A higher return investment can have a broad distribution of potential outcomes, as conveyed by this graph from Howard Marks of Oaktree Capital Management (the graph is from his book The Most Important Things Illuminated).
This graph is a more helpful way to understand risk than the traditional graph (the traditional single line sloping up showing higher returns going along with higher risks) because risk doesn’t have a single relationship to reward. Each risk gives a wide range of possible outcomes, a range of rewards.
Compared to traditional venture capital, I believe the investment strategy at my investment fund, Greybull Stewardship, is achieving returns on the higher end of the graph without as many potential negative outcomes as in traditional venture capital. We believe this will be true because of three hypotheses: 1) more firms are making it through the start-up phase to EBITDA of $1-3m while still founder-controlled because today it is possible to build larger businesses with less capital than historically (there is also more education/knowledge about how to build businesses in the world), 2) a growing sub-set of these businesses do not want to utilize the “invest/buy and flip” model of traditional venture capital or private equity, and 3) our selection criteria at Greybull Stewardship, we believe, helps eliminate some of the downside potential outcomes.
Model for Investment Returns with Greybull Stewardship
Some of our criteria that we believe help eliminate some of those potential downside outcomes while preserving many of the potential upside outcomes are:
- Invest when the evidence demonstrates a proven model. Usually, this means waiting until a company has profits and growth. We are not interested in taking start-up risks like “product market fit” or risk that a technology may or may not work. There are plenty of founder-controlled companies that make it to this stage. Then, we are finding a growing sub-set of these firms are no longer interested in the buy and flip model of venture capital or flip equity.
- Invest only when the management is in place and wants to stay. We don’t invest when the management is selling out and bailing out — or there isn’t management in place with a track record with the specific business. We see a higher likelihood that existing management can build on an already good track record and less likelihood that new management could do better. (Yes, this is different than traditional vc’s who believe a founder has a ceiling on his ability to manage the business. And, yes, we have examples in our fund proving management can improve over time.)
- Don’t change the strategy or impose new constraints on the business. Greybull’s evergreen fund model gives founders more flexibility than traditional venture capital or private equity models that require certain growth rates, certain exit timeframes, and other constraints — such as never having a flow-through tax entity. With such constraints, the business ultimately gets twisted around the constraints of the investment firm/fund. Unique strategies make all the difference in a business — its moat for example. When your investors do not allow you to pursue a unique strategy because of an investor’s constraints, the tail comes before the head.
- Earn returns from cash flow or exits or both. I believe it is dangerous for a company, particularly when it’s the largest financial asset of the founder, to aim everything toward an all-or-nothing moon shot exit. The VC has the portfolio benefit of some home runs balancing out some strike outs, but the founder doesn’t have the benefit of a portfolio and doesn’t want to strike out with his or her main asset. It is much more sensible in most scenarios to earn financial returns through a combination of current cash distributions and a potential exit. Greybull’s investment fund is built to allow this, including investing in flow-through entities for tax purposes. (Such flow through tax entities cannot work in most traditional venture capital and private equity funds.)
The traditional venture capital strategy — having every investment strive to be a high risk win because the big winners need to offset some total losses and some middling results — has not been working lately. VC returns have been low and problematic for over twenty years according to this report from the Kauffman Foundation. (See their comments on evergreen funding as Greybull uses.)
I believe Greybull Stewardship’s model helps eliminate some downside outcomes while opening more upside outcomes and is a better model for today’s world than the old venture capital models.