If you go to Amazon.com and search for books about venture capital, you get 14,114 responses, which includes many text books. Andrew Metrick, a professor of finance at Wharton, has just written a new book on the subject — titled, Venture Capital and the Finance of Innovation. Unlike the thousands of other books on the subject, though, this book offers a different approach, especially in areas such as valuing startup companies and IPOs, by bridging the gap between finance fundamentals and venture capital practice. Knowledge at Wharton spoke to him about his new book and also about hedge funds, which are in the news almost every day.
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Knowledge at Wharton: There are more than 14,000 books on Amazon.com that deal with venture capital. Could you tell us a little bit about what makes your book different?
Metrick: Well, I think the main difference is that my book takes a quantitative approach, and that quantitative approach has two main features. One is that the book is closely rooted in the data — i.e., what kind of evidence do we have about performance? What kind of evidence do we have about what happens to companies after venture capitalists invest in them? There are a lot of statistics and a lot of information that would help a decision maker and root their decision in what we know historically. So that’s one aspect that’s quantitative.
The second aspect is in actually valuing the companies. In thinking about what they’re worth, whether to invest in them, we take a finance framework, a finance approach — the same way that an investor would look at a public company, or like we teach at Wharton, that a CEO should look at an investment his company is making. So, that’s really the way in which it’s different.
Most of the books that are out there are going to, I think, tell sometimes very interesting stories about what different people have done and call upon experience in a way that tries to give people a sense of what it is to be a venture capitalist. But this book is really quantitatively based.
Knowledge at Wharton: You also have a quick way to value IPOs. Could you explain that?
Metrick: Sure. In the course of making an investment decision, a venture capitalist has to imagine, what will this company be worth upon a successful exit? And then they have to try to estimate the probability of success and discount all of that back to today, since we are years from that success.
In trying to think of what a successful exit would look like, a successful exit is usually an IPO. We need a way to say, “Okay, what will a company be worth at IPO, when that IPO might be four or five years from now?” That same technique can be applied to IPOs at the instant that they go public.
What makes the approach a little bit different than what’s usually done is that it is, just as I said before, a quantitative approach, rooted in data: What do we know about other companies that have had IPOs? How fast do they grow in the five to seven years after their IPO?
When do they end up looking like other companies in their industry? What is a very fast growth rate — what would it look like? And then you need to pull all of those things together into a discounted cash flow analysis. A discounted cash flow analysis is a common thing to be using for valuation, but it’s not used that often for IPO’s.
Knowledge at Wharton: Even before a company can go through an IPO, though, it goes through a start-up phase, and one of the hardest things is how do you value a start-up, especially in the technology area? This can be extremely difficult. What are some of your thoughts on that?
Metrick: Well, I agree, that’s a very, very difficult thing. And, what I’m trying to do in the book and in the course that we teach here at Wharton is to give people an idea of how they could put some bounds on that valuation. How can we learn, from the thousands and thousands of start-ups that have gone before, what a wonderful performance looks like, what an average performance looks like, so that we’re not just staring off into space, putting our finger in the air and trying to gauge which way the wind is blowing?
And so, I think that that problem is very difficult. I think that people who are great at it will become very, very successful. And this is really just an attempt to give people the tools, so that they can take their natural abilities and become great at it.
Knowledge at Wharton: So what kind of tools can they use? Spreadsheets and some common sense, is what I have heard….
Metrick: Yes, that’s probably the combination. As it stands, they’re using common sense, and the idea in taking a more academic approach is to not throw away the common sense. A lot of times we think that academics are just saying “plug things into models and it’s garbage in, garbage out.” I’m sensitive to that critique.
Instead, what we’re trying to do is figure out a way to frame people’s common sense; to take their common sense and filter it through data and through standard tools, so that they can put a quantitative framework on their common sense.
I call one of the models in the book The Reality Check Model. This is because it enables you to take what you already know and kind of crank it through a standard framework, so that you can put a reality check on your valuation.
Knowledge at Wharton: One of the difficult challenges that venture capitalists face, especially when they’re flooded with so many business plans, is figuring out which companies they fund are going to lose money, which will make moderate sums of money and which ones will be blockbusters. Does your book offer any suggestions about how VC’s can predict how well their investments will do?
Metrick: I agree with you; that is the greatest challenge. I think, actually, a lot of that is more the art of being a great venture capitalist than it is the science. What the book, I hope, enables people to do, is that when their “artist intuition” is telling them that this company is going to do really, really well, they can put some science on what “really, really well” would mean.
But, I think that when a wonderful manager comes in front of you and says, “I have this great idea,” deciding whether this idea truly has a huge market and whether or not this person can pull it off — a lot of that is art. I think that I would be stretching if I said that my book tells people how to do that. I think that if anyone had a magic formula for that, they probably wouldn’t put it in a book. But instead, what we do is, we enable people who are developing their intuition for those things, to again give their intuition some backbone.
Knowledge at Wharton: So, based on what you just said, would I be right in assuming that this book is not just for students — you have material there that could be helpful to venture capitalists and also to entrepreneurs?
Metrick: Well,I certainly hope so. But I’ve learned through hard experience that since I spend all of my time talking to students and teaching students, that’s the audience that I should write for. And if I try to write for an audience that I’m really not qualified to write for, I’m certain to mess it up for everybody.
So instead I wrote a book that I know will communicate with students, that has equations in it, that would be a book that as a pure trade book wouldn’t fly. And I hope that given that it has a cohesive framework and it has a specific audience in mind, that people with an academic bent from outside that audience would benefit from the book.
Knowledge at Wharton: Let’s look at hedge funds for a minute. Lately, there have been loud demands that hedge funds should be regulated. And in fact, when the U.S. Secretary of the Treasury, Hank Paulson, was in Germany recently, he said that he feels scared when he looks at the hedge fund industry. Do you share that view?
Metrick: Yes, I think that that would be a very good fear to have if someone were a Treasury Secretary or any other senior policy maker. They are controlling well north of a trillion dollars worldwide, and that gets amplified tremendously by the leverage that they take on. And, a lot of their trades and a lot of what they do is opaque. We don’t really know what they’re doing and there is a tremendous amount of long counter party chains in the industry.
When we saw Long-Term Capital Management collapse nine years ago, it immediately made people concerned that maybe this could bring the whole financial system down with it. And, while a crisis really was averted then, we still don’t know a whole lot more about what the chances are of such a crisis. So, I think that the Secretary is wise to be concerned, and until we know more, I don’t see how anybody could say that they’re not concerned. We just know so little and we can tell that there are some potential dangers there.
Knowledge at Wharton: You know, a lot of people have been asking about more regulations for hedge funds. Other people don’t think that’s such a good idea. I was wondering what your take on that whole issue is, and whether you think that self-regulation is the right solution, or does the government need to have more pro-active controls?
Metrick: I don’t see how significant regulation could actually be implemented at all. I would imagine that if the U.S. government tried to regulate hedge funds in any way that really kept them from performing to a level that they want to perform, they’ll just all move to the Cayman Islands. So, I think that we’re better off with extremely light forms of regulation that at least enable the hedge funds that are out there to not hide from us.
And on top of that, I would echo a suggestion of [a colleague who is now at MIT] who has called for something akin to what we have for plane crashes. When there is a plane crash, we go in there with a team and we try to figure out what happened. We really look through everything and then publicize the results: “This is why this crash occurred; this is why Amaranth, for example, went down.”
So, the only thing that a hedge fund should be required to do is to agree that if they have a shut-down, within certain rules — they’re larger than a certain amount and they have a certain amount of out flows — that they simply agree in advance that they’ll open their books after they’re closed.
Knowledge at Wharton: But, just looking at why plane crashes occur doesn’t seem to prevent them.
Metrick: Well, it certainly has reduced them. I think people feel very strongly about that. For example, there was a horrible plane crash many years ago. It was a U.S. Air plane crash, from a plane that had been de-iced and that had gone back out on to the tarmack and waited again to take off. And then when it took off, it turned out that it had re-iced again. After that they learned what the problem was, which is you can’t de-ice something before it leaves the gate and think that that is enough. You must de-ice an aircraft right before it takes off. So, we haven’t had a crash of that sort since then.
Knowledge at Wharton: But, are crashes occurring at the same frequency, but for different reasons? I guess what I’m trying to get at is, just analyzing what happens when a hedge fund gets into trouble, does that necessarily mean that it’s going to prevent future blowouts?
Metrick: Well, we don’t know, but I think that there is strong evidence. And here, I am going too far off field from what I know. But there have been no major accidents related to this type of commercial airline crash in an extremely long time. So, it’s always hard to extrapolate from very small samples, because there was never a high rate of crashes. But, I think that most industry experts would tell you that we are better at preventing airline crashes.
Now, will the same thing happen for hedge funds? We don’t know, but it’s actually, I would think, a relatively cheap experiment. And, I would imagine that the tighter control that we would all perhaps feel more comfortable with would be an illusion. Were the government to say, “Everyone must register and everyone must open their books to us every two years,” or something like that, the hedge funds would all move away. And that is because this is capital — it doesn’t need to be physically located and legally domiciled in the United States to be effective.
Knowledge at Wharton: Let’s speak about transparency and the opaque nature of hedge funds that you referred to earlier. As we know, on February 8, The Fortress Investment Group went public, and it was the first U.S. hedge fund manager that went public. Do you expect that other hedge funds will follow, and is this a move towards greater transparency?
Metrick: Well, certainly when someone is successful at something, others will follow. I certainly expect that some others will follow. I am skeptical about whether you will ever see very much of the industry publicly held for two reasons. Number one, I don’t think that transparency is good for them. The transparency may be good for us, as outsiders who would like to regulate or watch over the industry. But, I don’t think that transparency is good for people who want to make money and make it very fast. So, I would expect that many of them would resist that.
Number two, I think that when hedge funds are successful — and again, there’s a large academic debate about just how successful they are as an industry — they are successful in part because they have very, very strong incentives for the decision makers. And the decision makers, who are already very wealthy individuals, are capturing a lot of the value of their success. I think that as organizations like this, which historically have been very small and closely controlled, as they go public or sell stakes in themselves, many of those incentives become weakened.
I would be surprised if you would be able to sustain the kind of hunger, speed and nimbleness that you need to be successful as an investor in a larger organization where the ownership and the control of the organization were more separate.
Knowledge at Wharton: When hedge funds invest in a company, they have the reputation of trying to make a quick killing. Is this aggression good for shareholders?
Metrick: Well, I guess that there are two types of quick killings, right? There is the trading quick killing, which is the historical domain of hedge funds and still their dominant domain. That is, “We think something is mispriced, so we’re going to go in. [If] we think it’s mispriced too high, we’re going to sell it short; or, [if] we think it’s mispriced too low, we’re going to buy it.
And I think that when they are taking advantage, essentially as passive traders, getting in and out of things, trying to make money from mispricings, I think largely that this has no effect on shareholders. Certainly we don’t like to see our stocks go down, but we like to see them go up. Overall, we are in these things because we expect them to be fairly priced. So I don’t think that the hedge funds have a very large effect on that.
There are two other sources that I think might be related to your comment. This is where issues do come up, and I think that one is negative and one is positive. There are hedge funds out there that have been accused of shorting company stocks and then actively working to get those stocks down.
Now, when there is some true malfeasance on the part of companies and the hedge funds are working to uncover it, certainly, the current shareholders in those companies are not pleased that that malfeasance has been uncovered, but the malfeasance itself is not the hedge fund’s fault.
When the hedge funds are actively working, as some managers have complained, to perhaps temporarily lower the value of the stocks, so that they can make money off of their shorts, that’s more dangerous. Now, I have no doubt that this goes on somewhat, but I don’t think that this is the standard way that a lot of hedge funds are operating.
There’s a third thing here: We’re now seeing activist hedge funds. And the evidence — and there is some recent evidence on activist hedge funds; Wei Jiang, who is currently visiting in the Wharton finance department has written a paper on this — the evidence is showing that actually when hedge funds come in as activists, that it’s good for the other shareholders.
The ones that we are hearing about now, that are coming in and jostling for change — companies actually do well after they come in. So, it’s a mixed bag, but I would guess that overall, prices are generally being moved more quickly to where they belong, and in cases where there are activists, they are doing well. And, it’s really only a small group that might be engaged in manipulative activities that are harming other shareholders.