A few weeks ago I mused on our thesis, but I'm not sure thesis is the right word. I've been reading a lot of fund thesis' and frankly they're mostly fluffy bullshit. I don't see how you get buy-in today on variants of, "we believe in software". Of fucking course you do. Many are so bad they're not even wrong. I'd prefer to say we're going to pick a vertical, or a market. A market is hard to argue against. If it isn't obvious, it should:
A. Already Exist
B. Already Exist
We will not be in the business of creating markets. That's what venture does well. I do not believe that is what we should attempt to do. As it relates to the companies we buy, this should be a law (as opposed to a rule). The small exception to this would be the micro private equity market itself :)
We're currently formalizing our legal structure to raise our first fund. My target is $2.5M. In anticipation of going out and pitching a whole different type of investor than I'm used to, we need to settle on what we tell potential investors we're going to buy.
Raising money is hard. I've kept a list of every investor I've ever pitched. It's close to 100. Some of them were random angel investors, others were AAA VCs from well known firms in Silicon Valley. Raising money for a company is hard, but I've heard that raising money for a fund is even harder.
Part of that difficulty, I'd imagine, is understanding how the vehicle is going to make more money than a comparable investment. This post will attempt to clarify my thoughts on how we're going to clearly, and simply explain how and why that will be the case.
Let's start with diversification. Portfolio diversification is well understood and is fairly engrained in the lexicon.
Real estate = "Location, Location, Location"
Portfolio Allocation = "Diversify, Diversify, Diversify"
It's so engrained that previously uncorrelated assets now are somewhat correlated because en masse, most people do actually diversify. There is a case to be made that actually this is not how you should allocate your portfolio these days, particularly for a young(ish), risk-seeking investor. If you read the early history of the power duo Charlie Munger and Warren Buffet, what you'll find is that those two actually made their initial nest egg via a concentrated (i.e. riskly) portfolio. This is quite the 360 from the diversified dogma you see from Birkshire today, however this is actually how Warren could afford to buy Birkshire in the first place. All this is to say nothing about the history hedge funds, but perhaps that's for another day.
Back to diversification, or at the very least parallel bets. It's unlikely we'll be asked directly, "Why should I invest in you vs X company?" We will certainly get asked why people should invest in us. But it's unlikely we'll be in direct competition with putting money in an individual company (not a fund). I should also assume each investor has some kind of relativly (or subjectively) optimal portfolio allocation.
So then, we're left with people who either have never put money into a fund, or people who have put money into a fund (likely a venture fund). People who haven't put money into a fund before are likely family and friends. There's maybe $500k to $1M there. That leaves $1.5M ish to gridinding and pitching (mostly) professional investors. Let's drop the family / friends people for now and focus on professional investors (or at least investors I currently do not know). Yes, trust is likely on the top of this list, but that's what this blog is for, as well as the podcast. I may expand on that another time, but the idea is to build trust by proxy. I may get on a call with someone who reads / listens and therefore feels like they know me (maybe they do?), but I do not know them.
Back to why (micro) private equity. I waffle between whether our model is or is not subject to power laws. In any portfolio you'll have winners and losers. This is how venture works. What I'm questioning is whether we'll have the same distribution of winners and losers as a venture portfolio. Venture returns are highly concentrated. Out of a portfolio of 20 companies, 1, maybe 2 companies provide meaningful returns. Yes, your reputation will be built with the other 18 companies, but your returns will be from a small number of companies in your portfiolio.
The default assumption is that we too should be subject to power laws, but I believe there's some nuance here. We buy businesses with cashflow. We pay a multiple on that cashflow. With each incremental revenue milestone comes some kind of diminished risk. I'm convinced of this. How much, you ask? Not sure. The naive answer is some. The nuanced answer is probably it varies. This will be a muscle we'll have to develop (or an algorithm I will write). Either way, answering this question predictably and reliably will be an element of our alpha.
The ideal answer on why us (or firstly, why this vs VC) should simply be answered:
- We're exposed to outsized, uncapped (read, venture scale) returns due to the nature of the companies we're buying (growing SaaS businesses).
- We're less risky than venture because we're buying things that "already work".
Let's workshop that a bit and bring in some technical trading terms. Because we have cashflow and some level of risk lower than starting a business from scratch (or pre-revenue), you could think of this model as having a collar. Private equity at the scale we're doing it is perhaps collared venture capital. Our upsides are somewhat diminished (perhaps because we're not creating new markets) but so are our downsides. I'm more convinced the downsides are protected than the upside is capped.
I agree, I'm incentivized to believe this, but here's the logic:
If we buy a business cashflow, then that business is less risky than a business with zero cashflow.
This is one I believe to be true. Or more simply as a statement: Businesses with cashflow are less risky than businesses without cashflow.
If we buy a business that is already 'working' then, to some extent, we may be more capital efficient than a typical venture scale startup.
Company building is not a capital efficient process, however because we skipped the experimentation phase, we should be able to immediately, upon taking control of the business, be able to pour fuel into a customer acquisition channel that is already working. We've done this several times now. The results are 66% unrealized but on paper, we have 5x-ed one company and 2.5x-ed another. This is obviously a small sample size but I'd bet (am betting) this is directionally correct.
We are not buying mature businesses. We cannot afford to. We do buy companies with cashflow, but we are earlier in the lifecycle and frankly do now know what the ceiling is for each company we buy. This is largely a good thing. It means our ceiling is high / unknown. I believe the micro part of what we're doing is a differentiator and could be (please!) interpreted as uncapped returns.
What's In A Thesis
What is making the most sense to me (before taking some punches during fundraising) is to pick a market. Take sales tools for example (which we may settle on). Let's define that as a tool that provably contributes to the bottom line of a company. These tools are amazingly sticky. Removing the tool should be as painful as losing a cusomter, that's how important it is. Customers are a non-technical crowd, and they're easier to sell (than, say 'productivity tools').
Make more money (offense) > Saving more money (defense)
Marginally, each thing we acquire should have the same customer base. This is what I mean by picking a market or a customer segment. I want the fund to have congruent customer bases. I buy company A and B who both have the same customer base. The tools are complimentary. In the first month of the acquisition, I want to be able to cross sell and increase MRR 25%. If we do this correctly, companies become more valuable because we own them. Perhaps this evolves into a moat.
In short, this model should have relatively uncapped upside, and relatively protected downsides. Probably should have opened with that!