The search for alpha in intellectual property: adventure capital, not venture capital

Kurt Cobain once said: "They laugh at me because I am different, I laugh at them because they are all the same.” I have been thinking about this quote quite a bit this week as I travelled from London to Philadelphia and New York. On this journey I have had the privilege to meet with two visionary company founders in life sciences and electronic engineering. Both have created unique companies around intellectual property. Both have had a struggle of Sisyphean proportions to find investors that both believe in them and are willing to commit capital to that belief.

I have worked with one of these company founders, R, for almost a decade, during which time he has turned his idea into a billion-dollar company and I have sat in the room with him as investor after investor told him: “We cannot find a flaw in your presentation, it is fantastic – but we will not be investing in intellectual property”. Perhaps the most extraordinary comment I heard, from a world-class firm of private equity investors, was: “We have never invested in a company with cash flow at this stage of development; we are not sure where it would sit in our portfolio.”

Predictably, the investor which did commit capital to the project was an outsider, a new entrant who did not know the rules. It thought that when you saw something you liked (that was disruptive, scalable and well managed), you invested in it. So it did. It is a revolutionary idea, but not as ridiculous as it sounds, because professional investors have three structural impediments to following their instincts:

• Being a venture capital or private equity professional is a job. Just as nobody got fired for buying IBM, so nobody will get fired for finding the next Facebook.  That's why we have so many 'me too' investments and too few original ideas. To paraphrase one global bank, "We want to be first to be second."
• Venture capital and private equity firms manage other people’s money. They do this for a fee and a share in any profits. The fee is charged in two ways: as a direct cost to the fund and as service fees to the portfolio companies in which they invest. This creates a moral hazard for management teams, since much of their compensation derives from fees that are unrelated to performance. More than 200 firms are currently the subject of Securities and Exchange Commission attention in this regard (www.businessweek.com/news/2014-04-07/bogus-private-equity-fees-said-found-at-200-firms-in-sec-review).
• Most of the money in venture capital and private equity comes from large institutions. These investors manage billions of dollars and their venture capital or private equity investment is a tiny proportion of their overall risk. The addition of venture capital or private equity to their portfolio has the effect of dampening the impact of market movements. It is not a search for specific investment returns (alpha) but a search for lower volatility, correlation and tax efficiency. To quote one global private equity firm, “We seek to generate 2.1x our money every five years; anything above that is too risky for our investors."

As a private family, R’s investor had no partners to answer to and no mandate so inflexible that it could not use its discretion. Unlike a private equity firm, whose investors may second guess poorly performing investments and are less inclined to invest in future funds as a result, R’s family had to answer only to itself. Having the courage of its conviction was what it was there for.

The second entrepreneur, S, is a theoretical physicist who founded a company with a unique technology that it could not manufacture or scale in-house. So it partnered with an industry leader and had this relationship documented professionally. As soon as the ink was dry on contracts, the industry leader stole the technology.

Faced with blatant commercial theft of his intellectual property, S went to his board, but it was unwilling to jeopardise the substantial base business of the company with a lawsuit whose costs could ruin it. So S re-acquired his own patents from the company he founded on a mission to secure proper royalty payments.

Finding funding for this task took him seven years – a biblical timeframe, but he hung in there with the same unconventional tenacity that led him to found the company in the first place. After 15 years he secured substantial royalty payments from every company that had acquired or used his technology. 

What strikes me about both of these stories is that they are not outliers. On a daily basis I meet accomplished and unconventional innovators who have been told by numerous professional investors "It's great, but not for us.” The reason for this is simple; the venture capital and private equity industry has mushroomed into an institutionally fed machine that seeks conformity, trying to repeat today what it did yesterday. Intellectual property may be the driver of 21st century wealth, but few investors have any experience in it, so a Catch-22 situation develops.

Of course, there are some extraordinary people who invest in the future and indeed in intellectual property – Paul Graham of the Y Combinator comes to mind, and his essay on the conformist test should be read carefully by every aspiring venture capital and private equity professional (www.paulgraham.com/say.html).

But it is not all bad news. Some really adventurous capital (adventure capital, if you will) is coming from families, acting as principals not agents, driven purely by the relentless search for alpha and without the moral hazard of fees driven by assets gathered rather than performance generated.

A disruptive, inflective moment may lie ahead for an industry that has defined itself on its ability to find and fund the disruptors. In 2014 venture capital and private equity are really asset management, whose steady fee-driven returns, modelled on yesterday's numbers (past performance) and risks are more attractive than betting the farm on successful innovators. The stakeholders in the current paradigm (managers, staff and public shareholders) are all aligned in this economically rational position.

Therefore, the message for innovators and iconoclasts is that you should understand that the venture capital and private equity universe is not there to fund your innovation – it exists to fulfil its own mandate.  Such mandates are often quite narrow and rest in comfort zones where collective investment committee decisions are not career defining. If you want to find true adventure capital which understands that tomorrow does not look like yesterday, it is a much harder search – but one place to look for it is with investors that deploy their own funds as principals. Outsiders such as families are good place to start.