Friday, October 3, 2008

Start a Company. Now.

My fundamental strength as a venture investor is having a clear view of what the future will look like (at least as regards my little niche of the industry.) My fundamental weakness has always been not being entirely sure how we get from where we are today to that future. I suppose there's a name for that, my type of goal-oriented thinking.

I am thinking about that today because Niki Scevak over at Bronte Media uses the other type of prediction (path oriented thinking?) to predict an entirely different future for startup financing than I do. He makes a convincing argument that the inevitable deleveraging at the major financial institutions and the resulting (relative) scarcity of credit will trickle down to a freeze in VC investment over the next 12-18 months.

As mentioned, I don't have truck with this type of argument. Partly because I don't think that way, but also because I'm not sure it leads to accurate end-states. As one of my smarter mentors once said to me--regarding financial modelling--"if you make 100 assumptions, and each is 99% likely to be true, you have a very convincing argument for something that's almost certainly wrong."

Populist probability calculations aside, I think it's clearly true that errors compound at each step in the path, making the resulting end-state much less likely than a naive reading of the path implies. I prefer to gauge the economic desirability and stability of the various potential end-states and assume that we eventually end up in the best of them.

But, while I assume that all of my predictions will come to pass, I am still waiting for some of them. The most valuable lesson I've learned in the past 15 years as an investor is that if you invest in real, economically substantial change, you'd better be pretty damn patient. The healthcare industry comes to mind.

Back to venture funding: I am more optimistic than Niki.

I believe--with Warren Buffet--that the deleveraging at the banks has to be balanced by money creation elsewhere*. I also believe that the "easy" money to be made in derivatives has crowded out investment in productive assets, such as businesses. As proof, I'll point to the change in the marginal product of capital. (The following relies on a blog post by Casey Mulligan; if anyone knows where to find the underlying data Mulligan used, please let me know.)

The marginal product of capital is a measure of how much profit a unit of capital returns. In the non-financial sector of the US economy, the marginal product of capital has averaged between 7% and 8% a year since World War II. The rate just before the 2001 dot com bubble popped was below this. The rate in late 2007 and early 2008 was about 10%. 10%! 10% is huge. I suggest (without any proof) that investors were buying MBSs and CDOs and the like instead of investing in non-financial businesses. Lack of demand for equity in non-financial businesses caused prices to drop/returns to rise.

If these two propositions are true--that (1) there will still be large amounts of investable capital, and (2) that the returns to be had by investing in non-financial businesses are much higher than average--then I expect investors to find, en masse, new glamor in putting money to work in equities.

Maybe I'm just an optimist, but I predict the return of good old company building as the primary fascination of our financiers over the next two years.

(Hat tip for the Casey Mulligan link to Greg Mankiw.)

* Buffet said that the deleveraging is not possible without someone else levering up, and that someone else has to be the government. I don't assume the mechanism, I just note that bank lending is where the vast majority of our money supply comes from and that if money is not created somehow to offset the disappearance of bank lending, then we will suffer a massive deflation. This would be disastrous, and won't be allowed. Since the government can reinflate the money supply in various ways--including firing up the printing presses and buying back government debt with trillion dollar bills (we could put George Bush's face on it!) if need be--they will.

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