The Eternal Search for Investment Returns

European Straits #136

Dear all,

I’m launching a long-term effort on allocation strategies with the goal of strengthening the case for investing in European tech startups. This is only the first round, and you can expect many more issues and publications around this subject in the coming year.

Now, I must start by mentioning that I have no deep background in either finance or macroeconomics (although I learned about both in , remember?). But I have been interested in allocation strategies for quite some time. Back in 2015, I was posing the question of “Why won’t investors allocate more capital to technology companies?”, a question to which you can find tentative answers here and there. Then my cofounder Alice Zagury, CEO of The Family, was approached by the French government for a mission reflecting on how to attract a larger proportion of the French public’s savings into French tech startups, leading us to do quite around this issue.

Ever since I’ve been reading a lot, talking with many professionals in financial services, spotting interesting sources, and clearing out my head. This is all probably still very far from perfect but, again, it’s only the first round—and I’m interested in your feedback! Read along 👇

1/ Returns are a hot topic. I clip many articles in Evernote, and I use dozens of tags to organize this huge database. The advantage of using tags is that you can feel some topics rising in importance. Last year, for instance, was a period during which I used the tag ‘@China’ more and more, to the point where I had to create sub-tags such as ‘CHINA-BRI’ or ‘CHINA-ColdWar’. More recently, however, there’s another tag that I’ve been using more and more, and that’s ‘ECO-Macroeconomics’. The reason, obviously, is the many discussions around an imminent recession, as well as the heated debate around the low level of interest rates, which is correlated with returns going down across various asset classes.

2/ One reason for lower returns is that economic growth has been too steady. There are various reasons for this sustained growth: the recovery from the 2008 financial crisis, the occasional fiscal or monetary stimulus that keeps things going, the improved performance of worldwide logistics. But there’s an adverse consequence, which is that a stable growth rate is taken for granted. For investors, it means that it’s easier to forecast a steady rise in asset value and so that upward trajectory is already priced into the market (and it only helps that capital is so abundant). Because the economy is doing well, assets are more expensive for buyers (notably equities, but also real estate), which brings down long-term returns.

3/ The lack of competition complicates making bets and deprives investors of potential rewards. Clayton Christensen has been writing for years about the fact that it’s rational for investors to cash out from their investments in companies rather than seeing the free cash flow allocated to higher wages and/or investments. This, indeed, explains the steady rise of dividends paid by mature companies as well as the higher frequency of stock buybacks. But at the macro level, this also means that investors have too much capital on their hands and no idea as to where they can reinvest it. In his interesting newsletter BIG, Matt Stoller points out that market concentration might be the culprit: “There’s just nothing to invest in, because you can’t put money into monopolistic markets and expect a return”.

4/ This can be put into sharper perspective with the enduring crisis in value investing. As pointed out here by Marc Rubinstein, value stocks (companies that are systematically undervalued by the market) have been outperformed by growth stocks (companies that don’t pay steady dividends but are growing at a fast rate) for quite some time, which he, citing Carlota Perez, declares characteristic of a turning point between the installation phase and the deployment phase. In this other very interesting article, Adam Seessel, himself a value investor, makes the point that investors need to radically reassess the criteria that make a good investment: basically, today it’s less Kraft-Heinz and more Netflix or Amazon.

5/ Private equity is still rising in volume, which is logical in times of cheap and abundant capital. But the race to raise larger funds makes it more difficult to generate outsized returns and might be motivated by a hunger for more fees. What’s interesting is the rift between different approaches to private equity. On the one hand are those who go the usual way and then realize that there is no such thing as steady dividends in an economy that rewards risk-taking and innovation. Make sure to read this article by Ranjan Roy where he points out (discussing Kraft-Heinz) that “You can’t cost-cut your way to new consumer brands”. On the other hand, I’m sure that there are private equity investors buying out companies with a clear understanding that their targets must become more like tech companies.

6/ Overall, the private equity world is lagging behind in understanding the current paradigm shift. In theory, investors looking to invest in established companies should divide their potential targets into three categories: those that will eat dirt because of the shift (in the TV and movie business, that was Blockbuster); those that will be gobbled up by larger players trying to reach critical mass (that’s Marvel Entertainment); and those that will end up dominating the market once the transition has wiped everyone else out (that’s Disney). In practice, however, I don’t see private equity investors . Yet this should be the rule of thumb: Don’t buy out companies because you’re counting on steady revenues in the future; buy them out so that those companies can resist the tech-driven crunch and see their businesses rebound after the dust settles.

7/ As for tech companies, I’d say returns depend on the quality of your deal flow. There are two stages at which investors can consider deploying capital in tech. Early stage startups are an interesting (and potentially lucrative) asset class, but either you are a seasoned angel investor with access to the best opportunities, or you don’t stand a chance trying to play that game. There are simply too many startups out there, and most of them are doomed to fail. Plus, you can’t forget the : the bets you make at seed stage in Europe should be very different from the ones made in the US. It’s a different context, different industries, different market dynamics, and different needs in terms of ecosystem.

8/ At the later stages, it’s a very different game, but it still depends on access to the best deals. Late stage venture is less about betting, because beyond the Series-B stage, the potential winners are easy to spot. What’s difficult is having access to those obvious deals in which everyone wants to participate. There are three options: You can be a well-funded, well-branded firm with a multi-stage strategy and you can simply follow up using your pro rata (see this recent TechCrunch article); or you have so much money on your hands that you can force your way into any deal and outbid your competitors (that’s SoftBank); or if you have none of the above, you can simply make your way to the founders and build a relationship with them. Yet very few investors can pick any of these options, which explains why all this capital stands unallocated while there’s a ton of money to be made in tech companies.

9/ We are seeing early signs of tech startups being considered as a more important component in allocation strategies:

  • Institutional investors have been looking to bypass asset managers and invest directly for quite some time. Fidelity and others have been part of the hottest deals over the last decade. And we know that more and more limited partners are negotiating co-investment deals with the firms that raise from them (thus bringing the actual management fees down).

  • Meanwhile, some venture capital firms are turning into . It’s still early and there are many ways of interpreting this trend, but as I see it these firms have realized, given their valuable portfolio of tech startups, that they can complement it with a broader, more diversified allocation strategies.

  • Finally, I find it interesting that more and more professionals from the traditional financial services industry are taking an interest in venture capital and tech startups. See this article by Marc Rubinstein (again) and this great series on “Unpacking Alpha in Venture Capital” by Ahmad M. Butt of Jetstone Asset Management.

10/ So what about Europe? Recently I was talking with a London-based investor about US firms investing here. What he had heard was that the competition was so fierce in Silicon Valley that some US-based investors were thinking about doing more deals in Europe. But what has stopped them so far are the terrible returns. If you have money on your hands and access to good deals at home, there’s really no point in scouting opportunities in Europe because you’ll never make as much money here as you would by investing in a US tech company. (And by the way, the same trend can be spotted in investment banking, with firms and deals being more and more concentrated in the US at the expense of Europe.)

However—and this could suggest that the future might be different from the past—we’re seeing more and more foreign capital flowing into European tech, with even SoftBank doing its very first deal in Europe! My bet is that with the growing rift between the US and Europe, the rise of a first generation of European tech champions, in-depth work on ecosystem building and discovering what it takes to build great companies outside the US, we will close the gap at some point 🇪🇺.

There are already many links above, but here are more articles about returns across asset classes:

Warm regards (from London, UK),