The Real Capitalism

When I first set out to write about my viewpoints on business almost six years ago, the one that was always closest to my heart was its potential impact.  In my opinion, the capitalistic approach is the best way to allocate resources, improve society,  and solve the world's problems.  And while I have written about microfinance, corporate and individual philanthropy, and social enterprise over the years, I feel I have never given it as much importance on the site compared to my conviction.  Unicorns were simply more sexy to write about and read.

First off, the double bottom line makes sense for companies.  I would want any strategist in my company thinking about how to reach consumers by solving fundamental issues.  Vodafone did it with mobile devices in Africa.  Unilever does so in India.  Google has single-handedly improved the standard of life for almost every person on the planet by giving them access to information once only held by the elites.  And these companies have dominated their industries and made gobs of money doing so.

I'm not moved by so-called "capitalists" that use their power to skim off the top to line their pockets.  The barbarians at the gate were just that.  The current political system is riddled with personal agendas that make me sick to my stomach.  To me, real capitalists are entrepreneurs that either bring new products and services to market or help lower costs or improve access for consumers.  Companies and systems that are profiting simply by their stature will not last in the long-term.  You see, for example, wall street continues to see their proprietary trading and advisory businesses decline as new entrants and models come to market.  In another example, the sharing economy is systematically taking money out of monopolistic or inefficient industries and giving it to consumers.  The tide is turning and will continue to do so as long as entrepreneurism is embraced.

Corporations are such an important facet of the world that it only makes sense to work in collaboration with governments and NGOs to accelerate social progress.  Corporations are one of the largest sources of revenue and should demand better conditions within their footprint.  Non-profits have the mission and access to serve, while corporations have the chops to measure, execute, and run programs efficiently.   Some of the most critical problems such as education, healthcare, poverty, and climate change will not be solved in a vacuum by one of these groups.  The only way to crack these complex problems is to harness the power of corporations, governments, and nonprofits into a common path.  This will lead to not only a sustainable, happier planet but also provide a stable environment for cash flows of businesses.

I'm optimistic in where the world is now as there is more momentum around capitalism's ability to serve.  Fortune magazine published their first "Change the World" list of companies this year.  Industrialists such as Bill Gates rival predecessors of the past in deploying their vast financial and operational resources to improve the world.   The millennials place more importance to company missions more than any generation in both in choosing where to work and whom to buy from.   New companies simply incorporate social efforts into their everyday business.  All the while, the strength of for profit impact ventures as well as NGOs continues to accelerate.  While governments continue to lose their ability to help due to political turmoil and budget constraints, it's good to see more power and emphasis shifting to those groups that can move quicker and more effectively.

I'll be taking a bit of a hiatus from writing due to my own constraints, so I wanted to make sure I wrote about this important topic.  I'll return when I have a more time to dedicate to writing and perhaps under a new more sustainable platform of my own.

America's Affordable Care Act Problem

If you are perplexed by Donald Trump’s continuing rise in the polls, just read one chapter of Steven Brill’s fascinating “Bitter Pill.”  The book chronicles the back door politics leading to the passage of the Affordable Care Act that would even make DC lobbyists cringe.  The frustration of government is real, and the ACA is a classic example of Washington's seemingly lack of understanding of reality.  The bureaucrats got the bad actors wrong, did little to bend the cost curve, and largely kept the deep profits in the broken system secure.  Years after passage,  is there anything we can do to improve health care in the US?

First, the bad.  Brill discusses at length the negotiations and ultimately concessions given by the government to, among others,  medical device companies, Big Pharm, and large hospital systems, None of these groups were targeted during Obama’s road to passage.  The insurance carriers were an easier target politically as the government publicly boasted medical loss ratio caps which maximized the percent of dollars payers could use for administration and profit.  But the ACA does little to actually lower the "medical losses."  As Brill points out, insurance companies are actually the only constituent besides consumers incentivized to contain costs.  Everyone else gets paid more for more products and services they provide.  Unfortunately, not only did the legislation perpetuate the same payment structure that has driven the system to the brink, but also exacerbated the situation by adding more people into the mix.  Sounds sustainable, right?

I’m not suggesting the managed care companies are victims by any stretch.  But when you see the outrageous tax breaks for “non-profit” hospitals, non-negotiable prices for prescription drugs, and CEO salaries that rival NFL superstars, it makes you sick to your stomach.  The insurance companies are a problem, but there are bigger fish to fry.  Squeezing carriers alone will not fundamentally change the cost structure - just look at any Chargemaster bill.

So where do we go from here?   The optimists are suggesting that the ACA was a start to real reform and the much needed changes will come later (have we heard that before?).  The holy grail of healthcare is the integrated ACO approach according to Brill, but as I have written in the past, I don't think these generally small and disparate efforts are scalable on a national basis.   Government programs such as Medicare will continue to gain power post-ACA and their continued moves towards pay for performance will lift all tides.

But like most broken societal issues, entrepreneurship is the quickest path to improve care and lower costs.  Great innovation and trends such as Telemedicine, better diagnostic technology, and preventative efforts will compel the oligarchs of health care to remain competitive.  Private investment in this space has not slowed, and I even think the megamergers in the payer space will help to bring costs down overall.   Let's hope market based innovation and continued pressure on the cost side of the equation bring consumers closer to much needed affordable, quality care.  Or we could just rely on Congress to fix the problems since they are so adept at it.  Enter the Donald.

The Good Guys are (Finally) Winning

When high finance first comes to mind, one immediately thinks of the excesses.  The $10M birthday parties, the "wolves" of Wall Street, and the Goldman bonuses.  However, the financial services industry, as has been the case with numerous others, is finally experiencing a seismic shift in power.  Innovation, transparency, and even lower fees are becoming the norm as pro-investor trends gain in popularity.  Has Main Street finally gotten control Wall Street?

For one, the largest asset managers, who happen to be the most investor friendly, have taken significant market share in recent years.  Vanguard, Blackrock, and Fidelity, now collectively manage over $10 trillion of assets  Vanguard and Fidelity are non-profit institutions and best known for bringing down transaction costs and low- fee, successful, passive investment tools.  Blackrock has taken it a step further as its popular exchange-traded funds have brought once untouchable asset classes into common stock like vehicles available to the masses.  According to a recent Fortune article, not only are these firms gaining share at the expense of high-priced competitors, but also now using its clout in board rooms to influence executive compensation and thwart short-term focused activist investor efforts.

And for those who have felt shut out of the hedge fund craze, innovative startups have paved the way for individuals to leverage some of those strategies.  The growing roboadvisors, such as Wealthfront and Betterment, provide sophisticated portfolio management techniques at a fraction of the cost.  For investors that prefer a live human, RIAs have become the industry norm.  These advisors, unlike their transaction-based fee predecessors, adhere to a "fidcuiary responsibility" standard that focuses on long-term planning and better aligns incentives.

Even the closed door world of private equity and venture capital have felt the impact of changing times.  Crowdfunding has brought early stage investing to the masses, which has in some ways created competition for VCs.  Many have now embraced the platform by creating their own syndicated investment vehicles on sites such as AngelList and Indiegogo.  Private Equity firms have started to feel the effects of declining pension allocations and increased competition both for deals and funding.  Large firms such as Carlyle and KKR have recently filed for IPOs to find new sources of liquidity and are even opening up to smaller investors.

No the world is not quite caving in for the Manhattan financiers.  But bonuses have not nor expected to reached pre-credit bust levels.  And the industry continues to lose top talent to Silicon Valley companies. With the shift towards friendlier asset managers, the democratization of information and services, and good old fashioned innovation,  the "Flash Boys" are facing the stiffest competition yet.   Perhaps the next big set of investment opportunities for them might be the very ones that disrupt their own industry and unseat them from power.

Why Unicorns Matter

Call them unicorns.  Or bubble companies.  But there is something significantly relevant about the technology startups that have joined the $1B+ valuation club.  When investor Aileen Lee coined the phrase "unicorn" in late 2013, there was an estimated 40 companies on the list.  Now there are almost 100.  Whether or not these valuations prove in or not is a hotly contested debate right now;  but what is missed is how important these companies are to the world.  To consumers.  To innovation.  To the balance of power.  Whether or not venture capital IRR's are met are not.

Most can remember the time of the DOS operating system and the step change that occurred for consumers once the upstart Microsoft released Windows.  Good timing and strategic blunders by the hardware vendors at the time (i.e. IBM) afforded Microsoft to quickly gain a dominating position in what became arguably the most important market on the planet.  Forget that hasn’t been any meaningful innovation to the computer operating system since then; it never mattered to Microsoft's shareholders.  It still controlled over 90% of computers.

You can see similar domination by many of the new technology incumbents in markets very important to consumers and enterprises.  Apple took a similar approach and market share gain in mobile phones (at least now it’s a two horse race with Android).  Oracle and Salesforce have dominated the enterprise software space for many years now.  Amazon crushed every meaningful ecommerce company that stood in its way in the 1990s and 2000s.  Google continues to dominate search.  Facebook boasts 1 in 7 people around the world as active users.  While many of the new incumbents appear much more friendly that its predecessors (i.e. “Do no evil” compared to Ballmer’s Dr. Evil appearance), their market dominance should continue to be tested.  Enter the unicorns.

Uber may not only be a cab company but also a formidable commerce competitor in the all important race for local services.  Pintrest and Nextdoor have cult-like followings that Facebook has not had since it was in the university setting.  Hootsuite and Palantir have a leg up on the big data front compared to Oracle and IBM.  The unsustainable profit streams of big pharma and large healthcare service providers will be tested by ZocDoc and Theranos.  And even the country itself faces stiff competition as many of the unicorns such as Meituan and Flipkart are based in Asia. 

In a lot of ways, the unicorns took similar paths to the preceding incumbent technology companies before them.  They gained aggressive valuations through market acceptance, university connections, speed, innovation, and strong management teams.  And now, thanks to frothy capital markets, they now have cash warchests to compete with any incumbent.  These valuations afford flexibility, independence, and an ability to pace growth based on long-term vision.  The beauty of many of the unicorns is that their business models are very low cost and highly scalable; in fact, many of them don't need cash now but are raising funds for the future and to cash in on generous capital markets.  

Its true that Apple or Google could acquire many of these companies if they wanted (and will);  but they can’t buy all of them.  While each individual company creates unique challenges and competition to market leaders, the litmus test of success will come over time.  Once the bubble pops, will the unicorns continue to thrive, keep prices down, and continue to provide innovative products and services to the market? I don't know if I believe in unicorns or not, but i don't think it matters.  They are here today.  They are preparing for battle.  And lets hope they win.

Is the Uber ecosystem sustainable ?

Will Uber get an opportunity to grow up?  Armed with a $40B valuation, many investors think so.   Whether you believe in the app based taxi hailer or not,  Uber’s impact can be felt all around the world.  There are millions of people using it everyday, momentum that its lofty aspirations will prove true, and intense controversy everywhere it goes.   Is this the world changer that it purports to be, or just the latest multi-billion dollar company to go bust?

Strategically, Uber is in a strong position.  Its logistical system, army of drivers, and competitive intelligence gives it a first mover advantage in its ambition to become the Walmart of personal services.  Cabs are just a platform for worldwide domination of local distribution.    But Uber is asset light, and its not  hard to see big players move into its space.  Amazon’s 2 hour delivery is gaining momentum.    Upstarts like Favor and Grubhub are cornering specific niches like food.   And how can you bet against Google or someone with significant physical infrastructure like Fed Ex?  The barriers to entry are not clear particularly against well capitalized companies.

Speaking of capitalization, Uber’s dot-com esque valuation has helped them act as a much bigger player than its revenue would suggest.  Even if Uber could continue to grow its value and raise gobs of money (hard to swallow by every conventional metric), some of its challenges cannot be resolved by throwing more money at it.    Governments, lobbyists, and pretty much every existing transportation company have vowed to fight Uber.  Even tech savvy cities like Austin and Vancouver have even banned the service.  Further, Uber faces a very micro problem;  it has to fight county by county, city by city, and country by country.  How long can it continue these individual battles?  And don’t forget about all the other legal battles such as data breaches and personal security cases from bad drivers. 

The more intriguing facet  of Uber’s uncertainty relates to the company’s mysterious pool of drivers.  Who are they and will they continue to support the company?  Uber recent survey showed glowing demographics of the people that drive for them (underemployed segments like the elderly and minorities).  A big question is how reliable is Uber for its drivers.  Starts and stops in markets have reduced the recurring nature of this income.  Few of its drivers derive their primary income from it.  The disparate nature of its drivers makes it hard to fathom that all of  these contractors will be available to support the service levels that Uber’s valuation implies.  Can a group of part timers be leveraged into a massive service provider all around the world?  It is very opaque, but a very interesting question nonetheless.    

Despite Uber’s uber-unicorn status, it is hard to bet against it.   It’s the poster child for the sharing and distributed economy.  Its challenges are greater than its tech giant predecessors have faced.   In fact, the laws actually supported Amazon and Google early on through a sales tax ban and broadband subsidies.  Uber’s road seems long and unchartered, but it has not blinked an eye through adversity.    Call it entrepreneurial, innovative, and principled.  But will we call it a survivor ?

The New New Bond Market

Forget everything you know about fixed income investments.  The days of corporate bonds, treasuries, and real estate income properties are over.  In are crowdfunded startups, movie projects, and student loans.   The new class of exotic asset backed securities promises investment choice, high yields, and upside.  But are the risk and fees worth the return?

I remember in 1997 when the “Bowie Bonds” turned heads.  For the first time, one could invest in the individual portfolio value of the rock icon’s song library.  Since then, alternative bonds have come in large baskets of regulated instruments such as mortgage backed securities and REITs.  But a loosening of regulations coupled with an increase in investor demand has brought excitement back into fixed rate securities.  The website SoFI gives access to a yield-producing basket of student loans from your alma mater.  Upstart can help you provide loans to individual people or career paths.   I got an email last week from a Hollywood producer who was looking to fund her next movie with a guaranteed 20% return.   There is something for everyone.  

Despite the implied steady returns, I wonder if they are sufficient enough to cover the risk.  Even back then, the unproven Bowie Bonds only offered a 1.5% premium above the 10 year treasury rates.  I don’t know if a 5% interest rate for Harvard loans are worth it (certainly a personal decision), but people should be cognizant of the risk associated with them.  Remember the AAA mortgage bonds?  Even the top credit agencies in the US failed to understand these novel complex securities.  It is tempting to chase yield in the current near zero interest rate environment, but the returns should be commensurate for the incremental risk taken.   

Fees associated with these securities also come into play.  Taking a page out of the hedge fund playbook, many charge both a management fee to participate and a “carry” percentage of the profits.  For the asset managers, it is a good way to shift capital risk to investors while taking fee income and participating in the upside.  Some will promise a “preferred return” which is far from guaranteed (despite a stated interest rate) and the ones that don’t charge a start fee (such as the crowdfunding sites) will take a larger percentage of the profits.   While I can understand this hefty cost in an equity-type scenario when the upside is tremendous if the next Facebook hits, it’s hard to justify them in a fixed interest rate arrangement.  A 2% charge on an 8% net return is a 20% fee.  Large fees don't always mean good performance;  remember the popularity of actively traded mutual funds that charged big loads despite most of them doing worst than their benchmarks.

Simply put, equity risk should not be taken for fixed income investments.  While I like the flexibility and ease in which to get into some of these new investments, it is imperative to assess the quality, diversification attributes, and fees associated with them.  There are many creative instruments out there with a limited track record and opaque risk disclosures.  While we'll never know whether the Bowie bonds were a financial success (Prudential bought them for the in-house portfolio), the choice is ultimately yours.  Do  you want to merely listen to “Ziggy Stardust” or invest alongside it?

Selling in a seller's market

From residential housing to Uber's dizzying $40B capital round,  asset valuations have never been so high. Understandably, many small business owners looking to sell expect to write their "own number."  While it may be possible in a few situations to do so, these expectations along with other perceived business risks have created substantial difficulty in executing deals in the small to mid market space.  As we wind down the year, I thought I would write about some tips (from a buyer's perspective) to prepare a small business to fetch top dollar while minimize the risk of remaining on the sidelines.

Grow, Grow, Grow: Even though most deals are based on a multiple of earnings, top-line growth is probably the single most important characteristic that increases business valuations.  Layer in two or three years of steady gains and a seller will see much more cash in a sale.   In any market, buyers struggle to find growth; they particularly recognize the premium required for entry in today's climate.  Smart buyers know how to cut costs and and improve profitability; finding sustainable growth avenues are much harder to manufacture.  This is why growth stocks yield a larger P/E ratio than dividend or stable companies.

Stay in (sort of):  Most owners know not to wait to sell the day he or she is ready to walk out the door.  By that point, the business has probably declined as would the valuation.  But even more importantly from a buyer's standpoint, they need people to run acquired businesses.  Some may claim they can bring in experts or leverage existing operations, but they all recognize the importance of keeping the existing entrepreneurs involved post-close  By keeping even a sliver of equity in the business (even 5-10%), buyers will be willing to increase their purchase price due to reduced risk.  A go forward interest may be viewed as an insider continuing to invest in the business and a seller might pick up some are all of the reduced cash upfront through increased valuations.  Timing is key; at least two to three years prior to exiting the business is ideal.

Address customer concentration proactively:   Many small business owners dance or try to conceal the fact they have one or two customers that drive much of the company sales.  If this is the case, it's best to discuss this early and openly with a potential buyer.  If you have a strong relationship with the customer, talk to them about a potential deal.  Even offer to introduce a serious buyer to them.  Trump up the fact that you have penetrated a large customer and have the savvy to do this with other similar ones.  Buyers often use this as a way to structure deals so that sellers take most of the risk (i.e. earnout, minority investment).  If this is not ideal for you as a seller, get the buyer involved in the customer relationship to get them comfortable with taking on some of the perceived risk.

Keep the books clean:  A common piece of advice, but it's very important.  It's very easy to use your business account to pay for college, vacations, and cars.  Sellers take pause in this advice because doing so will increase tax bills.  Too many personal expenses will raise red flags.  Buyers see this as increased risk and bankers sometimes do not allow all of it to be considered when potentially financing a transaction.  Conversely, a "clean" company will often be seen as easier to transition and yield a greater valuation.

Know your industry: I often hear that the buyers that show interest are not the ones originally anticipated.  A successful business should be courted by a host of different types of buyers.  If utilizing a banker or formal process, make sure the firm understand the full industry dynamics and are open minded to explore different types of potential partners. Also,  when in discussion with a potential buyer, understand their endgame. Ask them a lot of questions. By doing so will help in negotiations (i.e. is this a stretch deal or blank check situation).

With most markets at an all time high, it is a good time to get your small business ready to take to market.  As we've seen before, an economic downturn usually has a magnified effect on small businesses.  What's most important is to find the appropriate partner to make sure that the enterprise will continue to have a lasting impact in the space it operates;  a successful business will find lots of suitors, so it's good to pick wisely.   By following a few simple steps and keeping your eyes wide open, you can actively participate in this white-hot seller market.