I am generally obsessed with learning from other participants in equity ecosystem like short sellers, traders etc. Some time back I did post on What LT investors can learn from short sellers. This time lets look at what can long term investors learn from successful Private Equity Players and Venture Capitalist.
Private equity mindset
Private equity tend to hold for much long periods of time than most investors with an average hold time of more than five years right now. They tend to favor smaller companies.
Focus on Absolute Long-Term Returns
Private equity investors do not benchmark their performance in the same way many public market investors do. In private equity, the goal typically is to generate absolute investment returns over a long period of time. By adopting a similar focus, public equity investors gain an edge over fellow market participants who make decisions based on short-term results or emotional swings. The increasing “short-termism” of many investors has created an opportunity for those willing to apply private equity principles to the public markets.
Error of omission is much more costly than error of commission
“The thing all the venture firms have in common is they did not invest in most of the great successful technology companies.” “The mistakes that we make in a field like venture capital generally aren’t investing in something that turns out not to work. … it’s the big hit that you missed. And so every venture capitalist who had the opportunity to invest in Google and didn’t just feels like an idiot. Every venture capitalist who had the opportunity to invest in Facebook and didn’t feels like an idiot. The challenge in the field is all of the great VCs over the last 50 years, the thing that they all have in common, is they all failed to invest in most of the big winners. And so this again is part of the humility in the profession.” Warren Buffett and Charlie Munger call this type of mistake an “error of omission” (i.e., what you don’t do can hurt you more than what you actually do). No one describes this category of mistake better than Charlie Munger: “The most extreme mistakes in Berkshire’s history have been mistakes of omission. We saw it, but didn’t act on it. They’re huge mistakes — we’ve lost billions. And we keep doing it. We’re getting better at it. We never get over it. There are two types of mistakes: 1) doing nothing, what Warren calls “sucking my thumb” and 2) buying with an eyedropper things we should be buying a lot of.”
Source: 25iq Blog post
People
Venture capitalists “spend a lot of time talking about markets and technology…. and we have lots of opinions. …but the decision should be around people…. about 90% of the decision [is people].”… “We are looking for a magic combination of courage and genius .… Courage [“not giving up in the face of adversity”] is the one people can learn.” When you have a team of strong people in a startup, their ability to adapt and innovate gives the company and the investors optionality. Weak teams which can’t adapt to changing environments usually fail. Identifying the right people is all about pattern recognition
Source: 25iq Blog post
For Anandan, the team is the most important parameter. Two to three co-founders are ideal, he says. “A great tech bent is a huge plus. They should have a track record and should have been around for some time,” he says.
“We invest more in people than in a specific plan, because plans often change.” “Failing quickly is a good way to plan. Failing often makes failures small and successes large….In small failures you accumulate learnings about what works and what doesn’t. Try many experiments but don’t bet your company on just one, keep trying, keep failing small.” “There are probably three or four things you can control out of ten that matter for the success of your company.” Competitors control another three or four. “The rest is just luck.” Partly for that reason, he is dismissive of business plans. “I’ve never seen one that’s accurate.” Entrepreneurs who can adapt are far more likely to achieve great success. No plan survives first contact with the competitors and customers in a real market. Investing in great teams generates optionality since great teams can adapt.
Source: 25iq Blog post on Vinod Khosla
Emerging moats
“You want to tilt into the really radical ideas… but by their nature you can’t predict what they will be.” “There will be certain points of time when everything collides together and reaches critical mass around a new concept or a new thing that ends up being hugely relevant to a high percentage of people or businesses. But it’s really really hard to predict those. I don’t believe anyone can.” This set of quotes describes the best way to deal with complex adaptive systems – rather than trying to predict the unpredictable, it is best to purchase a portfolio composed of mis-priced optionality
Source: 25iq Blog post
Market potential
“Anyone who has pitched VCs knows they are obsessed with market size.” “If you can’t make the case that you’re addressing a possible billion dollar market, you’ll have difficulty getting VCs to invest. (Smaller, venture-style investors like angels and seed funds also prioritize market size but are usually more flexible – they’ll often invest when the market is “only” ~$100M). This is perfectly rational since VC returns tend to be driven by a few big hits in big markets.”
“If you are arguing market size with a VC using a spreadsheet, you’ve already lost the debate.” For early-stage companies, you should never rely on quantitative analysis to estimate market size. Venture-style startups are bets on broad, secular trends. Good VCs understand this.” “Startups that fill white spaces [areas where there is latent demand without supply] aren’t usually world-changing companies, but they often have solid exits. They force incumbents to see a demand they had missed, and those incumbents often respond with an acquisition.”
Source: 25iq blog post
“A big (scalable) idea and a great team are key,” says Kalra. Also, the fundamental due diligence of an idea is necessary while the market size needs to be big enough to lure him. “I would not invest in an idea where the market size is restricted. It should have the potential to grow and be able to give better than the [average] market returns,” he says
Read more here
Customer pain
Jim Goetz is a venture capitalist at Sequoia Capital> He says “Many of the entrepreneurs that we back are attacking a personal pain.” “Our view is that, early on, if you’re solving a meaningful problem, even if it’s for a small group of people, there is an opportunity to expand beyond that over time.If a business is not solving a genuine customer problem in a unique and compelling way and in a manner that is defendable via a moat, a business is unlikely to succeed.
Source: 25iq blog post
Power Law
In 1906, economist Vilfredo Pareto discovered what became the “Pareto principle,” or the
80-20 rule, when he noticed that 20% of the people owned 80 % of the land in Italy— a
phenomenon that he found just as natural as the fact that 20% of the peapods in his garden produced 80% of the peas. This extraordinarily stark pattern, in which a small few radically outstrip all rivals, surrounds us everywhere in the natural and social world. The most destructive earthquakes are many times more powerful than all smaller earthquakes combined. The biggest cities dwarf all mere towns put together.
The error lies in expecting that venture returns will be normally distributed: that is, bad
companies will fail, mediocre ones will stay flat, and good ones will return 2x or even 4x.
Assuming this bland pattern, investors assemble a diversified portfolio and hope that winners counterbalance losers. But this “spray and pray” approach usually produces an entire portfolio of flops, with no hits at all. This is because venture returns don’t follow a normal distribution overall. Rather, they follow a power law: a small handful of companies radically outperform all others. If you focus on diversification instead of single -minded pursuit of the very few companies that can become overwhelmingly valuable, you’ll miss those rare companies in the first place. The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined. This implies two very strange rules for VCs. First, only invest in companies that have the potential to return the value of the entire fund. This is a scary rule, because it eliminates the vast majority of possible investments. (Even quite successful companies usually succeed on a more humble scale.) VCs must find the handful of companies that will successfully go from 0 to 1 and then back them with every resource. Of course, no one can know with certainty ex ante which companies will succeed, so even the best VC firms have a “portfolio.” However, every single company in a good venture portfolio must have the potential to succeed at vast scale.
Return per unit of time invested
As a venture capitalist once told me, venture investors are investing two things: time and money. The concern with the financial investment is obvious. Less obvious, however, is the opportunity cost in terms of time. Because the cost of continuing to invest time in the entrepreneur’s venture is the inability to take on another, potentially much more lucrative venture, the venture capitalist often has an incentive to shut down the venture and move on before the entrepreneur is willing to do so.
Source: The Masters of Private Equity and Venture Capital (p. 149). McGraw-Hill Education. Kindle Edition.
How to take long term view?
“Five-year plans aren’t worth the ink cartridge they’re printed with.” Great teams are able to respond to a world which changes in ways which cannot be foreseen. This is why venture capitalists spend so much on the people employed by the startup. A strong team of people means the startup itself has optionality. The ability to “steer” as conditions change is more valuable than the ability to create medium- and long-term plans. Good venture capitalists mentally giggle when see hockey stick shaped distribution curves based on unrealistic assumptions that don’t map to reality
Source: 25iq Blog post
Estimates do not matter, what’s matter is the thinking behind those numbers
“Even though the numbers [in the entrepreneur’s business model] will likely be wrong, your thinking behind how you arrived at those numbers is critically important. Think of each assumption as a dial. Which ones connect to things that matter, and what impact would they have on your ultimate outcome if they turn out to be only half as effective – or then again twice as effective? Of the ones with the biggest impact, what underlying factors determine their outcome? Which ones can kill your business?”
Source: 25iq Blog post
“When they have their five-year plan and they come down to net profits, that’s okay. But then when they tell you how much your earnings per share is going to be and what the dilution is going to be and then how much, at what price earnings ratio the stock is going to sell at and then they tell you, well, you know if you invest it today you would make twenty times or a hundred times or something on your money, at that point I don’t want to talk to them anymore. Very nice to have met you. Goodbye. Good luck.”
Source: 25iq Blog post
ContrarianValue Edge 
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