Soaring on Ridgelift

Perfect storm of unintended consequences?

As I write this the NYSE is off almost 300 points - the market fretting about spreading "contagion" and the wait for Congress to pass the "Emergency Economic Stabilization Act of 2008" – formerly known as the "Bailout".

While the current Black Swan event continues to unfold I, like many others, struggle to try and understand how this happened – consistent with Nicholas Taleb's definition of a Black Swan event where human nature compels us to ascribe rationale and predictability to unforeseen events.

I suspect that when the dust settles we will find ourselves in the aftermath of a perfect storm of unintended consequences:

• A desire to extend home ownership
• Declining interest rates as 9/11 and the dot com collapse wrought prior havoc on the economy
• Changes in the accounting standards (FAS 157) to provide "better transparency" into asset valuations

Late Friday afternoon, Michael Arrington of TechCrunch offered "How the US Government Engineered the Current Economic Crisis" as he highlighted an article in the NY Times from 1999 where Fannie Mae was under pressure to extend loans to "borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans".

From the graph in the TechCrunch article you can see how US Residential debt grew rapidly, fanned by declining interest rates.

The masked villain in this plot begins to look like FAS 157 – today's newspapers are full of analysis of the "bailout" but there's little mention of sections 132 (Authority to Suspend mark-to-market accounting) or 133 (Study on mark-to-market accounting) – both buried in the 110 page draft of the bailout bill – you can find the full text here.

The Federal Accounting Standards Board (FASB) issues a series of statements that define the framework for GAAP (generally accepted accounting principles) – these in turn are used by accountants and auditors in preparing financial statements. Statement 157 defines how to establish the value of certain assets using so called "mark-to-market" valuations.

Here's a critical element of FAS 157:

"This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)."

I highlight the issue that may be the masked villain. FAS 157 works fine until you have to contend with an illiquid asset such as a private company stock or (as in the current crisis) mortgage backed securities when the credit market dries up.

Pricing assets under these conditions is a lot like trying to catch a falling knife – you have to keep reducing the price to fire sale valuations. The underlying asset may not be impaired but FAS 157 requires you to reduce the valuation to the price you would hypothetically receive in an open market transaction.

If you read the article on briefing.com that I linked to in my last post, FAS 157 is the reason why these assets are being held at heavily discounted values – the institutions holding these assets have had to report an accounting loss as a result. The knife started to fall as the credit market dried up and buyers became concerned (panicked!) about the risk of massive mortgage defaults thus driving prices down.

It's interesting that the proposed bill gives the SEC the power to suspend FAS 157 and also calls for a study to examine the role FAS 157 may have played in the meltdown.

When the dust settles, will anyone have the courage to call the crisis a result of unintended consequences of otherwise good intentions? Somehow I doubt it – Main Street, so poorly informed by the media about the issues behind this crisis is howling for blood… and in an election year, they will surely get it.

Time to pick up the phone…

The crisis facing our economy is unprecedented. As former President Bill Clinton said in his interview with Larry King (aired on CNN last night after President Bush's address on the crisis), this is a time for humility – where the true roots of the crisis lie will be hotly debated for years to come. After all, as a true Black Swan event, human nature condemns us to seek a rational explanation… and of course to pin the blame on someone else.

Regardless of how we got here, the crisis has frozen the credit markets – the implications of this illiquidity are dire and need prompt action. Meanwhile our elected officials have turned this into "Wall Street versus Main Street" – a cute moniker but one that ignores the realities that most American's have sizeable exposure to the equities markets.

An opinion poll in today's Wall Street Journal shows that voters expressing an opinion on the "bailout" are divided (33% against, 31% for), not surprising given the complexities of the issues.

Why "bailout" in quotes? To me this is not an issue of saving "Wall Street" by purchasing "bad" assets but instead of restoring liquidity to a frozen market. There have been several articles that do a great job explaining the underlying problem and of pointing out that the Government stands to make a good return for its assumption of the risks. For example, Briefing.com has a great article – "Why the rescue plan can work" and today's Wall Street Journal has an op-ed piece by Andy Kessler – "The Paulson Plan will make money for the Taxpayer" that makes the same point.

President Clinton pointed out to Larry King that the US made money when it "bailed out" Mexico and Chrysler in the past. There's a lot of smart money (including Warren Buffet) that I believe think the same way.

It's appropriate for our representatives to investigate and debate how to structure the plan proposed by the Treasury and Federal Reserve – but that debate can't go on nor get split by partisan politics. So please, get current on the issues, realize that the plan (with safe guards) can be a solid move to unfreeze the credit markets and then pick up the phone and call your representative to tell them you support the plan.

I made my call yesterday.

Surviving the Downburst

The latest developments in the US financial markets look like a severe downburst from a severe thunderstorm.

A downburst is the outflow from a thunderstorm that is characterized by a massive downward airflow creating immense hazards for aircraft – a severe downburst can swat even the most powerful aircraft from the sky and create a tragedy.

 

The failure of Lehman and the acquisition of Merrill Lynch by BoA show the power of the current thunderstorm in the financial markets. No one knows when this will end but in the mean time there is a lot of collateral damage.

We have already seen the market interest in new stock offering (IPO) evaporate. Some investment bankers I've talked to believe that the US won't see a recovery until 2010 and that the IPO market likely remains closed for a long time.

As a result, the number of M&A transactions has fallen dramatically and typical transaction values are low and unappealing to investors and management alike.

I've written in the past about the critical need for early stage companies to conserve their capital and drive aggressively to break even. This latest downburst places even more emphasis on gaining control of your own destiny.

Here are a couple of areas I believe have higher risk in the current environment:

• Cleantech investments where the combination of capital requirements and later round pricing creates a mismatch of expectations between investors and management on exit values.
• Social media companies where valuations result from growth in user base without strong underlying business fundamentals.

Companies in both these areas will need strong investor syndicates with deep pockets (and willingness to invest yet more capital) or they will fail.

Despite these issues, I still see many new company proposals targeting these areas – time to get real folks! The winners in these areas have left the starting gate – the late wannabes do not get to run.

It's a timely reminder to look for the seeds of the next investment cycle.

The dynamics of innovation

A lot has been written over the past few days about Judy Estrin's concern about declining innovation in the USA and Silicon Valley.

While I agree with some of the quoted issues underlying the declined such as the quality of our education system and how the Federal research budget is administered, I (like others it seems) believe that innovation is alive and thriving in the US.

But as the NY Times article quoted Vint Cerf (one of the true fathers of the Internet and now Chief Internet Evangelist at Google):

"There is a remarkable telescoping of vision and an unwillingness to make long term bets."

I think Vint has nailed the true issue on the head – it's not innovation that is declining, it's the way companies are now being built that is the real issue.

Let's step back for a moment and look at the dynamics of the late 90's – the run up to the Internet bubble…

• The vision of the Internet was being embraced by everyone – the "new frontier" effect with lots of opportunity and "real estate" for expansion.
• The threat of Y2K was top of mind for every IT executive – "we need this for Y2K" was almost a blank check for IT spending.
• The impact of PCs, software and communications on productivity was becoming clear.  Some pundits even used "ever increasing" productivity as a counter to Alan Greenspan's "irrational exuberance" concerns about the rapid growth of the stock market.
• Corporate demands to address Y2K and productivity were poorly met by incumbent vendors making it much easier for startups to sell into the Enterprise.
• The stock market was on fire – there was tremendous appetite for new stock offerings (IPOs) that tapped into the opportunities of the "new worlds" of the Internet and productivity improvements.
• VC's has plenty of capital, the cycle time for investments to exit had seldom (never?) been shorter (2 years!) and as a result, VC returns were off the charts.

In short, times were great and growth was fueled by a confluence of drivers (Internet, Y2K and productivity improvements).

Back to today – we're faced with almost the polar opposites of most of these factors…

• The Internet has been widely adopted by the enterprise.
• Y2K was a non-event.
• The low hanging opportunities for productivity improvements are gone.
• The Enterprise buyer is back to being very conservative and a startup now has a very hard time selling into the Enterprise.  This has driven up the cost of sales and the time to complete a sales process – all consuming more capital for the startup.
• The current economic mess has further dampened the appetite (and budgets!) for buying new products and essentially shut the IPO market.  M&A exists are down in number and exit value.
• VC's still have plenty of capital but the time from initial investment to exit continues to climb and is now averaging about 7 years. 

Most VCs will tell you that times of economic turmoil set the ground work for the next wave of dominant players to emerge – this means being optimistic about the future and making investments in early stage companies despite the likely 7+ years it will take to grown them to a decent exit.

Meanwhile, the pressure to generate returns has driven a larger percentage of dollars and focus to later stage (more mature companies already well into revenue) investments or to companies with accelerating growth in a belief that this will lead to a high priced (nearer term) M&A.

For these latter investments, accelerating growth doesn't have to show as revenue – in many ways we are back to counting eyeballs, page views and the number of concurrent users.  The investment is made on the thesis that the path to monetization will be found along the way – perhaps through advertising or by carving out a big enough piece of real estate that an existing player will pay up so that they can use their own monetization process.  This works some of the time…

As a result, it's much harder for a raw startup to raise capital from the VCs or angel investors when they are proposing to build a new product that will take a couple of years to reach the market and then even more years to build up meaningful revenue.

Mindful of these dynamics, the entrepreneur adapts… and turns their focus to leveraging cloud computing, Google AppEngine, Amazon Web Services etc. to build a much simpler and focused software company.  Less capital is required so the entrepreneur can finance the company themselves or through friends and family.  If the entrepreneur picks the right problem to solve and leverages the Internet for everything (distributed development, open source, marketing, buzz…), it's possible to generate rapid growth.

So innovation isn't declining, its dynamics have simply adapted to the current environment.

Time to be a contrarian – when everyone turns their attention to the short term there are indeed opportunities for a big long term play.  The trick is to focus on the magnitude and prevalence of the problem you set out to solve – then apply innovation to build the solution.  Leverage the dynamics of innovation in your favor!

So please, it's TIME TO THINK BIG!!!