Should private companies raise money from mutual funds?

There is a trend lately for private companies, in later stages of their fundraising, to include mutual fund managers in their venture rounds. In theory,the idea has a lot to offer, but in practice this is one of those things that does not always work out as well as planned.

It seems like it should work. The big mutual funds, firms which typically invest in public securities, devote a small fund to late-stage public companies. It gives the mutual funds a chance to improve returns slightly. Venture returns seem to be on fire lately, and the big mutual funds already invest in a wide array of securities to generate better yields for their own investors (i.e. you, me and everyone else who has a 401(K) plan). It also seems like a good idea for private companies, a way to dip their toe into the water of eventually going public and dealing with public investors. As one CEO put it to me recently, it is a way to “inoculate” management teams to the vagaries of the public markets.

This idea is not new. I can remember two prior periods when public market investors tried something similar. The first was during the 1990’s dot.com Bubble, and then again in the mid 2000’s. The first time it was mutual funds, the second period saw a lot of hedge funds make a similar attempt. There were probably periods that predate those. And if you look at the timing, the motivation of the public investors is clear. They are periods when the big funds had ample cash to invest, and periods when the venture market seemed to be on fire. Neither of those attempts ended particularly well.

The problem is that for the big, public funds venture investing is a very small piece of their overall investment portfolio. As such, it never seems to get the full backing of the institutions behind them. This creates a seemingly inevitable mismatch in timing between when the funds want to exit and when the companies want to provide them that exit and go public.

Typically, the big funds hire very good, very smart investors (not always, but often) to run their venture books. These managers make smart bets, but eventually the timing issue comes up. Funds that buy public securities need to have room to maneuver, they are accustomed to the fact that they can exit a stock or bund investment in the public markets at any time of their choosing. For the big mutual funds, their ability to exit a stock becomes a cap on how big a position they are willing to take in a stock. These investors look at a public stock and its daily trading volume. Usually, they do not want to buy a position that is more than seven times daily trading volume, and even that level is pushing it. So if a stock trades 100,000 shares a day, the fund manager who takes more than a 700,000 share position in that stock is going out a career limb.

By contrast, a private company CEO is accustomed to venture investors. They expect to eventually exit, but are willing to wait years, not days to do so. For a company in late-stages before an IPO, the last card the CEO has to play is the timing of that IPO. The decision to list will hinge on many factors beyond just the demands of one or two investors. By the time a private company gets to the size where these things happen, they typically have close to two dozen investors. All of them want an exit, and if only one or two sees urgency in going public, the company can hold off for a period.

What seems to happen next is that there is some shift in tone in the public markets. The markets crash or interest rates change direction. This causes the investment strategy committees at the public funds to rethink he way in which they allocate funds among the various classes of securities. And suddenly, the team running the private funds find that their investment horizons are shortened. Suddenly, they are under immense pressure to get liquidity in their investments.

At this point, something has to give. Either the fund manager brings so much pressure to bear that the company is forced to go public early, which makes the company unhappy. Or, the company delays its IPO (I mean, look at those markets…), and the fund manager suffers ugly returns, which makes the management company unhappy.

That, at least, is the way this has played out in the past. Maybe this time is different. The biggest mutual funds are now very big and have all sorts of less liquid investment on their books. And if I remember all of this, the people running the fund companies can certainly learn from history.

Still, I would caution private companies from taking funds from public investors too early. I caution all management teams about taking any outside money. Taking an investment means you are going into business with those people. Most companies are now well-practiced in picking their VCs carefully, selecting those that offer advice, access or some other strategic benefit, over those merely offering cash. The same holds true for taking money from mutual funds.

And as for the ‘inoculation’ factor, it only goes so far. There is very little training to prepare a CEO or CFO for dealing with the public markets, other than ‘on-the-job’ training. Having a few, venture-like public investors is still a far cry from dealing with a sea of hedge funds. The public funds tend to send people with venture or private-company backgrounds to run their venture investing, and as such, they are a very different personality type than the majority of public company investors.

I do not think there is a hard and fast rule here. Sometimes these investments go exactly as planned, but just as often they do not.

Are there any value stocks in Technology?

I do not usually write about investment styles, but I suffered through two winters at the University of Chicago, which means that  I am entitled to occasionally touch on the subject.

I have been listening to Barry Ritholtz’s Masters in Business podcast on Bloomberg. Lately, the podcast has been interviews with quant investors. One of their big themes is that ‘value’ stocks tend to outperform the market over time. Here, value is defined as something with a cheaper multiple (P/E, Price to Book, pick a metric) than its peers. There is a ton of data exploring this phenomenon, and everyone seems to agree that it works across all sectors.

When I heard this again, years after business school, it sparked a discordant note in my head. The University of Chicago side of my brain says believe the data. But the Valley side of my brain says this rule cannot possibly apply to tech.

When I was a research analyst, we used to say that “There are no Value stocks in tech.” The idea being that tech stocks with low multiples are cheap for a reason, and that they rarely recover. The landscape is littered with “Value Traps”, cheap stocks of companies that had fallen by the wayside. The idea being that in technology if a company mis-executes or misses a product cycle, it then faces oblivion, displaced by whatever the new technology is. The textbook example of this is Nortel, which was incredibly cheap all the way until it declared bankruptcy, having largely missed the 3G upgrade cycle (among many other problems).

Ritholtz, the podcast host, once made a similar concession noting that the value strategy of buying the worst performers of last year worked well “Unless it’s steam power or buggy whips.”, implying that technologies do go obsolete.

Now, I do not have access to all the stock databases anymore, so I can not directly research this. (If you have the database and want to share it, drop me a line. Happy to do a research project here.) But my guess is that, if we go back and look at “Technology” stocks for the past thirty years (or twenty or ten or five), we will find that Value methodologies work for technology as well as they do for any other sector.

So why the discrepancy between the hard data and empirical wisdom?

Obviously, this so-called ‘wisdom’ could just be an emotional bias. The stock market is littered with these, and there is a reason that quant funds have grown so big. However, I think there is something else going on here. I think we are mis-pricing technology in some way, and we need a better way to measure the quality of earnings of technology stocks. In this discrepancy, I see an arbitrage opportunity of some sort. The conventional wisdom and the quant data can be reconciled if we measure things better. In short, how do we quantify the risk of technological obsolescence, and then factor that into our stock-picking?

One of the themes of quant investing holds that while value stocks outperform, “quality” stocks outperform as well. And if we can find a way to measure quality, and apply that to value investing, we may have a way to meaningfully outperform. When the quants talk about quality they use metrics like revenue growth and margins or share buy backs and dividends. In technology, I think we can find a better measure of quality. The trouble is, what is that measure?

I do not have the answer just yet. I know buy backs and dividends are flawed since so many tech companies are growing so rapidly that deploying capital in this way is probably not a good investment. Also, I know that margins only tell part of the story. There are structural reasons for some parts of ‘technology’ to have better margins. Semiconductors are lucky to get 50% gross margins, but software companies should have at least 80% gross margins. But buying software over semiconductors is only a strategy that works during certain points in the cycle, and probably would have been a losing bet over the last three years.

On the other hand, our goal should be to remove as much subjectivity from this as possible. I am looking for quantifiable rules that remove any potential emotional bias.

My guess is the answer lies in some combination of growth metrics and changes in margins. I also think it needs to be applied on a sector basis. Buy a bundle of semis stocks and short a bundle of SaaS names, for example. My guess is that if we apply these new rules to technology sectors as a whole, there is a solid strategy in there, somewhere. I recognize that these are already widely used quant strategies. So at this level, I think there is room for a more qualitative metric. Just assigning companies to different tech ‘buckets’ alone will introduce some of this.

I do not have a complete answer yet, but I do think it merits further exploration.

It’s Complicated – My thoughts on the Apple Keynote

I watched Apple’s keynote yesterday, and I wanted to post something about it. If this blog were my source of income, I would have to post something because nothing generates traffic like putting Apple in a headline. (Well, that and dancing kittens.) But I had such a visceral reaction to the event, I just wanted to get my thoughts on ‘paper’ and keep them from running around in my head.

First, on the watch. I just cannot escape the sense that the Apple Watch is too complicated.  There are two iPhones – a big one and a small one. They come in different colors, which are the same price  and memory sizes which are not the same price. Easy to keep track of. With the Watch, there are three models, with different sizes, then there are different colors and strap combinations. I think there are slightly over two dozen combinations, but I honestly could not parse it all out.I mean, someone built a spreadsheet to keep track of all the versions (hat tip to Daring Fireball for that link). I understand that a watch is a much more personal and fashion-sensitive item, so a vendor needs some of this, but it just feels un-Apple-like.  Doesn’t that feel like something from the bad old days of Windows?

To make matters worse, it sounds like the Apple Watch User interface (UI) is not that simple itself. I hard a time following the UI model from the video. I did not attend the event, but several people who did, and actually handled the watch, said the same thing. None other than leading Apple blogger Jon Gruber raised this question. He linked to a Nilay Patel article on The Verge that had a similar complaint. And so did Ben Thompson (subscription required, and you really should subscribe).

I am not going to extrapolate from the Apple Watch and predict that Apple is on a downward trajectory. I think they are going to sell a lot of the watches, and make a lot of money from them. However, I do think that in the Watch launch we can some faint cracks in the company. Maybe these will amount to nothing. Maybe they are just cracks in the skin as a new company emerges. But maybe, someday they will become something else.

In particular, I cannot escape the sense that there is something about Apple that is very precious. I do not mean that in the Golem/Ring sense of the word, but more in the slightly condescending British use of the word. I am a big fan of Apple products, I own some version of most of them. I definitely have some emotional tie to the brand, with positive associations. But there is still that voice in the back of my head whispering Vertu.

For those who do not remember Vertu, it was Nokia’s luxury phone brand. They sold features phones for $60,000 and up, with diamonds screens and gold cases, complete with special retail outlets in ultra-high-end malls. I never understood who bought them, other than this guy, and the whole venture always seemed like a sop to the company’s design team. As if they all really wanted to be jewelry designers, but had to settle for phones.  Now Apple is not Nokia, and the Apple Watch, even the $10,000 Edition Watch, are not Vertu devices. But like I said, there is that little voice whispering to me.

That all being said, one other thing really stood out for me from the Apple keynote, especially in their launch of the new MacBook. They are capable of some incredible engineering. The logic board of their new laptop is so small. Online, people are complaining about some of the design decisions the company made, but I look at that board and I see a company that knows how to make choices. They are sacrificing certain features for a bigger goal. i was also impressed by how they reworked battery structure to fill every last gap in the chassis. Serious engineering.

Of course, they repeatedly claimed that they had ‘invented’ many new technologies for the MacBook. I have to wonder how much of that was their own invention, and how much was the work of their beleaguered suppliers. Setting that aside, I really wonder how the rest of the industry will keep up. Apple has so many resources and so much talent, I think other laptop makers are permanently relegated to second place in technology leadership. Apple has built a very different kind of organization, staffed by some very smart people. This, combined with their ability to make tough choices, would scare me if I worked for a competitor.

At this stage in the evolution of an industry, I would probably argue that the biggest threat to Apple is disruption from someone with a radically different approach to computing. However, as we have seen, Apple is perfectly capable of ‘disrupting’ itself. Which brings me back to the watch. I am not sure this is the right product, and I am not planning on buying one, but it I do think they are headed in an important new direction. There is no reason to see the smartphone as the pinnacle of mobile computing. If you deconstruct the ways in which we use computing devices, having a six inch slab of glass, plastic and aluminum has no natural reason for being our default way to communicate. Smartphones have done well because they combine connectivity, computing and identity. The watch is a powerful contender for becoming the identity leg of that troika, and with a few more years of miniaturization, it could hold the other two legs as well.

MWC 2015 – A Year of Substance

It feels like the last few years, Mobile World Congress (MWC) has been filled with vague concepts and more marketing than substance. I think there is a change in this, evident at the show. Private companies were able to point to real carrier wins or important partnering agreements. Even some of the vaguest, fluffiest technologies like the “Internet of Things” (IoT) now have some real products and real businesses hacking apart different aspects of what IoT promises.

A few months back I noted that IoT is starting to move from the frothy realm of the marketers into the sober daylight of Product Managers’ reality. At MWC I saw several signs of this trend continuing. Companies are starting to think about IoT in much more practical terms. I saw many very specific demos. These spanned the range from updates to very old concepts like connecting transportation networks to some much newer ideas like building a marketplace for data (more on this in a future post). There was also the usual sea of ‘wearables’ but as my following piece on the handset OEMs should make clear, these are pretty undifferentiated.

I was also encouraged by the progress of several private companies I have gotten to know over the years. This was the tenth year of MWC in Barcelona, I even picked up my commemorative 10 year pin. And by my count I have had close to 700 meetings at the show over the years. One of the most enjoyable parts of these for me has been the chance to get to know many private companies. Starting a company is still a very risky venture, especially in the telecom equipment space. I like speaking with private companies, and I am always gladdened when I see them making real progress. It means that the industry is healthy and things are working.

One such company is SpiderCloud. I have written about them often in the past. They have built a network box that is often called an ‘enterprise’ femto-cell, but I think this seriously understates what they have achieved. Their system is not just a small base station, it is really an entire mobile network in a box. It is targeted for installation inside large office buildings or other dense indoor settings. I will save the technical details, but they have built an impressive piece of engineering.

At the start of the show, they announced a partnership agreement with Cisco, the networking giant. SpiderCloud already has a number of carrier wins under their belts, with some very solid names. Adding Cisco as a partner is a big achievement and offers the potential to greatly expand SpiderCloud’s footprint.

The announcement is also interesting because Cisco does not really play in the mobile access space. They obviously make key pieces of telecom switching and routing gear, but they have never done much in the access space. With the SpiderCloud partnership, they now have access to base station technology for the radio access network (RAN). I would not read too much into this, but it does offer a tempting vision of a very different market. And if I were Ericsson or Huawei, I would read a lot into and be very careful about how I address that partnership.

Another interesting company who I have been meeting with for years is Apperian. Put simply, they provide systems to help companies build and deploy enterprise mobile apps. In the past few years, I have written about the slim hopes of the Mobile Device Management (MDM) space. MDM was a hot topic briefly leading to the $1 billion acquisition of AirWatch by VMWare and IPO of Mobile Iron. My concern was that MDM was a very limited set of features, many of which are either blocked or done almost as well by Apple and Android. Apperian’s approach is much broader, solving several more serious pain points for enterprises. Enterprise apps are much more complicated than IT departments realize at first. Building an app is ‘easy’, or at least straightforward, but getting those apps deployed and working across personal devices on Android and iOS becomes very complicated very quickly. Apperian helps to solve that problem.

So I was greatly encouraged by Apperian’s traction over the past year. I am not quite sure what is public, so I will skimp on the details for now, but the company has racked up some very serious customer wins. If you are building apps for your employees and partners and consultants, take a look at them.

I could go on. There were many other examples of the ‘substance’ I detected at the show, but I will save them for future posts. One common complaint I hear at trade shows nowadays is the lack of ‘innovation’. It is almost as if the rise of mobile phones, and then the even faster rise of smartphones has led us to expect a ‘disruptive revolution’ every year. When I say that out loud, I realize how untenable it sounds. We are at the point in industry evolution when disruption is overrated. What we need now is slow, steady, grinding progress. This makes trade shows seem less exciting, but execution is often more important than great ideas. And I think this was a year of progress on many fronts in that regard.

MWC: A Radical, Crazy Suggestion for Mobile – Intel + Qualcomm

One of the clearest trends over the past few years has been Qualcomm’s dominance of the LTE modem market. I have written about it a bit in the past, and I know there is an ocean of ink being written about it on the Street coming out of the show. Rather than dwell on the details which are being covered elsewhere, I want to make a somewhat crazy suggestion.

Intel has spent the past twenty years and probably $20 billion trying to get into the mobile market. For all of that, they still have very little to show for their effort. As far as I could tell at MWC, their only design wins are in low volume SKUs at a few global OEMs or equally low volume designs at China design houses. And they continue to heavily subsidize these devices. One vendor had an Intel-powered phone in their booth that the vendor claimed would retail for $60. The large screen on that device probably costs $40 alone. If I had to guess, I would say that Intel is paying the ODM $20 or $30 per device in ‘contra-revenue’ aka marketing subsidies. Intel can afford to subsidize a lot of these phones (for now), but eventually Mediatek and Spreadtrum will get to volume in LTE (probably mid next year) and at that point, even the subsidies will not keep Intel chips competitive.

So here is my idea. Intel should exit the mobile business. They have looked to mobile as a way to fill their fabs, so abandoning mobile will leave a hole to be filled. As many have pointed out, the best way to fill that hole, would to open up their fabs to outsiders and become a 3rd party foundry. So when they announce their mobile exit, they should also announce their first major foundry customer – Qualcomm. Qualcomm needs a new foundry supplier, given their difficulty with TSMC in getting their latest Snapdragon 810 product out the door. So they could use the help of a leading foundry. In turn, Qualcomm could also abandon its nascent ARM server business. This relationship would rock the industry.

This idea is odd enough that I hesitated to publish it. But during the Qualcomm investor Q&A I heard an interesting comment. In response to a question about Moore’s Law, Qualcomm pointed out that they have a choice of multiple foundry partners for the 10nm process node. The way they said it made me think multiple meant more than three, but there are really not that many options left – TSMC and UMC in Taiwan, Global Foundries and Samsung are pretty much it. My basic premise is that Qualcomm wants to diversify (not abandon, just diversify) away from TSMC because of the 810 snafu. That leaves three obvious ones. Maybe I am reading too much into an off-hand comment, but I have to wonder if they had maybe considered Intel.

I will be the first to admit that such a deal would be so complex that it may not be operationally feasible. Technically it does not make a lot of sense. It may not even be legal. But it would certainly shake things up. Maybe its time to think the unthinkable.

The Global Handset Industry is set for Self-Destruct

If a person does the same thing over and over again, each time expecting a different outcome, we call that insanity. If dozens of companies in a multi-billion dollar market do it, we call that the global handset industry.

Let’s say you make a product, and you have a lot of competitors, dozens, hundreds. Prices are falling. More people are piling into the market. Now it is time for you to design a new product. Do you experiment with a radically new form factor? Let a single designer attempt to craft a finely honed product that stands out for its quality? Or do you come out with a product that is just a modest upgrade of last year’s product, with no distinguishing design or features?

Well, when you put it like that…..

Really, I am kinda dumbfounded. That handset OEMs seem to be on a path of self-destruction. I visited every major OEM’s booth and dozens of smaller vendors. I am sure I missed one or two interesting devices with some novel feature, but at some point, I can only stare at identical black, plastic slabs for so long. There is nothing new or differentiated out there, and this cannot last.

I have to admit, at one point, I almost lost my temper. A couple times actually. The industry seems to be in some very complicated form of denial. And there seem to be a couple common threads to their excuses.

One handset OEM manager wanted to blame Chinese handset vendors, complaining that they were just copying what everyone else is doing. The lack of self-awareness in that statement was hard to fathom. In fact, the only companies that seem to even to be trying to do something new are the small China OEMs. They are now selling a wide variety of ruggedized phones. One vendor even had a new line of flip phones, some Android powered, some not. Full credit for trying.

By far, my favorite excuse, one that I heard multiple times, was that the industry’s declining fortunes was Apple’s fault. If only Apple was not doing so well and sucking up all the industry’s profits. I understand that excuse, I used it in sixth grade. It was not my fault that I got a B in math, the homework was just so hard, and algebra is really hard. Not my fault.

I suppose, if you want to get abstract about it, you could blame Google. They are not that helpful to their handset partners. I mean, other than providing an operating system for essentially free, saving everyone else hundreds of millions of dollars of R&D. But other than that they are not helping.

I know I am ranting. And in all fairness, the OEMs are constrained in many ways in what they can offer. Google does restrict home page hardware. Many companies in China can operate on very thin margins because they have a special, ultra-low cost of capital. And the carriers, well, let’s just say they are not part of the solution.

Nonetheless, something has to change. In the next five years, a lot of companies are going to have to exit the market. Even the big names are vulnerable. Time to make some bold bets, there is nothing left to lose.

I have a few suggestions, and if they ask around, they will probably find some more ideas. But make no mistake, these are risky ideas. They may not succeed, companies need to experiment, and that risks failure. Some companies are going to try new things that will flop, and that flop will force them to shut down. But if everyone continues on the same path, they will close anyway.

So here are my rough ideas. Offered up for free, but if they work, buy me a nice dinner, or find me a comfortable board seat somewhere.

  • A QWERTY keyboard Android phone. There are still millions of Blackberry users, and lapsed Blackberry users. The easiest way to spot a banker or investor at MWC is to look for the people with Blackberry’s. I spent $60 on a Typo cover for my iPhone, it works OK, but dampens the design of the phone. A full-powered, well-designed high-end keyboard phone could sell millions to some of the biggest spenders out there. I can say conclusively that no one is making these. I know because I have scoured the world looking for a design. None of the big OEMs are making one. I even tried to hire a design house in China to build one. But there is no demand in China for such a phone, too hard to type Chinese characters on one. There have been a few other attempts, contact me if you want to know what those did wrong, but there is definitely a big opportunity out there.
  • Find a really good designer, someone with product expertise from some other kind of product. The kind of person who designs things in their spare time because they see the world differently, but who also has a proven ability to deliver real products. Then let that person have total 100% control. Keep their team locked away from the salespeople, marketers and management. Let them design their vision of the perfect device. Quality can still stand out in this market.
  • For the big OEMs, fire everybody. Stop spending millions on cute software tricks and unneeded features. Build a solid phone using stock Android. Tell Google about it and see if they will put it in the Nexus line-up some year. Warning, this will not save the company, but it will maximize the profits that a company can harvest before the market gets really bad, and then exit gracefully.
  • Try to build a brand-new youth oriented brand, completely unrelated to the core brand. Use every social media trick to generate enthusiasm. Sell the phone online only to save costs and avoid having to deal with the carriers. Maybe launch some other consumer products tied to it somehow. The only thing is that this cannot be attempted in China. Xiaomi and One Plus are already far down this path. But other regions are open to the approach – India, Africa, Western and Eastern Europe, the Middle East. Lots of regions with untapped consumer loyalty to find.

Not the best set of options, I know, but there are not many other choices left. In fact, it is time to either make these bets or go home. Or just give into the illusion, and pretend everything is going to be fine.

MWC: Semiconductor Consolidation Cont’d

One of the biggest pieces of news last week was the sale of Freescale to NXP. Both companies have products targeting mobile, but neither can be considered overly reliant on mobile. So while this was a major deal, the direct impact on mobile is a bit low.

I noted in January that there is going to be major consolidation in the semiconductor industry in coming years. This was just the start. There are still something like 300 analog chip vendors in the market, a number which just feels too big in a world with no obvious hyper-growth end-market.

What I found most interesting was the degree to which the many small or mid-sized chip companies seem ambivalent this consolidation. I spoke with a few CEOs and Corporate Development executives from these companies, and they all seemed to feel that NXP/Freescale really had nothing to do with them. The common theme seems to be that the two companies have few overlapping areas and that the combination was driven by financial motives rather than technological ones. Well…. Yes, that is exactly the point. Semiconductors are not a growth business anymore. It is a cyclical business where scale, operations and margins matter most.

I think we are moving to an industry model where there are only two kinds of companies left – acquirers and targets. Pick which one you are and run your company accordingly. This is not the same as small companies and large companies. Small companies have the ability (and the currency in the form of their high-multiple stock prices) to become large companies. And large companies are going to wake up some morning to realize they are not so large relative to their peers anymore.

On the topic of semiconductors, one of the big off-shoots of the IoT delirium is the notion of sensor networks. Millions of sensors in everything connected to the Internet somehow. I have spent a lot of time looking at the chips that make those connections, but I noticed at the show how the big chip companies lack as robust a portfolio of sensors. Barometers, pulse rate, breath rate, blood oxygen, humidity, temperature – the list goes on. Some of these categories are getting addressed somewhere in the supply chain, but the category is far from robust.

If I were running a semiconductor Corp Dev team, I would be scouring the world for interesting new products here. I get the sense that this taking place, but I imagine the degree of intensity will increase in coming months.

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