, I firmly believe that segregating toxic, hard-to-value assets from the rest of bank balance sheets is the only way true healing can take place and additional investment can be secured. Here is what I said about the benefits of such an approach a month ago:

The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital.

Otherwise, investors will continue to be surprised and disappointed, much like those SWFs that have spent billions by investing in the equity of Citigroup, Merrill, Lehman and others, well before their balance sheets had the transparency and simplicity necessary for making an investment with a Graham & Dodd "margin of safety." Who knows what cheap really is in the absence of objective, verifiable data? This is the basis on which many purportedly "smart" investors have been deploying capital, much to curiousity of people like me. Sure, they say "We take a long-term view." Well, I'd rather take a long-term view by establishing a basis 50% lower than those at which they invested. But that's water under the bridge at this point.

From today's Wall Street Journal:

For the real-estate assets, Lehman has set up a so-called good bank/bad bank structure. Such a deal is likely to involve a spinoff of the holdings to shareholders as well as an investment by outside investors.

Details of the plan weren't clear. One option may be a "sponsored spin." That would involve bundling some of the troubled assets into a new entity, which would then be spun off to Lehman holders on a tax-free basis. Also, a new investor or group of investors could take a big minority stake in the new company, thus "sponsoring" it.

Lehman, according to one person close to the deal, is expected to provide at least some financing. Lehman was sitting on $40 billion in commercial real estate at the end of the last fiscal quarter and another $24.9 billion in residential assets.

If Lehman goes with this plan, it will differ from the one Merrill Lynch & Co. opted for in August when it sold more than $30 billion in toxic mortgage-related assets at just 22 cents a dollar. That deal was done with just one buyer: private-equity firm Lone Star Funds but Merrill provided financing.

The WSJ piece does a god job highlighting the differences between the Lehman plan and the Merrill deal, one for which I had much less enthusiasm than I do the Lehman structure. The degree to which Merrill retains recourse due to the seller financing it provided to the single buyer, Lone Star Funds, together with the uncertainty around how much of its distressed real estate assets were actually represented by the assets "sold" makes its strategy akin to putting a band-aid on a deep wound. Is the Merrill transaction a "true sale," either in substance or in form? They are definitely walking a fine line, but analysts must sharply discount how much risk has truly been transferred when arriving at the true economic effect of the transaction. The Lehman deal seemingly has far less ambiguity. Theirs might become the true bellwether of how banks should deal with troubled asset portfolios. If Lehman is able to sell a meaningful percentage of its asset management business, and is successfully able to raise capital in order to jettison its $60 billion+ real estate portfolio, it will be well on its way to surviving what many felt has been a losing battle. Say what you may about Dick Fuld and his aggressive expansion into some dicey asset classes late in the game, but his toughness and focus in dealing with Lehman's problems lays in stark contrast to the denial and delay of Bear Stearn's management in handling their brush (and eventual capitulation) with death.

Lehman may just make it, and if they do it will be because of a smart, aggressive approach to risk reduction, the centerpiece of which is the Good Bank/Bad Bank asset transfer. I would posit that their approach to balance sheet repair (read: survival) will be replicated many times by many firms over the next 24 months, unlike the finger-in-the-dike strategy favored by their friends over at Merrill Lynch. It is hard to do the right thing, to take drastic measures in the face of crisis. But sometimes, it is the only path to survival.

On the Unfair Treatment of Certain Common Equity Holders

Events of the past several months have been very disconcerting, particularly as it relates to the risks and rewards conveyed to common equity holders. It has become evident that due to political pressures, separate and apart from plain economics and market forces, that the returns to certain common equity holders have been subsidized to the detriment of other investors competing in an ostensibly free market. Further, many in the media and among the general public have viewed the sharp drops in certain issues to be "unfair" and due to "mismanagement" and "ganging up" by mean-spirited, money-hungry investors (read: hedge funds). In sum, the U.S. Government and its charges have willingly skewed free-market forces in the name of protecting the broader market. The problem is, the U.S. Government as well as many others are mixing up dampening systemic risk with protecting the interests of common stockholders. By mis-interpreting the essence of what it means to be a common stockholder, policy-makers run the risk of creating a set of problems far larger than those they are seemingly protecting against.

Investing in common stocks, particularly those of financial institutions, is akin to holding the "z-bond" - the residual - of a pool of mortgage-backed securities. It is a massively leveraged interest, one that rides extremely high when things go well and falls precipitously when things go poorly. This leverage is even more than what is appears on the balance sheet, where 30:1 is not an uncommon ratio of assets to equity, due to the prevalence of derivatives and other off-balance sheet exposures. Investors in such shares should know these facts, and understand the risks they are bearing. I didn't hear anybody complaining or read any stories about disgruntled investors when shares of BSC (Bear Stearns), FNM (Fannie Mae) and FRE (Freddie Mac) were top-ticking in the wake of low interest rates, calm markets and rising real estate prices. But when conditions turned, liquidity dried up and counterparties got scared, managements and investors started crying foul. Negative press. Coordinated short-selling by hedge funds. But why? Because losing money feels really, really bad. But this is part and parcel of being a common equity holder. An investor could have bought senior securities. They could have reduced risk by selling calls. They could have pared down their long positions when things started to sour. But all this is forgotten in the shell-shock of a rapidly falling share price. Deer in the headlights. Can't. Move. Can't. Sell. But sure can complain. And managements could have done a far better job financing their books. Liquidity cures a world of ills; it also lets you play another day. But by the time money is scarce and the price is dear, it is already too late. Bear Stearns found this out. But if you live in a highly leveraged world and don't provide for a rainy day, the inevitable downpour will wash you out. But in Bear Stearn's shareholder's case, they got precisely $10 per share too much for their common. They should have gotten zero. And that window dressing supported by the Fed and agreed to by JP Morgan sent the wrong message.

And the situation with Fannie Mae and Freddie Mac is even worse. Far worse. And might get much, much worse. In this case not only should common shareholders get zero, but certain subordinated investors might also deserve zero. But again, the U.S. Government has and will continue to pull strings to ensure that this doesn't come to pass. Why? Politics and other non-market oriented reasons. We, the U.S. taxpayer, will end up subsidizing these common stockholders and subordinated investors, and to what end? It will only further embolden managements of large institutions, thought of as "too big to fail," to take imprudent risks and swing for the fences. Because if things work out management and common stockholders get handsomely paid. And if they don't, management simply loses their jobs while common stock investors get some undeserved residual interest in the enterprise.

I don't fault our Government leaders from trying to ward off a massive systemic meltdown by providing credit to ensure the orderly disposition of obligations and maintenance of a functioning credit market. But no such obligation is owed to common equity holders. And every time policy-makers elect to bail out their interests, it lays the foundation for an even greater disaster down the road.

Back to the Future: Are Banks Getting Religion?

Credit pricing and appetite based upon the market's gauge of a bank's cost of capital? Numerous examples of firms' moving away from the "universal bank" model towards one that is better focused and more streamlined? Suffice it to say, these are basic building blocks of sounds financial management and business strategy, yet have not been the hallmarks of most financial institutions' decision-making over the past 20 years. Get big. Build market share. "Diversify" by adding seemingly uncorrelated business lines, yet somehow extract synergies by having all these capabilities under one roof? What a joke. The detritus left in the wake of these poor decisions is not very funny, however.

Pricing Loans Based on a Firm's Cost of Capital? Duh.

This is simply not revolutionary, my friends. In theory, and now in practice, you need to be able to mark your books to market. Banks using the credit derivatives market as a vehicle for pricing and risk managing loan portfolios is not new. I can't tell you how many times, when either looking at large credit-bearing derivatives trades or friends in leveraged finance evaluating large underwriting positions, have tapped the credit derivatives market either for outright credit protection or for a benchmark of how much spread to build into a transaction. This from Sunday's Financial Times:

Morgan Stanley and Goldman Sachs are responding to the credit crisis with systems that use the market's view of their own creditworthiness as a basis for lending decisions, according to people familiar with the matter.

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Morgan Stanley is essentially tying its promise to provide financing to hedge fund clients to the prices of credit insurance on its own debt. If the cost of the protection rises to a certain level, that would trigger a reduction in Morgan Stanley commitments to hedge funds. Goldman Sachs is understood to have a similar arrangement that uses its bond prices as a reference point for credit commitments to hedge fund clients.

This is simply common sense. If this really didn't happen before, well, it's about time. Its not as if you can easily buy credit protection on a hedge fund that has not publicly listed securities. Further, the value of internal capital is so high in this uncertain environment that banks need to spend it wisely, and only at times when exporting it (via client default risk) is more valuable than retaining it (to avert firm default risk). Bottom line, this is a straight-forward and common-sensical concept. If this is news to senior bank management and/or risk managers, the out to be shown the door. Immediately.

All Things to All People? It Didn't Work for Sears, So Why Should it Work for Banks?

The "universal bank" craze was crazy from the get-go. There was a time when conglomerates were all the rage - ITT, Gulf & Western, and so many others. This was the 1960s. Expert centralized management and financing creating synergies for myriad operating companies, regardless of synergies among them. "Give us your money, and we'll diversify it for you" was the mantra. This is NOT Berkshire Hathaway, either. Warren buys companies that meet his criteria for shareholder value creation. Period. No synergies expected. With very few exceptions, the conglomerate model has been proven to be a failure. Do what you're best at, do it exceptionally well, and win in the marketplace. Let investors diversify themselves; they can do it much better than you can, anyway. Yet this is not the approach taken by many of the financial institutions across the globe. Give them personal and mortgage loans. Give them credit cards. Give them investment products. Advise their companies. Finance their companies. Insure their companies. And on and on. Firms that started to look more like governments than private enterprises. And if we know anything about government, enterprises that spread themselves too thinly ultimately do badly at pretty much everything. And this is what we've seen over the past several years.

Good times mask a lot of problems. Bad times, well, we're seeing that right now. Correlations go up. The benefits of diversification are illusory. All you see is a mismanaged pile of assets, the problems of which are of stratospheric proportions due to the sheer size of the enterprises in question. American Express Shearson Lehman Hutton. Anyone remember them? Citicorp Travelers Salomon Smith Barney? Another winner. Sears Dean Witter? A beauty. UBS Swiss Bank O'Connor Brinson Warburg Dillon Read? Oh, baby. The list goes on and on. Value creation? When a rising tide is lifting all boats, sure. In times of distress. Forget about it.

Anyway, hopefully some of these "forward-thinking" firms will get back to basics. Because I don't think the global financial system can take any more expressions of growth-at-all-costs machismo. It's really about growing and protecting shareholder value. Really.

Valleywag, Monitor110 and Telling it Straight

Few things irk me more than shoddy journalism, lousy research and bad intentions, and these three neatly came together in a piece by Nicholas Carlson published today in Valleywag. The thesis: Monitor110 wasn't brought down by the issues I raised in my post-mortem, but because our lead VC failed to live up to a financing commitment. This was the story-line Mr. Carlson was hell-bent on writing about, and that he did. He reached out to me, people that know me and people that might know me concerning the lead he had gotten from somebody, and received a "no comment" from everyone I know that he touched. Somehow my "no comment" was twisted into a "he did not deny (the "facts" of his article)." Nice inference, Nick. But that didn't stop him. A paucity of facts and understanding of the situation together with a total lack of knowledge of early-stage operations made for a most forgettable article. But I can't forget it. Because words have power, even in the tabloids, be they off-line or online in nature. And using that power irresponsibly pisses me off.

Here is a total cut-and-paste of the article that ran today:

Why did investor-news aggregator Monitor110 go under, taking $20 million in funding with it? Read early investor Roger Ehrenberg's surprisingly humble and informative blog post about the ordeal, titled "Monitor110: A Post Mortem," and it sounds like the startup fell prey to the usual pratfalls — too much PR, weak leadership, and a confused product vision. Probably all that's true. But what's also true, a source tells us, is that Monitor110's own investors, specifically Draper Fisher Jurvetson, which invested most of that $20 million, ensured Monitor110's failure during its final months.

A source familiar with the venture capitalists tell us that after Monitor110's last funding round, the company began to burn through cash faster than expected. Fortunately for Monitor110 CEO Brennan Carley, the company's primary investors at DFJ were very understanding. They promised — "truly promised," our source tells us — Monitor110 a bridge loan to get the startup through until its next funding round. Monitor110 went ahead and spent the money, "with DFW's "assurance the bridge was coming," our source says. But it never came.

Instead, DFJ killed the bridge loan and — as is being reported today — funded Monitor110's direct competitor Skygrid instead, leaving Monitor110's other investors, like Ehrenberg, with nothing better to do than write humble postmortems. Ehrenberg, reached for comments, did not deny any of the particulars of this story.

The real lesson of Monitor110, then, is this: Never trust a venture capitalist. Why isn't Ehrenberg telling us this story? He wouldn't say, but the most likely explanation is that he knows he might do business with Draper Fisher Jurvetson again, and he doesn't want to be blackballed. Far easier to play the humble martyr, and gain popularity by licking his wounds and sharing anodyne lessons learned.

Here are the real facts:

• Monitor110 was burning cash more quickly than expected, not due to cost overruns but due to revenues falling short of projections.

• We did have a disagreement with our VCs about a bridge. The contingencies they thought were baked into the commitment were different than those we perceived. Did this suck? Yes, it certainly did from management's side of things. But did it cause Monitor110's ultimate demise? No. Poor execution did. And I'm not sure simply adding more capital would have enabled us to grow out of our deeply-seated problems.

• If the company had generated revenues within spitting distance of our revised projections, the issue of a misunderstanding concerning the bridge would have been moot because our VCs would have gladly come up with the money required. They're not stupid; they invested to make money, not drop millions on a neat idea that couldn't be successfully commercialized.

• The new CEO, Brennan Carley, came into a very difficult situation and played the hand he was dealt the best he could. His was the role of rationalizing the business, increasing efficiency and reducing costs in order to provide some extra runway for achievement of revenue milestones. He did a great job; it was just too little, too late.

• Skygrid is a fine company and Kevin Pomplun is a smart young guy doing some interesting stuff. I have sought to provide him input and counsel as a member of the same community, facing similar challenges and possessing similar interests over the past 18 months. I hope he has better results than we did, and I trust my input has and will be helpful in this regard. I begrudge both him and his investors nothing and wish them only success.

• I don't need DFJ to do my next deal or any other deal and the issue of being "blackballed" is beyond a red herring. It's moronic. I have money. I have access to lots of money. I have access to plenty of non-VC money. If someone (such as myself or any of those at Monitor110 with whom I've worked) is smart, ethical and acts with honesty and integrity then the "blackballing" of which Mr. Carlson speaks is a non-issue.

• I am not "playing" the role of martyr or anything else, and the popularity issue is almost hilarious. Nobody was more shocked than me at the response to my earlier post. The fact that many found it helpful was terrific, surprising and fulfilling. And if Mr. Carlson had ever read my blog, he'd know that the post-mortem was completely in-character and consistent with both the intent and ethos of my writing over the past two years.

• I am an angel investor with a portfolio of 25 investments, several of which are undeniably successful, some of which have achieved successful exits, and precisely one of which was a total write-off: Monitor110. Am I really licking my wounds, Nick? Is that really what I'm doing?

Why should I care what a muckraking reporter wants to print? Because words have power. And with that power comes responsibility, at least as far as I'm concerned. Mr. Carlson chose a single issue in a much larger, more complicated situation as a vehicle for both damning our VCs and implying that my post-mortem was something less than ingenuous. It's writing like this that gives Internet journalism a bad name. Issues of reputation and relevance are paramount in separating the good from the crap (and this is an area I know pretty well), and it's hard enough separating the good from the really good than having to deal with the lousy masquerading as good. My post will do absolutely nothing to stop the tabloid-style journalism that seems so popular today, but if you are shooting for lots of clicks then at least get the facts straight, ok? And if you lack the facts may I suggest a three-step process: stop; breathe; and think. Either get more facts or don't write the story. This is what real journalists do.

Monitor110 Learnings: The Good, The Bad, and The Really Bad

The response to my Monitor110 Post Mortem was pretty shocking. I want to thank those who commented, sent emails, and simply took the time to read the post. If some of you are really able to take my experiences to heart and to avoid some of the mistakes made by myself and the team, that would be terrific. To that end, I am going to spend some more calories drilling down on key areas of note during my 3+ years working with the company.

The Good: Articulating an Idea and Raising Money

From the time Jeff Stewart and I decided to press forward with Monitor110, we were very thorough and systematic in our approach to raising money. First thing I did before formally deciding to invest was to go around to potential customers - principally hedge funds and Wall Street firms - and get their reaction. We were able to show them the v1.0 system (the one we trashed, remember?), screen shots of the next generation application and our vision for the future. The general response: if you guys can deliver what you say you can deliver, I'd be very interested in the product. Good answers; just the answers a potential investor (me in this case) would like to hear. Little did I know that what we said we could deliver we actually couldn't, and that it would take almost three years for the key constituencies (management, development, the Board) to figure this out. [The reason: buy-side investors wanted a system that would extract the nuggets of differentiated, unique information and present it to them in a form that was beyond clear, something so easy that they could look at it and literally make a trade. In short, readily actionable. Reality, unfortunately, did not line up with this expectation. The ultimate release was much more of a research application, not something that immediately generated actionable, monetizable data.]

Be that as it may, we didn't know the execution problems at the time and the vision we were articulating was very seductive, to clients, to investors, to recruits, to ourselves. From a variety of client meetings we honed our pitch, created a presentation deck that we iterated on several times, and set about pitching a variety of top angels and VCs in Silicon Alley, Silicon Valley and Route 128. We raised $1.25 million from a group of angels, most of whom we considered strategic due to their either working at hedge funds, bulge-bracket Wall Street firms or were independent traders. This gave us the runway to make key hires, begin building the next generation product and to systematically tap the venture capital community. The pitch deck was no more than 15 pages, had lots of pictures, a handful of focused, powerful words and concepts, and a clear explanation of how we intended to use the money. While I'm no Guy Kawasaki, I know a good pitch deck when I see it and can sell it. Especially since I believed so passionately in the company's mission and prospects. So my message to those seeking to raise funds is:

1. Believe deeply in the mission and vision of the company; otherwise, no one else will.
2. Use few words, many pictures and be brutally clear. If the audience doesn't get it within 60 seconds, it's tough sledding.
3. Think of lots and lots of use cases and be ready to share them at will. This isn't just for pitching; you'll need this to understand the market opportunity as well.
4. Pitch early and often. We learned so much from speaking to dozens of smart, insightful people. I think we would have failed faster and better and/or increased our chances of success if we had listened more.
5. Hone the pitch on lower-likelihood prospects early and ramp up to the real targets after polishing the presentation and the delivery. The first bunch of times you will suck. After sucking for 5-10 times you'll tend to get much, much better. There is no way to short-circuit the process; there is simply no substitute for experience.

The Bad and The Really Bad: Recruiting, Metrics, Lack of Focus and Cash Management

1. Great team, wrong team
2. Inadequate metrics
3. Resources spread too thin
4. Poor cash burn management

The Bad #1: Great Team, Wrong Team

I'd argue that Jeff and I were very good at recruiting. We hired great people. Smart. Passionate. Opinionated. Caring. Problem is, I think in retrospect that we hired many of the wrong people, not because they weren't good but because they didn't have the depth of experience necessary to solve the problems we need to solve. We took the approach of hiring "best athletes," on the theory that super smart people can figure hard stuff out. For example, a few years back one of the teams that competed and placed in the DARPA challenge wasn't from MIT, Stanford or CMU, but a team hacked together by a tech guy from an insurance company and a bunch of his buddies who said "We can do this." They drew parallels between the DARPA challenge requirements and the dynamics of video games, and devised a completely out-of-the-box approach to solving the problem. And they proved that it didn't take a bunch of rocket scientists to compete in a crazy robotics competition. This was our fantasy. We'd be these guys.

Unfortunately, our reality is that we were cracking monumental problems at the frontiers of natural language and statistical text processing, data harvesting (ripping and cleaning), entity extraction and real-time matching of terabytes of data. Instead of building a team that had experience in each of these areas and could attack the scale of our problems from the get-go, we staffed the company with bright people who had to learn the material first before attacking the problem. Because of this, it took much longer to understand the magnitude of our issues, time that could have been spent either solving the problems or taking a different approach. By the time we figured out the depth of our issues, we had burned lots of resources which left us precious little runway to get a salable product to market. Best of intentions. Worst of decisions.

The Bad #2: Inadequate Metrics

It took us a long time to build the next generation product. And during the development process, we didn't do a good enough job creating metrics to measure our progress and the efficacy of the components of the system. And by the time we got around to measuring stuff (hard release cycles, data precision and recall, speed of throughput, processes around source expansion and quality, etc.) we were very, very late in the game. In retrospect, we should have placed a much greater emphasis on the creation and use of key metrics, and building greater accountability into the culture. It would have forced us to face into our issues early on, potentially enabling us to change direction before wasting scads of precious capital. Our lack of a metrics-driven culture let the science project live on - and on and on. We discussed the importance of measurement dozens of times but got derailed by the many technical problems we encountered. We completely lost the forest for the trees. This was no excuse. We screwed up on this front, big time.

The Really Bad #1: Resources Spread Too Thin

We initially had a vision of a single product: a dashboard. The entire company was executing against this vision. Problem was, the market was telling us that a dashboard was not necessarily what it wanted. It wanted a research product using the data underlying the dashboard. It also wanted the ability to access our data via a feed or API. Therefore, our laser focus on a single offering split into three. While we were trying to listen to the market, we only ensured that we would do nothing particularly well. And as mentioned in my earlier post mortem, the Board was never really supportive of the research business and didn't really understand the opportunity posed by the feed business. What would have happened if we had only focused on one of the products? We either would have increased our chances of success or failed faster, both of which are superior outcomes to what eventually went down - a slow, painful death.

The Really Bad #2: Poor Cash Burn Management

Monitor110 wasn't some biotech company conducting research and using money to get through clinical trials. It was a technology company trying to sell a service to a very defined universe. Our cash burn got way, way ahead of where it should have been given our revenues. Because, as we thought, the ultimate salable release was right around the corner. But it wasn't. I can't count how many corners that product was around, but it was more than five and less than ten. Yes, we were working to solve a complex problem. But before we went "all in," we should have had much stronger signals from the market that it was prepared to buy what we were selling and at approximately the price point at which we intended to sell it. But because we were so concerned with disappointing our customers in light of the unexpected PR we had received, we really hadn't gotten much market input since early in the development cycle. We were so convinced that the demand would be there once we got the product out that we just kept building - and building, and building. And when we finealy stopped building and said "Here it is," they said, "That's nice. Kind of. And that price? Too, too high." Not happy words to ears that were poised to hear something materially different. And because of the burn level, it made staying in the game long enough to get the penetration needed to succeed virtually impossible. Moral of the story: test the market. Think. Design. Execute. Go back to the market. Repeat. Stop when the market says "I'll take it." And then start the cycle again.

Sure, there's more. But this will have to do for now.

Merrill's Restructuring: On the Right Track, But...

Well, Merrill just provided the market with a great example of what a bank has to do to achieve the results of a good bank/bad bank split:

1. Take a massive write-down of its illiquid asset portfolio;
2. Fulfill a colossal make-whole agreement on prior financing rounds by rolling down the prices of earlier offerings; and
3. Issuing billions in fresh capital at sharply depressed prices.

Net net, rather than doing a classic good bank/bad bank bifurcated structure, it bit the bullet and did the whole thing internally. $40 billion in write-downs in the past year. Additional payments to financing sources that were massively underwater, except for the fact that their paper contained reset options in the event that fresh equity was sold at lower prices within a prescribed time period. And oh boy, were the prices ever lower and did it ever happen within the prescribed time frame!

My question is: after all this, is there even more to come? As reported by the Wall Street Journal, Merrill's CEO said the following:

Chief Executive John Thain said the securities represented the "substantial majority" of Merrill's collateralized debt obligation, or CDO, positions, calling the sale "a significant milestone in our risk reduction efforts."

Can anyone out there tell me what a "substantial majority" is? If you are going to go through the pain and suffering of such a restructuring, don't you think it would make sense to either write it all down or to provide transparent disclosure of what was written down, what remains and what management thinks the realization on the remaining pieces will be? I just don't get it. If we believed bank CEOs every time they said "The worst is behind us" we'd all be in the poor house.

Come on, John. Better disclosure, my man. You have the chance to take the leadership on best practices in this area. Because without it, you and your banking buddies are still leaving investors with a murky outlook, and your share prices will continue to reflect this lack of confidence.

Update: Here is a more detailed article from the WSJ.

Banking Sector Band-aids Just Won't do It

We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed when devising a plan for healing the banking sector:

1. The plight of equity-holders should be ignored;
2. Long-standing rules governing bank ownership shouldn't be compromised in a panic; and
3. Bank balance sheets won't heal unless deep pain is felt, and preferably as quickly as possible.

Bank Equity Holders: Out of Luck

Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario. When considering the plans put forth for rescuing the GSEs - Fannie Mae and Freddie Mac - I do not want to see Treasury Secretary Paulson spending my tax dollars propping up existing equity holders. This is money that should go to restoring liquidity and order to the mortgage market and enabling debt holders to get their money back. Equity holders - they should be wiped out. GSE equity holders have long enjoyed the benefit of a guarantee off the backs of the U.S. taxpayer; now the tables are turned and it's payback time. If you want the potential returns to equity, then you need to shoulder the risks to equity. And those risks have been borne out. And you are busted.

Now, this is an issue separate from fraud. If it turns out the disclosures were improper and that equity holders did not have the information necessary to make an informed investment decision, then by all means file a class-action lawsuit and seek appropriate remedies. But this is also part and parcel of being an equity holder. Bad things can and do happen. It's high time that equity investors understood this. And I'm not the only one to have this view: consider the words of David Einhorn, manager of the widely-respected hedge fund Greenlight Capital, from his book Fooling Some of the People All of the Time:

The truth is that investors in corporate securities are risk takers managing investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully.

Exactly.

Don't Play Games With the BHCA

2. The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, but the long-standing Bank Holding Company Act rules make a lot of sense to me. Banks play a special role in the fabric of our economy, from money creation and credit to safety and access to liquidity. These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?

We have the example of TPG/WaMu, which, I'm afraid, is not a template for bringing capital into the sector. This was a deal done behind closed doors, at terms that frankly illustrate why the sector is so badly damaged. TPG wanted lots of cushion in order to do a deal, because of a high degree of uncertainty surrounding the investment portfolio. It presumably took large deal fees. The structure was also massively dilutive to current shareholders, and further provided anti-dilution protection against subsequent capital raises at prices lower than its deal price for 18 months. I'd be willing to wager that this is one anti-dilution feature that will surely end up in-the-money. Not bad, TPG. But to be fair, if I was TPG I'd have pushed for the same deal. Why? Because almost every large financial institution in the U.S. is made up of two institutions; a good bank and a bad bank.

Good Bank/Bad Bank as a Way to Move Forward

The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments). The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital. This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity - now -  in order to lay a strong foundation for future growth.

Note to Bank Managements: Take the Medicine - Now

3. Bank management's steps towards fixing their balance sheets has been a slow, painful process, which is likely to be played out over even longer periods of time. This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up. But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books. And as it stands today, there are still way too many unknowns to make financial commitments to the sector. Those who did so early got smoked, and others, like TPG, received deals that ultimately hurt the bank and its shareholders and don't address the issues of transparency. Mr. Paulson should devote more calories to this issue and less to bailing out the GSE's and protecting their common stockholders. Yes, the GSEs are hugely important, don't get me wrong. But the larger banking sector needs fixing, and it appears that a little prodding is in order.

Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool's game. Get to it.

Monitor110: A Post Mortem

Turning Failure into Learning

Writing a post mortem is hard, particularly when the result is failure: a failed deal; a failed investment; a failed concept. That said, without a post mortem, without deep reflection, honesty and introspection, how can we get better and do better the next time? Quite simply, we can't. My involvement with Monitor110, as an investor, Board member and leader, was one of the most interesting and informative experiences of my life. I learned about areas I never dreamed of. I worked with a terrific group of young, exceptionally bright people who believed in the vision. Ultimately, we failed. But why did we fail, and what could we have done differently?  Some of the stuff is pure 20:20 hindsight. These observations aren't worth much. But the interpersonal dynamics, the issues of organizational structure, the need to change strategy in light of new information, the relationship with key investors, all of these are very instructive. I will endeavor to be as honest and candid as possible.

Let me say that I deeply respect everybody involved with Monitor110 from the original founder, Jeff Stewart, to our investors, employees and customers. Everyone tried very hard to make things work, and this post is not an indictment of anyone. There are no "bad actors" in this story. But a confluence of factors made success an uphill struggle.

The Seven Deadly Sins

While we certainly made more than seven mistakes during the nearly four-year life of Monitor110, I think these top the list.

1. The lack of a single, "the buck stops here" leader until too late in the game
2. No separation between the technology organization and the product organization
3. Too much PR, too early
4. Too much money
5. Not close enough to the customer
6. Slow to adapt to market reality
7. Disagreement on strategy both within the Company and with the Board

A Little Background

I was initially approached in early 2005 by Jeff Stewart, who had the original idea for Monitor110. It was a compelling idea. The thesis: more and better information is being put out on the Internet every day, information that can be valuable to Institutional investors who are constantly looking for an edge. And these investors were not very sophisticated about how to best access this information; Monitor110 would use technology to help them get that edge. Jeff and a few guys had hacked together a version 1.0 of the system, which was based on a boolean matching engine with rules corresponding to each company and investment theme. It was fast. It worked ok. We spent some time working with PubSub, who had built a scalable matching engine but was not focused on the financial services industry.

By mid-2005 the system worked, but spam was becoming more prevalent and caused the matching results to deteriorate, e.g., too much junk clogging the output. Around the same time we started to dig into natural language processing and the statistical processing of text, thinking that this might be a better way to address the spam issue and to get more targeted, relevant results. This prompted us to not push version 1.0, instead wanting to see if we could come up with a more powerful release using NLP to mark the kick-off. In retrospect, this was a big mistake. Mistake #5, to be precise. We should have gotten it out there, been kicked in the head by tough customers, and iterated like crazy to address their needs. Woulda, shoulda, coulda. Didn't.

An Unusual Leadership Structure

The idea was that Jeff was the technology guy and I was the business guy. Jeff focused on technology and product and I focused on fund raising, HR, controls and client access (given my Wall Street and hedge fund rolodex). On paper, made sense. Jeff was a successful three-time entrepreneur, I was an experienced senior Wall Street executive. The problem was, however, that when it came time to make hard decisions the two-headed structure really didn't work. It was a technology company working to solve a complex problem, and ultimately technology dominated the discussion. Ultimately, we ended up building something that the business side was not happy with, which made selling it difficult. An indication of Mistake #2. Neither Jeff nor I had the power, real or perceived, to simply change direction. The Board was supportive of this management structure. This was also a mistake. Mistake #1.

A Real Product versus a Science Project

We talked about "release early/release often," but were scared of looking like idiots in front of major Wall Street and hedge fund clients. Is it better to wait a bit before releasing to have a more compelling product or to begin getting feedback on a less impressive offering? We chose #1; in retrospect I think we should have chosen #2. By choosing to wait we lost our intimacy with the customer (Mistake #5 again), falling into the classic (as a "green" entrepreneur I didn't know this, but as a seasoned four-year venture investor I know this now) trap of pursuing a "science project," not building a commercially salable product. Dumb. Another problem: technology and product management were effectively bundled together, with the same decision-makers for both. This was another crucial error, #2 again. Instead of having product management as the advocate for the customer and the product evangelist, we had technology running the show in a vacuum. Huge mistake. This allowed us to perpetuate the science project for much, much longer than we should have. There were no checks-and-balances built into the system. This was a recipe for failure. I intuitively knew it then but as an inexperienced entrepreneur didn't feel empowered to act. Really, really stupid. After 20 years of making consistently good business decisions why didn't I throw a fit and and be more assertive in communicating my concerns? No good answer here.

And these bad behaviors were reinforced by an unplanned event that sharply impacted our psyche: being on the front page of the Financial Times. It is hard to call it a mistake since we didn't seek to get such exposure, but I put it down as Mistake #3. To be honest, this single fact was a very meaningful factor in our failure. It raised the level of expectations so high that it made us reluctant to release anything that wasn't earth-shattering. It was also catalyst for us raising our last and largest round of capital. So the net effect was that it enabled to raise all this money that kept us far from the customer. Truth be told, we were probably afraid of customers at this point because we didn't want to disappoint them or look bad. Oh, we'd build something they'd love. We just wouldn't show it to them until it was done. Ugh. Just so stupid.

Too Much Money

Too much money is like too much time; work expands to fill the time allotted, and ways to spend money multiply when abundant financial resources are available. By being simply too good at raising money, it enabled us to perpetuate poor organizational structure and suboptimal strategic decisions. Mistake #4. We weren't forced early on to be scrappy and revenue focused. We wanted to build something that was so good from the get-go that the market would simply eat it up. Problem was, with all that money we hid from the market while we were building, almost ensuring that we would come up with something that the market wouldn't accept. And then there were technology issues that came up along the way, very substantive issues, that because of so much money we simply didn't face into nearly fast enough. And this drove a wedge in the company between those that were more plugged into the market (and felt we weren't building the right thing or addressing the data issues the right way) and those who were building the product (and felt very convinced that what they were building was responsive to the market). I would almost argue that too much money enabled the other six mistakes to be made again and again and again. Seems counter-intuitive, right? It's not. And believe me, I am super sensitive to this issue now as an investor. If a company wants to raise significantly more money than I think they need to get to revenue, I push back. Hard.

Investor Expectations versus Market Reality

We raised money based on a vision of a scalable web portal, a tool that would eventually be the web-enabled side of Bloomberg. We never believed we'd replace Bloomberg, Reuters or Thomson for market data and mainstream news, but that we'd eventually become a necessary part of the Institutional investor research mosaic. We were positioned as a technology company, not as an alternative research provider or a services business. And it was the deep belief in Monitor110 as a pure technology company that created a rift between the business side of the company and powerful members of the Board. Mistakes #6 and #7, as you'll soon see.

We did an angel round in the latter part of 2005 followed by an institutional round early in 2006, enough money, we thought, to help us build the new version 1.0 of the product. We then did another institutional round in Q3 2006 to further execute against this vision, because the money was offered to us on a pre-emptive basis and around six months earlier than we were planning to do a raise. The new release would be whizzy, fast, comprehensive and use all that neat technology to analyze unstructured data in real time, and to score each data element by reputation and relevance. Easy to filter, discover and analyze. Super cool, right? Sure. Problem was, we started out trying to analyze most of the dynamic web (probably up to 100 million sources by now) in real-time, and using technology (NLP, pattern matching, etc.) to do the filtering, indexing and categorization. This was no mean engineering feat. We had a very, very large and complex back-end. And even with this, the quality of the data coming through to the end-user was just not that good. Too much spam, still. Duplicate posts. Sometimes mis-categorized. Difficulty applying our reputation algorithms. Not good.

Those closer to the customer wanted to effectively chuck this approach and to build up a high-value corpus of data from the bottom up, using our deep knowledge of the source universe to assemble a body of data from publishers of high reputation. Really more akin to a "Bloomberg for the Web" than the original product, as the sources would be of high-quality and indexed correctly. They also wanted to build a research capability, where a desk could generate customized reports for clients leveraging our technology and data. But making this fundamental change to our approach towards data and the business model resulted in a fight. Almost a jihad, where certain parts of the company were vehemently in favor of changing our approach while others said "improvement to the current system is right around the corner." This could only happen because of Mistakes #1 and #2, where nobody could pound the table and say "this is the way we're going to do it and here's why," nor could the business side simply say "this is what our clients want. This is why we should do it." We were one big, passionate, driven, dysfunctional family. This argument played out over months and months, and cost us an enormous amount of money. Eventually we did change our approach to data, but it was a fight that spiritually damaged the company and morale and had a financial impact that substantially depleted our coffers.

And in Conclusion

The good news for me personally is that I now invest in a way that actively seeks to avoid the seven deadly sins listed above, and the performance of my portfolio companies bears this out. But I simply wasn't smart enough or experienced enough to see all of these mistakes or to feel empowered to do something about them until it was too late. I would like to thank all of our investors for having the confidence in us to pursue the Monitor110 vision, and I'm sorry that we weren't financially successful. I'd also like to thank the people with whom I worked during my tenure at Monitor110. Not a bad apple in the lot. Smart, hard-working, highly motivated professionals. They will invariably do extremely well in their post-Monitor110 lives.

The market for alternative information and tools is very, very challenging, and the current market environment isn't making it any easier. But there are clear needs out there that should and will be addressed. I will write a post on the alternative information market at a later time. Thanks for listening.