Is Angel Investing Irrational?

The Berkley Center For Entrepreneurial Studies at the Stern School of Business is famous for its courses and co-curricular activities in entrepreneurship and innovation. On February 24, 2010, the Berkley Center’s Himelberg Speaker Series featured David Rose, Chairman of the New York Angels (http://newyorkangels.com/), angel investor himself, founder of Angelsoft (back-end infrastructure software) and manager of a proprietary portfolio that consists of no less than 75 companies. Rose was invited to present his strategy in angel investing. He faced an auditorium tightly packed with about 300 entrepreneurs, entrepreneurs in the making, and investors in entrepreneurial ventures. Rose spoke for a good two hours to mainly communicate one idea: angel investing is irrational.

Who are the angels? They are individuals (they are not professional money managers who represent institutions, endowments, or wealthy individuals); they are rich (-ish) people who invest their own money for economic or other reasons; they invest on average amounts that range from $25K to $100K. Yet, compared to Venture Capital investments (that today represent later stage investments), angel investments cover about 49,000 deals (and about $20 billion).

Why are angel investors irrational? Because they know that half of the deals in which they invest will go under and the rest will greatly underperform expectations. While the economics of angel investing is predictably irrational, it is also highly lucrative as long as angels invest in that one deal that will return a 30 times multiple the original investment and will compensate the investor for the losses he incurred with the rest of the deals that flopped or underperformed.

How does one find deals to invest in? Rose insists that there is logic to the madness of angel investing. He usually looks for:

· Large and growing market

· Scalable business model

· Competitive advantage

· External validation

· Reasonable valuation

· GREAT PEOPLE

While every deal comes with a team, the most important person for Rose is the ENTREPRENEUR, someone who has already demonstrated:

· Integrity

· Passion and the desire to create something big

· Experience (but not necessarily in the field of the new enterprise)

· Knowledge

· Skills (how to make it happen)

· Leadership

· Commitment (to her idea)

· Vision (to change the world via her idea)

· Realism

· Coach-ability

Having completely disproven his original point, Rose defined angel investing as a highly complex thought process that focuses less on analytics and fancy presentations and more on the qualities of the people on the team.

Global IPO Market 2010 Outlook: Slow Activity and Strong Exits

If history is ever a good predictor of the future, 2010 is going to remain slow in IPO activity but may showcase a few very strong exits for fundamentally sound companies, Graham Powis, Managing Director and Head of U.S. Equity Capital Markets, Lazard Ltd., asserted on January 28^th during a panel discussion organized by FTSE and Renaissance Capital exclusively for New York Society of Security Analysts members.

Right now, private equity firms affected by credit dislocation and the recession have one primary goal: to ascertain the quality of IPO opportunities as an exit strategy for the global private sector. While other exit considerations include dividends financing in the debt markets and despite the fact that valuations are substantially lower than what the IPO market achieved from 2000 to 2005, General Partners are concerned with returning capital to their LP investors.

Christopher Turner (Warbug Pincus), Phil Drury (Citigroup), and Jonathan Art (Federated Kaufmann Fund) of the same panel, moderated by William Smith, CEO of Renaissance Capital, agreed that uncertain capital origination, market ambiguity, and indeterminate liquidity exemplify an opportunistic market. This type of market has a two-sided effect: on one side, researchers observe low willingness on investors’ part to join in public offerings within volatile markets paired with high preference for less risky deals; on the other side, capital markets participants recognize the IPO market as a highly inefficient category of public equities.

Inefficiency is good. In fact, for sophisticated investors inefficiency is great. Paul Bard, Head of Research for Renaissance Capital, demonstrated that the IPO market presents experts with the opportunity to create investing strategies with remarkable returns. As an indication, while the returns for the Russell 3000 and S&P were -5.8% and -8% respectively in 2009, the IPO index registered returns of 28.5% for the same year.

The inefficiency of the IPO market is based on the following facts: private companies are not well researched; they operate within new industries; their management teams are relatively unknown; private companies have not been traded yet and therefore the predictability of their success in trading is practically impossible. A bottom-up fundamental study of IPOs as well as expertise based on historical data lead researchers to believe that 2010 may be the year for some very strong companies to go public as it happened in the 1970s, another period of slow activity. With an approximate number of 100 to 120 deals in the pipeline, of which 39% in Technology and Healthcare, the sophisticated investor has the advantage of deep discounts in some fundamentally strong, top performing private companies that promise high quality operations, overall growth, and proven profitability.

Is uncertainty the new paradigm?

I would like to dedicate the first entry to my professor, Ed Altman, the Max L. Heine Professor of Finance at the Leonard N. Stern School of Business at NYU and Director of Research in Credit and Debt markets. Dr. Altman is an expert in the fields of corporate bankruptcy, high yield bonds, distressed debt and credit risk analysis.

To Dr. Altman I owe a solid understanding of corporate and municipal bonds and primarily an insight into what it means to be a leader and professional of the highest caliber and standards.

“The New Paradigm for Private Equity” was the inaugural annual conference in a series organized by Alvarez & Marsal, a leader among global professional services firms today and originally founded as a restructuring boutique in New York City. For this conference that took place on January 21st, Alvarez & Marsal collaborated with the Stern School of Business and placed Ed Altman at its helm as the co-chair and one of the two keynote speakers, the second one being Wilbur L. Ross, WL Ross & Co. and Invesco Private Capital.

Both Dr. Altman and Mr. Ross maintained that the New Paradigm is actually not so new or surprising but rather a resurgence of trends that mark a distinct phase of evolution within private equity. The point was proven eloquently and convincingly with two different methodological approaches:

Dr. Altman presented his rigorous analysis of the market and, specifically, the default rate of corporate bonds and how these can be studied to predict an impending credit bubble. His five discrete approaches (the Macroeconomic Model, the Mortality Rate Model, the Market Based Model, the Recovery Rate Model, and the Distressed Debt Market Size Estimate) confirmed events that today everyone recognizes in retrospect. For example, Dr. Altman proved that historically, default rates of corporate bonds rise for two years before a recession. While his predictions for corporate defaults are in agreement with those announced by the big rating agencies, the point worth noting here is that a thorough study of market conditions gives early warning signs. These can be used as techniques to assess the sustainability of market trends, avoid credit bubbles, and assist investors understand the true financial profile of companies as well as identify opportunities for investing.

The evolving nature of private equity was confirmed in the second keynote address, in which Mr. Ross presented a list of seven “new” paradigms for private equity drawn from his own long career in the field:

#1 Washington is the new Wall Street; #2 By necessity, there is a proliferation of private public partnerships; #3 The FDIC framework cannot protect failing banks, which is leading to an extreme reduction in the number of existing banks in the US—not such a bad thing, after all; #4 Private Equity firms are becoming the new tax revenue targets; #5 The terms of financial engineering in private equity are changing rapidly. The gap between the top 25% and low 25% of distressed firms is widening. #6 It will take years to repair the economy while the slow recovery will affect turnarounds, the success of which will be more the result of the micro aspects of the business rather than the macro conditions of the economy; #7 There will be more capital available for distressed investing in private equity.

The remainder of the conference was organized in three panels:

Panel 1, Distressed Investing for Control (Moderator: Mark Patterson, MatlinPatterson Global Advisors LLC; Panelists: Kipp DeVeer, Ares Management; Angus C. Littlejohn, Jr., Littlejohn & Co., LLC; Michael Psaros, KPS Capital Partners, LP; Jason New, The Blackstone Group)

The volume of defaults in the last two years has substantially increased the scale of supply of distressed companies and, therefore, has impacted the breadth of management expertise needed in distressed investing. Screening of distressed companies has become more complex as well. This has led investors to a greater degree of specialization and conservatism. The panelists represented investors who are in distressed investing for the long run, and not for the quick trading of distressed companies in which hedge funds are usually interested. Consequently, the relationship between the private equity sponsor and distressed company management is very important and becomes tighter in difficult times. Therefore, conservatism, management, and execution are the key characteristics of the panelists’ approach to investing. In addition, these three are their tools for success in creating value for the management and the sponsors, which is, they asserted, the definition of private equity: value creation for the stakeholders.

Panel 2, Private Equity Investment in the Banking Sector (Moderator: Steve D. Goldstein, Alvarez & Marsal; Panelists: P. Olivier Sarkozy, The Carlyle Group; Mark K. Gormely, Lee Equity Partners LLC; Max Holmes, Plainfield Asset Management LLC; Fred D. Price, Sandler O’Neill + Partners, L. P.)

Compared to the clearly operations-driven first panel, this panel on banking left the audience trying to decipher aphorisms on banks and “their notoriously weak management teams.” Having said that, Steve Goldstein did an excellent job setting up the discussion and introducing banking as a new area of distressed investing, a perfect follow up to Mr. Ross’s keynote speech in which he had admitted to favoring investing in regional banks of relatively small size ($5 to $8 billion market cap). This panel’s negative overview of American banking is based on: the government’s involvement in subsidizing the real estate market and, consequently, in creating an unsustainable economy; the weak management teams that still remain in place; the restrictive legal framework that does not allow private equity sponsors to hold a seat on the board in any of the banks they partially own. In fact, a private investor holding anywhere between 15% and 24.99% will be called to sign a passivity agreement; one holding anything above 25% and up to 49% will be called to sign a bank holding agreement. Both agreements are designed to strip private investors from power in any management issues (i.e. no voting power on the bank’s board) despite the capital they may have poured in.

Panel 3, Portfolio Company Management—Picking the Right Horse for the Course (Moderator: Jeff Feinberg, Alvarez & Marsal; Panelists: Joseph R. Edwards, First Reserve Corporation; Kevin Haines, Protostar Partners, LLC; Dean B. Nelson, KKR Capstone; Bill Sullivn, Apax Partners LLP)

The uniqueness of this last panel derived from its own composition: all four panelists are specialists within a particular industry, except for Mr. Haines, whose firm, Protostar Partners LLC has a unique approach to investing since it is one of the very few firms who buy entire portfolios of companies. This approach confirms a point made earlier, namely that private equity firms today have a need for breadth of expertise. In contrast, the other three firms have found their respective market niches in which they know all the players. This makes it easier for them to distinguish who is a good fit for their team, usually a professional who combines deep knowledge in the specific field combined with finance experience. Still, they all agreed that private equity creates an intrusive relationship that affects or even completely erases existing management. Regardless, the sponsor-management relationship can work successfully when it is based on: commitment from both parties; courage to make the necessary difficult decisions for the company; and conviction that this relationship can indeed bring results.

Regulatory uncertainty may very well be a sign of the times but the main takeaway from the January 21st conference was Tony Alvarez’s II (Co-CEO Alvarez & Marsal) three-prong assertion on private equity’s new paradigm: #1 One cannot take anything for granted when liquidity capacity is unpredictable; #2 One should ask a lot of questions, especially when the goal is to assess a partner and his/her suitability; #3 Teams need a leader and one needs to be ready to pick one and move on with the task at hand. Considering that Tony Alvarez II transformed the small boutique firm he co-founded to a global service organization that operates in 16 nations, I would certainly follow his lead.