Why the PE & VC industries have bright days ahead of them… Part 1: late-stage / mature investment

Russel Steenberg, Managing Director and Global Head of BlackRock Private Equity Partners, gave an interesting view on the future of the private equity industry last week in an interview by PrivCap. The money quote goes as follows:

Steenberg: How many stocks do you think there are out there in the world that you can invest in today?

PrivCap interviewer: Globally? I don’t know.

Steenberg: The number is someplace in the 30,000 to 40,000 range my experts at BlackRock tell me. What’s the capitalizations of the world’s public stock markets?

PrivCap interviewer: I can’t guess.

Steenberg: It’s in the trillions of dollars. The amount of money available in private equity funds, even if you count the leverage which people like to add, is less than 1% of the capital available to chase these 40,000 stocks. I’ll put it to you, there’s comparatively much more money chasing public securities in the world today than there is in the private equity world because the number of private companies that exist in the world today that would be investable goes way beyond 40,000. So we have only scratched the surface on private equity.

[…] The biggest barrier to entry to the private equity business always has been and still is the ability of a group to raise their first fund.”

Beyond this bold “back of the envelope” estimate, there are a number of underlying trends supporting the argument that the late-stage PE industry is set for long-term growth, both in the pre-IPO and post-IPO segments.

  • Post-IPO growth

Public-to-private buyouts will increasingly represent a much needed vehicle for publicly-listed companies to get out of difficult situations when drastic decisions/pivoting are required. The truth is public companies are not well structured and incentivised to implement such significant/brutal pivot because of the enormous pressure they receive from the stock market; shareholders expect stable and predictable financial results on a quarterly basis! For instance, have a look at what happened last week to Apple’s market valuation (despite record-breaking earnings!) when its latest results turned out to be below analysts’ forecasts. As a consequence, executives of public companies are not under the right incentives and most adopt the unfortunate “boiling frog” tactic when faced with tough challenges, instead of implementing a new course of actions. Executives in PE-backed companies, on the other hand, are free (and in fact incentivised) to make these difficult changes. Going forward, given the ever more challenging and competitive business environment companies operate in you can bet there is not going to be a shortage of public companies finding themselves in tough situations. Consider the recent demise of HMV in the UK: would this bankruptcy have occurred, had the company undergone a strategic U-turn, supported by a buyout, 2-3 years ago when the signs of imminent failure were already obvious?

  • Pre-IPO growth

Ever-larger injections of private investment are required before growth companies can have a shot at an IPO, in part because the Sarbanes-Oaxley regulation in the US has made the IPO process more costly and more difficult to pull through. The resulting need for bigger pre-IPO deals has fuelled the creation of “mega-VCs / secondary market funds” whose investment model sits somewhere in between VC and Private Equity funds. Digital Sky Technologies (DST) is a prime example, having pioneered this type of mega-deals by investing $200 million in Facebook in May 2009 and then launching in July 2009 a tender offer of $100 million to Facebook employees.

Given these two trends I expect to see a continuous rise in the global amount of assets under the management in private equity funds focused on late-stage/mature companies.

[This article will shortly be followed by a second part with a focus on early-stage / seed investment]


The formula that explains why entrepreneurs are a grumpy bunch…

This week Steve Jobs makes the news headlines once again… “Dark Steve” that is, not “Steve the Messiah”.

Secret ‘no-hire emails’ sent by Steve Jobs were released in US Court as part of a lawsuit investigating  an alleged wage suppression tactic that fully stretched across Silicon Valley for years and ended up costing high-flyer employees millions of dollars in unrealised salary raises and hampering freedom to switch jobs in Tech companies.

Of course it is not the first time that “Dark Steve” makes an appearance on the media stage. Many will remember the unapologetic article published on Gawker in October 2011, in which Steve Jobs was portrayed as “rude, dismissive, hostile, and spiteful to Apple employees; […] bullying, manipulation and fear followed him around Apple”. Why did Steve Jobs have such a difficult personality?

An explanation occurred to me this week, as I was thinking about just how difficult entrepreneurs in general can be to work and live with. The idea comes from a simple formula that I first learned about during a “Change Management” lecture at Cambridge University, back in my student days.

This formula, first created in 1969 by Richard Beckhard and David Gleicher, provides a model to assess the relative strengths that affect the likely success (or failure) of organisational change programs.

The formula expresses a condition that needs to be met for change to happen:

D x V x F > R

The product of D, V and F must exceed R, where:

  • D is the Dissatisfaction with how things are now;
  • V is the Vision of what is possible;
  • F represent the First, concrete steps that can be taken towards the vision; and
  • R is the archenemy: the Resistance to change

It strikes me now that this formula seems as relevant and applicable in the context of entrepreneurship. Have a second look at it:

  • V: When you read biographies of revered and legendary entrepreneurs the word “visionary” is bound to come up a dozen times
  • F: Entrepreneurship is about doing. Trying something new, experimenting with new concepts/products/services are all first concrete steps that are like second nature to successful entrepreneurs
  • R: if changing HR processes or the culture of an organisation is met by significant Resistance to change then put yourself in the shoes of an entrepreneur. Think of the tremendous level of skepticism and apathy that you have to face to make your dream come true: this stellar CTO that you need to recruit when you have nothing to show for it other than your passion and your idea, this VC investor who is sitting on a mountain of dollars and is reluctant to loosen the purse strings, this first customer who is not sure about giving his bank details to a shabby-looking thirty-something dude in T-shirt and flip-flops, that dominant industry player who has the financial resources to put you out of business the minute he feels too threatened…

Now all of this leads us to the D-word: the answer to the question we’ve been trying to answer. One of the forces the entrepreneur needs on his side to make sure he can beat Resistance to change is “Dissatisfaction with how things are now”. There goes your difficult personality!

To support this argument, here is a story shared on Fred Wilson’s blog that comes from Don Valentine, the founder of Sequoia (one of the best venture capital firms in the business):

When one of the younger partners in the firm started, Don took him aside and drew a four square quadrant. Along one axis, he put “easy to get along with” on one end and “hard to get along with” on the other end. One the other axis, he put “normal” on one end and “brilliant” on the other end.

He then said, “sometimes we make money with brilliant people who are easy to get along with, most often we make money with brilliant people who are hard to get along with, but we rarely make money with normal people who are easy to get along with.” 

e-commerce vs. UK High Street: who will be the next casualty?

The iconic music and movie retailer HMV has confirmed this week that it intends to appoint administrators. Whilst HMV will continue to trade and seek a purchaser for the business, things are not looking great.

HMV’s 239 stores in the UK have entered last week a month-long sale with 25% off prices, as the company needs to liquidate stock after poor Christmas trading and The Financial Times has reported that key suppliers, including music labels and film companies, have declined to help HMV with funding so that it could continue trading. Clearly music and film companies no longer think that HMV constitutes an indispensable distribution channel…

This Wednesday brought another bad news in the same industry sector, with Blockbuster UK confirmed to go into administration, putting into question the survival of its 528 high street video rental stores.

Frankly, these recent events are hardly surprising. The demand shift from physical goods to digital goods in the music and movie industry has been obvious for years, led by iTunes, LOVEFiLM, Netflix and their peers. For instance, publicly available data (as reproduced below from the 2012 US music sales report by the Nielsen Company) shows the evolution of the digital market share of music albums and track equivalent assets sold in the US since 2008:

  • 32% in 2008
  • 40% in 2009
  • 46%  in 2010
  • 50.3% in 2011
  • 55.9% in 2012

As you can see, the Digital distribution channel overtook the Physical channel for the first time in 2011. You don’t need to be clairvoyant to be able to spot the trend here. HMV’s and Blockbuster’s management can’t possibly say they didn’t see that one coming…

In their defence, they are not the only ones who have failed to adapt their strategy in this changing environment, as attested by a number of recent high-profile demises of UK High Street retailers in other industry sectors, as summarised in a BBC article:

  1. Camera chain Jessops also went into administration last week
  2. The last Comet stores closed in the week before Christmas after the electrical retailer ran out of credit
  3. JJB Sports went bankrupt last year; with rival Sports Direct buying 20 of its stores but the remaining 133 closed in October
  4. Clinton Cards went into administration in May; a US company later bought the brand but 350 out of a total of 784 stores closed

As the French saying goes, “le Malheur des uns fait le Bonheur des autres” i.e. all is not lost for everyone. In this case e-commerce players are amongst the obvious beneficiaries of the High Street’s mishaps, with the following companies springing to mind, in respective order:

  1. pixmania.co.uk
  2. tlc-direct.co.uk and electricshopping.com
  3. amazon.co.uk and milletsports.co.uk
  4. 123greetings.com and someecards.com

And in HMV’s and Bockbuster UK’s case: the big winners are iTunes, LOVEFiLM, Netflix and Spotify… That’s the effect of disruptive innovation in practice, you can’t have omelette without breaking eggs (another French saying for you!).

So who do you think will be the next High Street casualty? I’m looking forward to reading your best guesses in comments below!!

How Sony gave away the MP3 player market to Apple… and then the digital music market

In 2001, Sony Corporation was already the giant conglomerate that we know today. It was engaged in four main operating segments – Electronics (including video games, network services and medical business), Motion pictures, Music and Financial Services. These made Sony one of the most comprehensive entertainment companies in the world. And yet, 2001 marked one of the greatest missed opportunities in the history of Sony. With the introduction of the iPod, Apple leapfrogged all of Sony’s legacy products in the portable music player market and strategically positioned itself as the number one platform for the emerging digital music market.

On paper Sony had all it needed to do what Apple did. And more if you consider all of the experience it had gained over several decades in the music and entertainment market. So how did this happen?

The biography of Steve Jobs by Walter Isaacson (2011, © SIMON & SCHUSTER) provides key insights to answer this question (if you haven’t read the book yet, I highly recommend it). I summarise below the relevant passages, paraphrased and highlighted in italic.

Step 1: The iPod – a superior design

In April 2001 an interesting gathering took place in Apple’s fourth-floor conference room, where Steve Jobs decided on the fundamentals of the iPod.

The meeting started with a presentation of the potential market and what other companies were doing. Jobs, as usual, had no patience. He wouldn’t pay attention to a slide deck for more than a minute. When a slide showed other possible players in the market, he waved it away. “Don’t worry about Sony,” he said. “We know what we’re doing, and they don’t”. Instead Jobs liked to be shown physical objects that he could feel, inspect, and fondle. Unlike any other CEO, he was totally engaged with the product. So three different models were brought to the conference room and Steve settled right on one of the options.

Product development started right away after this meeting, with Steve Jobs getting actively involved in design sessions using his genius for product simplification and aesthetics. Ten years later, Apple has sold 300m iPods and holds an estimated 78% market share of the music player market, which doesn’t leave much room for good old Sony…

But what led to this staggering success was not just the iPod’s superior design. Mostly, it was the creation of a superior platform.

Step 2: The iTunes store – a superior platform

In 2001, executives in music companies were desperately scrambling to agree on a common standard for copy-protecting digital music. Warner Music and AOL Time Warner were working with Sony in that effort, and they hoped to get Apple to be part of their consortium so a group of them flew to Cupertino in January 2002 to see Jobs.

It was not an easy meeting, Jobs, sitting at the head of the conference table, fidgeted and looked annoyed. After four slides, he waved his hand and broke in. “You have your heads up your asses,” he pointed out. “You’re right,” they said after a long pause. “We don’t know what to do. You need to help us figure it out.”

If the music companies had been able to agree on a standardized encoding method for protecting music files, then multiple online stores could have proliferated. That would have made it hard for Jobs to create an iTunes Store that allowed Apple to control how online sales were handled. Sony, however, handed Jobs that opportunity when it decided, after the January 2002 Cupertino meeting, to pull out of the talks.

Instead Sony joined with Universal to create a subscription service called Pressplay (ever heard of it, anyone?). Meanwhile, AOL Time Warner, Bertelsmann, and EMI teamed up with RealNetworks to create MusicNet. Neither would license its songs to the rival service, so each offered only about half the music available. Both were subscription services that allowed customers to stream songs but not keep them, so you lost access to them if your subscription lapsed. On top of that, they had complicated restrictions and clunky interfaces.

At this point Jobs could have decided simply to indulge piracy. Free music meant more valuable iPods. He knew, however, that the best way to stop piracy was to offer a legal alternative that would be more attractive than the brain-dead services that music companies were concocting. So Jobs set out to create an “iTunes Store” and to persuade the five top record companies to allow digital versions of their songs to be sold there.

When the iTunes platform went live in April 2003, Bill Gates expressed his frustration. He admitted that Steve Jobs’ abilities to focus in on a few things that count, get people who get user interface right, and market things as revolutionary were amazing. But he also expressed surprise that Jobs had been able to convince the music companies to go along with his store. “Somehow they decided to give Apple the ability to do something pretty good”.

How good did iTunes turn out to be? The chart below shows the cumulated number of digital transactions completed on iTunes since its launch.

iTunes downloads

As you can see, the “billionth download” landmark was reached after less than a year-and-a-half of operations. Pretty good indeed…

Take-away lessons

Here are the lessons you would hope Sony’s management has gained from that experience:

Lesson 1: a company is only as good as its product/service

Sony should have been able to develop an innovative product and re-invent the portable music player market more than 20 years after they had first introduced the Walkman back in 1982. With the ever-improving access to the internet and consumers’ interest in digital music, radical innovation should have been Sony’s priority in the late 90’s. Instead, they were spending millions of dollars improving the efficiency of their manufacturing process and supply chains so that they would be able to ship more and more of their devices to the market and at a cheaper price. Nor should they have been spending millions on advertising, trying to convince consumers that Sony’s portable music devices are “the cool thing”

Lesson 2: strong leadership is needed to beat the silos

What made the iTunes success all the more infuriating to executives at Sony is that in principle they could have done the same, but they just never could get their hardware, software and content divisions to row in unison. This kind of “silo” mentality was unthinkable under Steve Jobs at Apple. He reined as a king (some would say dictator) and was the unifying element around which all divisions would orbit. This is reflected in the high level of integration in Apple’s products and services: beyond being compatible, they complement and reinforce each other.

Any employee from Sony would have been stunned by the decision-making process that took place in April 2001 when Jobs decided on the fundamentals of the iPod. At Sony just like in many other major corporations, decisions like this would have taken dozens of meetings, the production of hundreds of PowerPoint slides and going back for more market study and competitor analysis. Would Sony’s history have been the same had it been shepherded by a stronger leadership?

Has Sony capitalised on these lessons?

Two things make me think that is not the case:

  • have a look at the evolution of Sony Corp’s share price over the last two years… it doesn’t seem like they are anywhere near the end of their ordeal (ticker symbol SNE at the New York Stock Exchange)

SNE stock price 2011-12

  • as far as lessons 1 and 2 are concerned: I will not attempt to judge whether Sony Corp’s executive team has improved its leadership and decision-making processes but I will give my humble opinion about the quality of Sony’s mobile phones: they are crap! I’ve had an Xperia phone (by Sony Ericsson) for just over a year and I can’t wait to get rid of it

David Ltd vs Goliath Inc: how start-ups beat corporate giants

It seems like the word “Innovation” is on everyone’s lips nowadays. My definition of innovation in the context of business is: “the development and commercialisation of new products or services”.

For most companies in “developed economies” (for lack of a better term), a strong innovation capability is no longer just a “nice-to have” but a requirement for survival. There are countless examples of once powerful corporations that have learned this the hard way, by failing to adapt their products and services to new market demands or changes in the competitive environment.

Take the example of Kodak, this industrial giant once defined the photography industry and it is now filing for chapter 11 because they failed to adapt to a new disruptive technology: digital cameras (they did try to jump on the digital bandwagon when they realised their mistake, but too late).

When such companies are at the peak of their growth and success it seems inconceivable they could ever disappear or let smaller competitors steal any significant market share away from them. But times and again the David vs Goliath story repeats itself: nimble, agile, quicker-to-react, hungrier competitors are able to take on these invincible giants.

How does this happen? Let’s look at the theory. The chart below illustrates the typical life cycle of an industry.

Pic 1

Of course the definition of an “industry” can vary a lot, depending on how specific you are. For instance, when talking about the photography industry, do you mean cameras in general or more specifically analog cameras? The lifespan of industries also vary a lot, from decades to centuries. For instance, the oil extraction industry has been going on for almost a century now and experts are still arguing about when this industry will enter its decline phase (forecasts depend based on estimates of remaining oil reserves, consumption trends and evolution of extraction technologies) whereas the mobile phone industry is only four decades old and has already undergone one cycle as smart phones are progressively replacing feature phone. However, the maturity cycle described in chart above generally holds true.

The tricky bit, of course, is how to get the timing right: how do you know exactly where you stand in the cycle as of today, and what the future holds for your industry? In hindsight things always seem obvious and it is easy to post-rationalise. But let’s put ourselves in the shoes of Gordon, the CEO of Goliath Inc., a corporation that has managed to establish itself as a dominant player in the widget industry, and reached a pretty big size in doing so. Goliath Inc. used to be a small start-up like any other, addressing the needs of a small niche of customers of the widget market place, the so-called early adopters (i.e. geeks happy to try anything new as long as it seems cool enough). However, Goliath Inc. was then successful in “crossing the chasm”: i.e. transitioning to the growth phase by capturing the interest of the so-called early majority of customers. One thing led to another, for some years Goliath Inc. rode the growth wave, as more and more customers flocked to the new and superior widget introduced by Goliath Inc. Of course this success very quickly caused competitor reaction as other players entered the market to get a piece of that growing cake and legacy competitors also tweaked their offering to try to remain relevant. But Gordon sailed through this competitive environment as well as he could and defended the leadership position of Goliath Inc.

This brings us to today. Over the years the collective revenues of participants in the widget industry have followed the curve shown below, and we are now located on point A.

Pic 2

What happens next?

  • Goliath Inc. gets complacent! When you are at the top of the curve it’s really difficult to see how things could ever go bad. You have to understand how tempting it is for the Gordon to keep on using the same recipe that brought him success in the past. It is also easy for him to kid himself into thinking that he still understands perfectly the user needs and requirements in the widget market: “I am the dominant player in this market, who else could possibly know more than I and my A-team of executive managers, filled with Harvard MBAs?”. And yet, year after year, the A-team spends less time on the field, talking and listening to customers, witnessing how the widgets are used in practice and instead spend an increasing amount of time strategising in fancy corporate meeting rooms, on the top floors of Manhattan skyscrapers. Sadly, even if the A-team does pay attention to the evolution of customers’ needs, this is not of much help because…
  • The customers of Goliath Inc. get complacent too! In a mature industry the vast majority of customers are of the “Late Majority” or even “Laggard” type, i.e. they are mostly happy to accept the product/service on offer without much afterthought. Gordon’s team is hardly going to come up with a breakthrough next generation of widgets by relying on the feedback they get from these customers…
  • The diversification trap: to make things worse, Goliath Inc. by now participates in not just one but several industries, each with its own intricacies and a different maturity curve. In fact, as Goliath got bigger and experienced ever-slowing growth Gordon decided to go on a buying spree. The logic went as follows: “What better way to diversify than to acquire another company? This would definitely bump up our sales, right? My deal advisor from Wall Street has identified the right target company and his analysis shows that the deal is justified: there is a $20 million potential synergy (!). I feel Goliath Inc. is going to become once again the darling of the stock market”. Of course mergers and acquisition deals very often prove to be value-destroying and synergies rarely materialise out of the thin air they are made of. Unfortunately, by the time this has become obvious to Goliath Inc. the Sirens of Wall Street are long gone (and you can be sure they didn’t forget to cash in their advisory fees). As Goliath Inc. fell into this diversification trap (several times), the A-team inevitably lost its focus. The bureaucratic burden got heavier and heavier. Next thing you know, strategy and management consultants were called to the rescue and asked to make sense of the situation. Poor old Gordon is still trying to interpret that 1-million dollar slide that was supposed to deliver “the answer”:

Pic 3

Looking at it this way, you can understand how the thousands of small start-ups experimenting with new products and services in their garage went largely unnoticed by the A-team of Goliath Inc….

Pic 4

That is until one of these start-ups, David Ltd, found “the next big thing”, and in one fell swoop made irrelevant the widget industry, the one in which Goliath Inc was once making millions…

Pic 5