The Facebook Founders Club never ceases to expand:
Indeed, Mr. Greenspan, who is now 24 and moved to Silicon Valley last year to start a company, appears to be a clear example of a truism in this high-technology region: establishing who is first with an idea is often a murky endeavor at best, and frequently it is not the inventor of an idea who is the ultimate winner.
Mr. Zuckerberg declined to be interviewed, saying through a spokeswoman that he was not sure how to respond. He did not dispute the chronology of events or the authenticity of Mr. Greenspan’s e-mail messages. Mr. Zuckerberg is seeking to dismiss the ConnectU suit.
Mr. Greenspan said that Mr. Zuckerberg’s lawyer contacted him this year in connection with the ConnectU lawsuit but that he had declined a request to serve as a witness, fearing that he would become embroiled in the legal battle.
In an interview at a cafe here this week, Mr. Greenspan said he had mostly made peace with the fact that Mr. Zuckerberg will be the first of the Harvard ’04 graduates to become a billionaire.
If Mr. Zuckerberg did borrow some of Mr. Greenspan’s concepts, he may have simply been working in a grand Harvard tradition. After all, it was a young Harvard dropout, William Gates, and his classmate, Paul G. Allen, who almost three decades earlier copied a version of the BASIC programming language, designed by two Dartmouth college professors, to jump-start the company that would grow into the world’s most powerful software firm.
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WatchMojo NewsletterIf you thought financing rounds were raising eyebrows, here’s a prediction, it’s about to get a lot more interesting, and competitive, starting… now. Part of the reason why is that exits are about to get more competitive.
Tech Crunch points to a press release that $15 billion hedge fund General Atlantic is backing Jon Miller - former CEO of Time Warner’s AOL - and Ross Levinsohn - former CEO of News Corp.’s Fox Interactive Media’s roll-up fund. We’d heard a lot about these roll-up funds, and now we’re seeing that move from concept to reality. The challenge, now, is the execution.
Michael Arrington raises a good point: the fund will be competing with Demand Media, what makes that interesting, is that Levinsohn and Demand Media Chairman and CEO Richard Rosenblatt teamed up on Intermix Media’s sale to FOX: the Intermix board brought in Richard Rosenblatt to replace founder Brad Greenspan… and eventually, FIM’s CEO Levinsohn got News Corp. head honcho Rupert Murdoch to sign the big check $580M to Rosenblatt and other Intermix shareholders.
Of course, Intermix’s Myspace was the crown jewel, but the MySpace guys only got $5M in the sale, and Greenspan to this day thinks he and other shareholders were short-changed. Afterwards, Levinsohn basically told Greenspan off, read more on Valleywag’s post, called “Fox interactive head: Brad Greenspan is a loser“.
Not to be outdone, Brad Greenspan, founder of Intermix, has since started LiveVideo.com and been busy buying up assets, he bought video search (Flurl.com) and probably, safe to say, hates both men (Levinsohn and Rosenblatt). He also tried to derail Murdoch’s planned acquisition of Dow Jones, which was beyond ballsy, and ineffective. Expect to see Murdoch try to derail at least some of Greenspan’s plans in the future.
Back to this new fund, by the sounds of the press release, Miller and Levinsohn are:
“to Serve as Advisors to General Atlantic’s Media and Consumer Sector,” but I think by next week you will see news that the gentlemen are launching a new fund and leveraging GA’s far-flung assets and know-how.
According to Anton Levy, Managing Director and head of GA’s Media & Consumer sector, said, “We are excited to be bringing Jon and Ross on board to work with our media and consumer team as we continue to partner with the leading companies in this high growth sector.”
Paid Content adds:
The new fund is called Velocity Investment Group, and among the companies we have heard it is looking at is online video distribution firm Broadband Enterprises. The two have also been talking to numerous other companies, at least a dozen of them according to our sources. The focus initially is platform/distribution companies.
Also, the two have been talking to various investors for while, and among them were Texas Pacific Group. The fund came very close to doing a deal with Warburg Pincus, but Warburg was putting in too many restrictive clauses which the two didn’t agree to, and General Atlantic came in at the last second, our sources tell us.
What’s more noteworthy, in fact, is that to some extent, Levinsohn got shown the exit door by News Corp. and AOL sheepishly fired Miller and replaced him with NBC’s Randy Falco. Guess who this fund will also be competing with?
Media companies like NBC and News Corp.
I am not sure if I should be saying this, but this week I held talks with a couple of media firms who wanted to buy us. Both fantastic businesses, but on my way back, I could not help but think that it was too early to sell and that the demand vs. supply mechanism was in our favor and we should hold out. I might very well never cross any of these men (well, Mr. Levinsohn certainly knows about WatchMojo.com, but I digress), but you are just starting to see the flow of things towards digital, mark my words.
I love this business.
I have no idea who Alan D. Mutter is, but I stumbled onto his site and his post, Print ad sales hit 10-year low, is damning for print media:
After six straight quarters of accelerating declines, newspaper print advertising sales in the first half of this year fell to the lowest level in a decade, according to statistics released today by the Newspaper Association of America.
Print revenues in the first six months of this year totaled $20.3 billion, the lowest since the $19.7 billion in sales recorded in the first half of 1997. Print ad sales in the first half of this year were 8.3% below the depressed level recorded in the same period in 2006.
Although the NAA touted a 19% increase in online ad sales to $796 million in the second quarter of the year in a spin-rich press release on the eve of the Labor Day weekend, print ad sales represented a bit more than 93% of the industry’s total volume of $22.49 billion in the first half of the year.
It’s also, I think, a sign of things to come for TV companies. Read more on that here:
- Understanding TV executives Angst and Envy
- Web Video Represents $150B market cap in 2011, but not for TV companies
- Digital Revenues are Never Incremental for Old Media
- Will TV companies face same fate at Print Companies?
- If You’re Old Media, What Would You Do?
- Vint Cerf is Latest TV Bogeyman (That’s a compliment)
When Valleywag is not promocking (promoting/mocking) Robert Scoble or Jason Calacanis, it publishes interesting commentary or identifies insightful reads [side note, I think I just invented the term promocking.]
Anyway, today, Valleywag points to Paul Graham’s How Not to Die post where he basically talks about what startups need to do to avoid from dying (shutting down) so that they can, well, get rich.
As I read Graham’s piece, I found numerous nuggets of wisdom. I’ll copied and pasted the best ones, but from a personal perspective, all I could think of was a personal experience from last year. Shortly after I started Mojo Supreme, I got attacked personally and legally. Our flagship unit WatchMojo.com was losing money and there was no way to assume that we’d one day, in the context of Graham’s post, “get rich” over it.
So in essence, I had to fight back (in fact increase our burn rate) to defend myself and avoid our company from shutting down, or dying. But the more I had to defend myself to avoid getting killed by the courts, the more I increased the likelihood that we’d die from too much expenditures.
And, if I were successful in defending myself and my company in the courts, then my prize, at least in the short term was essentially losing more money from operations!
My friends thought it was crazy, my family thought I was insane; thankfully, my wife supported me.
Today, it’s obvious that I would do what I did all over again, but at the time, it was anything but obvious.
Anyway, some highlights from Graham’s piece:
A couple days ago I told a reporter that we expected about a third of the companies we funded to succeed. Actually I was being conservative. I’m hoping it might be as much as a half. Wouldn’t it be amazing if we could achieve a 50% success rate?
Another way of saying that is that half of you are going to die. Phrased that way, it doesn’t sound good at all. In fact, it’s kind of weird when you think about it, because our definition of success is that the founders get rich. If half the startups we fund succeed, then half of you are going to get rich and the other half are going to get nothing.
If you can just avoid dying, you get rich.
(…)
You may have heard that quote about luck consisting of opportunity meeting preparation. You’ve now done the preparation. The work you’ve done so far has, in effect, put you in a position to get lucky: you can now get rich by not letting your company die.
(…)
We don’t know exactly what happens when they die, because they generally don’t die loudly and heroically. Mostly they crawl off somewhere and die.
For us the main indication of impending doom is when we don’t hear from you. When we haven’t heard from, or about, a startup for a couple months, that’s a bad sign. If we send them an email asking what’s up, and they don’t reply, that’s a really bad sign. So far that is a 100% accurate predictor of death.
Whereas if a startup regularly does new deals and releases and either sends us mail or shows up at YC events, they’re probably going to live.
(…)
When startups die, the official cause of death is always either running out of money or a critical founder bailing. Often the two occur simultaneously. But I think the underlying cause is usually that they’ve become demoralized. You rarely hear of a startup that’s working around the clock doing deals and pumping out new features, and dies because they can’t pay their bills and their ISP unplugs their server.
Startups rarely die in mid keystroke. So keep typing!
If so many startups get demoralized and fail when merely by hanging on they could get rich, you have to assume that running a startup can be demoralizing. That is certainly true. I’ve been there, and that’s why I’ve never done another startup. The low points in a startup are just unbelievably low.
(…)
Startups almost never get it right the first time. Much more commonly you launch something, and no one cares. Don’t assume when this happens that you’ve failed. That’s normal for startups. But don’t sit around doing nothing. Iterate.
(…)I like Paul Buchheit’s suggestion of trying to make something that at least someone really loves. As long as you’ve made something that a few users are ecstatic about, you’re on the right track. It will be good for your morale to have even a handful of users who really love you, and startups run on morale. But also it will tell you what to focus on.
(…)
The number one thing not to do is other things. If you find yourself saying a sentence that ends with “but we’re going to keep working on the startup,” you are in big trouble.
(…)
A startup is so hard that working on it can’t be preceded by “but.”
In particular, don’t go to graduate school, and don’t start other projects. Distraction is fatal to startups.
(…)
One of the most interesting things we’ve discovered from working on Y Combinator is that founders are more motivated by the fear of looking bad than by the hope of getting millions of dollars. So if you want to get millions of dollars, put yourself in a position where failure will be public and humiliating.
(…)
So I’ll tell you now: bad shit is coming. It always is in a startup. The odds of getting from launch to liquidity without some kind of disaster happening are one in a thousand. So don’t get demoralized. When the disaster strikes, just say to yourself, ok, this was what Paul was talking about. What did he say to do? Oh, yeah. Don’t give up.
(…)
Indeed, starting a new business is not for the faint of heart… but once things start to roll then it’s the best thing you could ever imagine…
Jack Welch argued that you should compete in a market so long as you could be #1 or #2 in that market.
Apparently, a lot of current VCs are students of Jack Welch. YouTube is the undisputed king of online video, then the market is fragmented:
I’ll admit this much, I am probably very diplomatic because most of these sites are distribution partners of our company WatchMojo.com, but by the same token, that’s never stopped me from ripping our largest partner YouTube, either.
So, first, some context:
- first Veoh raised $40M
- then, Metacafe raised $30M
- today, it’s Daily Motion, who raised a whopping $34M
According to WSJ, via PaidContent.org (who is less diplomatic than we are, calling the post “The Race of Also-Rans: French Video Sharing Site Dailymotion Raises $34 Million; More To Come”):
If Veoh can raise $25 million, and Metacafe can up the stake to $30 million, then why not Dailymotion? The France-based online video sharing site has raised $34 million in its second round of funding. The round was led by Advent Venture Partners of London and AGF Private Equity of Paris, a division of Allianz AG. The site has raised about $9.5 million in October last year from Atlas Venture and Partech International.
Dailymotion, which is based in Paris and was launched in 2005, has grown rapidly to reach some 37 million visitors a month, the story says. It was recently fined a modest $32K by a court in Paris for unlawfully carrying a clip from a 2005 movie by a French director. With this big round, the copyright infringement stakes are going to get higher, for sure. Last month Dailymotion rolled out Audible Magic copyright detection software on its site, which catches clips after they have been uploaded.
Of course, GE operated in mature businesses, well, mature by the web’s standards. So online, the argument could be extended to competing in a space so long as you can be Top 5.
In fact, that makes sense, if you think of search, where Google, Yahoo!, MSN, Ask.com and AOL account for 99% of the market share and all boast multi-billion dollar businesses.
In fact, 99% of the total market capitalization of the search engine industry is
= Google’s $150B
+ Yahoo!’s $17.5B
+ MSN’s $10B
+ Ask.com’s $3.15B
+ AOL’s $3.15B
= $183.8B.
For our analysis of their respective search business’ worth, click here and scroll down to Part II. This link actually outlines the value of the video advertising business in 2011, and the parallel between search and video is eerie.
Today, the search industry accounts for 40% of all online advertising, or $10B worldwide per year. By 2011, the more aggressive projections by Understanding & Solutions call for video to generate a $10B market (more dovish projections by eMarketer call for a $4.3B market, but we digress).
If you connect the dots, the potential for the Top 5 video players can represent as lucrative of a market in video in 4 short years as it does in search today. Mind you, this is a massive leap of faith. Also, one problem is that there is no guarantee that the Top 5 “value-holders” will all be video file sharing sites.
Yesterday, for example, News Corp. and NBC finally baptized NewCo./Newsite Hulu, and that already boasts a $1B valuation according to provate equity bankers Providence. Then, like we’ve outlined previously, come the numerous video search players who are vying for a seat at the table of Top 5…
Translation: it’s not my partner status as executive producer/founder of content producer WatchMojo.com that makes me diplomatic, I actually think that some of the VC investments in late round stages makes sense because a lot of VCs want exposure to this space. Where I tend to respectfully disagree with the “smart money” is that most of the content that currently gets played on YouTube, Veoh, Revver, Metacafe, DailyMotion and company is not what advertisers want, meaning that a lot of the use of funds will go to subsidizing hosting and bandwidth.
Of course, other uses of funds include legal fees. Make no doubt about it. As ridiculous as Viacom looked today in the Web Junk snafu, expect more legal muscles to be flexed… Another use of funds, obviously, is building out sales teams. Right now, most of these companies don’t have the sales infrastructure required to capitalize on the booming market, which takes us to the most likely scenario surrounding many of these “also-rans” (to quote Rafat, of course).
I know what you’re thinking, looking at the Table above: “but Veoh, Metacafe and Daily Motion” are not in the Top 5″. True. But considering YouTube was acquired by Google, MySpace was taken off the market by News Corp., and then Google Videos, Yahoo! Videos and MSN Videos being corporate giants, in VCs eyes, they are Top 5 sites.
A lot of these companies will eventually get bought out… either for traffic, or technology, or simply out of sheer paranoia.
So, are VCs dumb or smart to back them, it depends… anyway, we’re seeing late stage VC investing in file sharing, where will we see Series A rounds?
When Benchmark Capital hired Dave Goldberg, a digital media executive and former VP and GM of Yahoo Music, people wondered if the venerable VC who backed eBay would take an interest in financing digital content startups (read Are VCs jumping on Digital Content bandwagon?).
This potential represented an interesting shift because historically, VC firms back technology companies.
Indeed, the initial crop of VCs were computer-types who hailed from firms like Intel, HP, etc. This background helped initial web companies who were creating the initial infrastructure of the web, because these needed to fully grasp how Moore’s Law would affect computing power and innovation, and thus, how web surfers would interact with the world wide web and how websites needed to time their developments to match the main device that would serve as the gateway to the Internet: the computer.
How Web Monetization Changes the Requirements of Being a VC
But, times have changed. The computer has now taken a back seat to the Internet. More importantly, a computer is not the sole device to connect to the world wide web. But it’s not the connection, but the commercial reality, that is affecting VCs most.
While websites such as Google today command the bulk of their revenues from advertising sales, their intellectual property largely revolves around technology, and as such, the VCs who shepherded the respective investments were technology deans, and not media or advertising gurus.
Though, in all fairness, it should be noted that one-half of the power duo that backed Google, Michael Moritz joined Sequoia in 1986 after working as a reporter for Time magazine. He also wrote the 1984 book The Little Kingdom: the Private Story of Apple Computer and he co-founded Technologic Partners, a technology newsletter and conference company. The other half, of course, was John Doerr, who obtained a Bachelor of Science and master’s degree in electrical engineering from Rice University and an MBA from Harvard University in 1976. Doerr joined Intel Corporation in 1974 just as the firm was developing the 8080 8-bit microprocessor. He eventually became one of Intel’s most successful salespeople. He also holds several engineering patents. The point is, Moritz was the exception, while Doerr was the rule.
Advertising is King
Regardless, thanks to Google’s $0 to $160B market cap march in less than 10 years, online advertising is starting to become the preferred business model for most, if not all of startups in the space.
As such, some of the traditional VC who hail from the technology bellwethers are, with all due respect to them, somewhat out of their element in today’s startup environment.
Applications
Part of the reason for that is something Fred Wilson talked about as a driving force behind the business plan of his new VC firm, Union Square Ventures. In essence, he and his partner Brad Burnham argue that the investments in the Web’s infrastructure are a thing of the past, today, the investments that will pay off are applications built on top of the existing infrastructure.
A VC’s Customer
Independent of whether you agree with Wilson’s assessment or not, it certainly is true that the more successful exits would lend to support his argument.
Wilson also argues that entrepreneurs are a VC’s client, if that is the case, then it’s important to follow the consumer to understand which VCs will win the most amount of business over the next few years.
For me, a new media entrepreneur, frankly, a VC who can only tear apart a computer and re-assemble it bears a somewhat hollow value relative to one who grasps the intricacies of how ad agencies work, or how publishers need to cope with digital threats and opportunities. The problem is that many of the folks who have that know-how might not be allured by the worlds of venture capitalism and as a result, VC as an industry suffers as a result.
Where is the Leadership Amongst Traditional Media Companies
This is why I cannot for the life of me understand why traditional media companies have not created a gameplan that will allow them to invest in new media startups and technology applications that will create value for them.
To give credit where it’s due, CBS has been very aggressive this year with investments in a cornucopia of digital assets, including Spotrunner (a video ad service) as well as outright purchases in community applications like Last.fm, currently geared towards music, but clearly providing CBS with video opportunities. But, CBS is the exception here.
Alas, a lot of that has to do with risk/reward culture and entrepreneurship. In other words, sure, Jeff Jarvis is an old media lad with considerable new media DNA in him, but how much does he actually represent the typical executive or writer at a traditional media company? Not much. If you are interested in print media, read Should Print be Free?
Case Study: Online Video
We’ve all seen the studies and reports, online video is going to be large. Video today accounts for less than 5% of online video advertising, but it is poised to grow into a considerable component of the total pie.
Today, with broadband in over 50% of homes, it could be argued that the video file-sharing platform segment is old news for VCs, especially after the #1 search company Google bought the #1 video platform company YouTube and made life for second tier players harder.
Naturally, the spotlight then shifted to video advertising; you needed to monetize the videos, after all. But, seeing the massive amount of money being poured in video ad networks, including:
- Brightcove | see my post about why Brightcove should keep it simple stupid here.
- Brightroll | see my interview with CEO Tod Saceroti here.
- Video Egg | see my interview with CEO Matt Sanchez here.
- Tremor Media
- Broadband Enterprises
- Yume
- Scanscout
- Google/YouTube
- AOL/Advertising.com/Instream
- VideoMovement
- etc.
Not to mention the video search players:
- Blinkx
- Pixsy
- Podzinger/Everyzing/todayournewnameis | see my interview with CEO Alex Laats here.
- Hmm… Google/YouTube?
you get a sense that the smart money seems to now think that there’s a bit of a bubble going on in that sub-segment (read: Has the “Bubble Pocket” Moved from Video Sharing Sites to Video Ad Networks?).
Is there an over-investment in video ad networks? Time will tell. In 2007, being a display/banner ad network paid off handsomely. After all, some of the top ad networks have fetched considerable multiple premiums: Doubleclick, aQuantive, 24/7 Realmedia all struck gold, if you include behavior targeting network Tacoda, but there are hundreds of ad networks that are irrelevant to varying degrees.
Why Applying AdSense Recipe for Success to Video Will Fail
But the level of investment in video ad networks is simply irrational, in my humble opinion. The problem with video ad networks is simple: they all strive to become Google’s AdSense, the ubiquitous ad network platform that monetized the scores of text-based content in a contextual and scalable manner.
With text, the content was bountiful but the ads were not optimal. Google’s AdSense, inspired one part by
- Overture’s pay per click model,
- Sprinks publisher network, and
- Applied Semantics’ contextual engine
proved to be a winner, hands down.
The Missing Variable: Content
With video, there are, as we highlighted above, countless platforms and endless networks. In fact, one of them, GoFish, is morphing from a platform to an ad network (disclosure: GoFish is one of the many syndication partners in our syndication network that reach over 95% of web viewers).
What is missing is professional, ad-friendly, low-cost, high-yield video content.
These are the global trends and macro factors driving WatchMojo.com’s business plan, in fact.
Don Dodge recently mentioned that entrepreneurs know best:
Entrepreneurs see things that others don’t. At first experts will say it is the dumbest idea they ever heard. But the entrepreneur pushes ahead and makes it happen anyway. Then the experts say, that was simple and obvious…the entrepreneur was just lucky…in the right place at the right time. Entrepreneurs know what I am talking about. It happens all the time.
He is right. Last year, I was called crazy for launching WatchMojo.com. Today, companies that we associate with video content, from both the traditional and new media spheres call us visionary.
The Money Trail(s)…
Naturally, this converts to VCs - the smart money - to follow the opportunities. Case in point: one more VC (Norwest) hires a media-savvy person (Joshua Goldman) to look into digital media (web video content) opportunities. For the record, Mr. Goldman has an accomplished “tech” resume, but his experience highlights that, in the words of NewTeeVee’s Liz Gannes, “Goldman knows his way around the world of video.”
The Writing is on the Wall
Like the Benchmark hire, Norwest’s move is not done in isolation. You will see a lot more VC money unable to reap sufficient returns or exits from technology alone, and their attention will invariably focus to digital media.
It’s also not a coincidence that last week, for example, we got our first ever cold call from a VC inquiring to invest in WatchMojo.com.
To conclude, it’s not like VCs have hitherto not invested in digital video, they have: companies like Mania TV and Ripe come to mind. In fact, even more recently, numerous companies like Revision3 and NextNewNetworks are popping up everywhere, too.
What I am seeing, however, is that there are more and more traditionally tech-oriented VCs that will begin to look at content. But, don’t take it from me, take it from someone in the space now. From the same NewTeeVee article:
Perhaps most surprisingly, Goldman said he had the go-ahead from Norwest to look at content startups (…) but Norwest has traditionally been devoted to information technology, emphasis on the technology. Times have changed. “It’s something my partners have agreed we will look at if the economics are right,” Goldman said.
In fact, the dynamics in media have changed from a mere five years ago. In other words, it’s not enough to simply transpose a media-oriented person in a venture capital partnership and assume he or she will succeed. But like all successful VCs and entrepreneurship will tell you: trial and error and experimentation is better than not trying at all.
Will every investment in digital video be a hit? Of course not. But, much like it happened with print media, the TV advertising juggernaut has started to shift towards digital and will accelerate its migration to the Web.
So there is plenty of room for video content startups, and that is why you will more and more VCs luring media guys in the hope of finding the next generation’s answer to HP and Google.
Digital media is the new software, once created, it’s all profit, apparently, I’m not alone in that thinking:
The CNN cable television news network said on Thursday it would stop using the Reuters news service, ending a 27-year relationship, to cut costs and invest in its own news gathering operations.
The global television news network owned by the world’s largest media company, Time Warner, said in an internal memo that it wanted to reduce reliance on agency material while achieving better control of its growth.
“This is all about us, not Reuters. This is about content ownership,” CNN spokesman Nigel Pritchard said. “Everything is changing and content ownership is king.”
Read the rest.
First VideoEgg, then MySpace China?
WPP recently bought 24/7 Realmedia (TFSM) to increase its exposure to the Web. In 2006, Sir Martin Sorrell said that his company’s online unit would double in terms of revenue contribution, from 15% to 30%.
Clearly, to get there, it will take deals and investments. While WPP outright bought TFSM, it has made investments, too (something that traditional media company CBS has been doing, too).
TFSM offers WPP many opportunities: in email, ad serving, as well as an ad network. As a remnant network, I’d presume TFSM already reaches a considerable amount of user-generated content, as such, WPP is quickly becoming a very aggressive traditional agency/marketing in this space: in addition to TFSM, the company invested in a Series C round in VideoEgg, one of the bigger video networks in the social networking video space, and today announced an investment in MySpace China. I totally understand the China part, but doubling up - or in fact tripling up - on social networking by way of MySpace is starting to expose WPP a tad too much on this space, one which despite the hype is set to grow to a $2.15B market by 2010, at a time when all online ads will be $30-70B.
Regardless, we commend WPP for realizing that online is where they need to be.
More importantly, we give props to News Corp. for understanding, like VideoEgg did, that having WPP as a strategic investor is key to getting global marketers to embrace user generated content, because if anyone has doubled up more on UGC than WPP, it’s MySpace and VideoEgg!
I used to think that the Montreal to NYC and back to Montreal trip in 12 hours or so was rough, but how about the Montreal to San Francisco, then back to Montreal on a red-eye in 24 hours.
Where am I and what day is it?
The following is a paper I wrote with a couple of classmates back in 1999, on Long Term Capital Management. I came across it this weekend. In light of the recent sub-prime credit situation and the capital injections made by banks, I thought it might be interesting to post it. I was 20 when I wrote this as a undergraduate student in finance.
Since the early 1980’s, the United States has experienced a tremendous Bull Run. After the 1987 correction, investors have required higher returns on their capital. Simultaneously, many sought to diversify their investments geographically in order to capitalize on cyclical growth patterns while spreading out their risks over many regions. As new investment vehicles were being created, more and more money was being poured into the financial sector.
THE FUND THAT WAS BUILT ON SAND…
1. Managers / partners
Following Salomon Brothers’ Treasury bond scandal in 1991, then vice chairman and proprietary trader (manager responsible for trading a firm’s own cash account) John Meriwether left . Gradually, a number of his former coworkers followed him to resurface in 1993. Meriwether’s brainchild was a hedge fund called Long Term Capital Management. Meriwether’s reputation as a great trader allowed him to recruit, among others, Nobel laureates Robert H. Merton and Myron S. Scholes , as well as David Mullins, vice chairman of the Federal Reserve Board until 1994 . This fund was to take positions that Meriwether and partners dictated .
2. Outside Investors
LTCM was distinctive from the beginning. It carried out positions that took 6 to 24 months before delivering profits. As a result, the fund ruled that investors in the fund would not be allowed to withdraw their capital quarterly or annually, which was the norm amongst hedge funds. Rather, it would force investors to lock up their minimum $10 million initial investment until the end of 1997 . This effectively ensured that the potential withdrawal would be 12% of the fund’s capital . LTCM’s investors paid unusually steep fees: 2% of capital invested in the firm as well as 25% of profits .
3. Returns
TABLE 1: LTCM’s Annualized Return on Capital
4. Disclosure
The hedge fund was very secretive, disclosing very little to outside investors. The lack of transparency and lengthy capital lock-up should have given investors an idea of the fund’s risk-profile . Nonetheless, investors looked the other way after the fund returned 48.3% in its first 31 months of trading with little volatility .
By 1997, contributions and reinvested earnings had raised LTCM’s capital to around $7 billion, at which time the managers’ greed began to outweigh their sense of logic. LTCM’s managers concluded that the fund had too much capital given its investment opportunities, forcing many newer investors to withdraw their money. By year-end 1997, the fund had $4.7 billion in capital, of which $1.5 billion belonged to insiders .
THE FUND THAT WAS TOO SMART TO FAIL…
LEVERAGE
Meriwether had acquired a near-cult following among coworkers thanks to his successful bond trading track record. Banks and brokerage firms were thrilled at the prospect of lending him money under favorable terms (by waiving collateral for example) . His legendary status at Salomon and LTCM enabled him to raise capital at low cost and with few guarantees .
By 1997, the fund had about $125 billion in debt, its balance-sheet leverage ratio was 25 to one. This understated the fund’s true credit risk because it had aggressively entered into off-balance sheet derivatives contracts that, by their nature create additional leverage .
INVESTMENT STRATEGY
1. Equity
LTCM’s entered the equities market in 1995 under partner Lawrence Hilibrand’s supervision . By June of 1998, the fund owned $539.2 million worth of stocks in 76 companies . The fund felt that its bond expertise was transferable to stocks. Conceptually, their equity arbitrage strategy was similar to what the firm was doing with bonds: long on the cheap security while short on the expensive one, based on historical trends . The firm’s equity trading strategy fell under three main categories:
a) Pairs trading (two related stocks: parent/subsidiary or two firms in similar industry)
LTCM had a $2.3 billion position in Royal Dutch Petroleum and Shell Transport. Historically, Shell had sold at an 18% discount to Royal Dutch. When the discount rose above that, LTCM bet that Shell was cheap compared to Royal Dutch. So, LTCM bought shares of Shell Transport while selling shares of Royal Dutch. If oil stocks go up, Shell would rise more than Royal Dutch would. If oil stocks go down, Shell would fall by less than Royal Dutch. Unfortunately for LTCM, the stocks diverged even further .
b) Risk Arbitrage
Rather than going long on one stock and shorting the other, LTCM entered into total return swaps with Wall Street firms. This allowed LTCM to pump up returns through leverage and shift most of the risk to its trading partners on Wall Street. Take for example Citicorp and Travelers Group. Based on the terms of the merger, Citicorp was relatively underpriced. Instead of buying Citicorp, LTCM bought a total return swap from a bank, whereby the bank would pay LTCM the total return on Citicorp stock (stock appreciation and dividend). If, on the other hand, Citicorp declines, LTCM must pay the banks the decline in the stock price. The advantage of such a strategy is high stakes gambling without a penny in margin. The disadvantage to risk arbitrage is that if the fund is wrong, they must pay up afterwards .
c) Market Volatility
LTCM bet that the wide swings in the markets would revert back to historical norms. The more volatile a stock, the more expensive are the puts and calls. Similarly, the more volatile a market, the more expensive are the prices of puts and calls on the index. LTCM felt that volatility was abnormally high. LTCM was short volatility, but it increased sharply, forcing LTCM to put up more collateral to cover losses and maintain its options positions .
2. Fixed-Income Securities
a) Arbitrage
Very few of LTCM’s bets carried direction or position risk . Instead of betting on which way the market was headed, LTCM would search for arbitrage plays: opportunities to profit from temporary disparities in prices of related assets
By putting its financial technology and experience to work at finding sectors of the bond market in which yields had gotten out of line with yields in related sectors, LTCM captured small profits from carefully hedged positions by buying the cheap security and shorting the expensive one.
Much of LTCM rationale was based on historical performance: converging spreads between risky and risk-free assets. Under such scenario, the fund does not care whether rates go up or down, as long as they converge .
TABLE 2: DIVERGING YIELDS
b) Market integration in Europe
Their reasoning was also intuitive. As Europe sought to integrate markets, it had to ensure that the 11 member countries would align their interest rates. Italy’s Central Bank, for example, would have to reduce inflation and lower its rates through monetary and fiscal policy in order to align them with the lower German rates. If not, different rates would present huge arbitrage opportunities once the Euro currency would begin trading .
c) Quantitatively oriented
LTCM is one of the 20% of hedge funds that are quantitatively oriented . By inputting financial data into computer models, LTCM could pinpoint profitable strategies while simultaneously “spitting out” the hedging strategy to limit risk .
Confident that its position risk was very low, the fund proceeded to take on colossal balance-sheet risk, seduced by the most addictive drug in finance: leverage. The fund’s annualized return per dollar was 67 basis points (0.67¢). Leveraged 30 to one, a 0.67% return on each dollar at risk would mushroom to 20% per annum, with little apparent risk . The beauty of “rocket science” in finance was that while the gambles were huge, the risks seemed minimal .
d) Computer Models
LTCM’s Achilles heel was that it believed that its computer models were full proof. Such bets failed because various factors were not fully incorporated into the models :
• Lack of liquidity: When a computer program pinpoints a profitable hedge, the assumption is that there will be a buyer on the other side of the transaction when the deal is settled. But the turmoil in Russia and Asia so unsettled markets that buyers disappeared.
• Breakdown of international diversification patterns: Usually traders can hedge their bets by investing in many different geographical regions. But the patterns changed, whereby a decline in one region was not being offset by a rise in another.
• Limited application: models that may be useful for countries with well-developed markets do not necessarily work well in smaller, less-developed markets.
• Missing street smart: many mathematical geniuses with little practical experience in financial markets have been hired by Wall Street. Black box models put on autopilot, without review or input by seasoned traders, can fail.
• Political risk: the models failed to realistically assess the risk that Russia would backslide so abruptly on the road to capitalism.
In order to function properly, computer models require liquid markets with demand on both sides of a transaction. But markets are thin in August as Meriwether himself told fundholders that “volatility and [the] flight to capital were magnified by the time of year when markets were seasonally thin. ” What exasperated such a shock was the worldwide phenomenon of liquidity drying up across markets. As a result, the geographical diversification strategy employed by most firms did them no good.
One critique of such complex models is the assumptions they make about market volatility. The Black-Scholes options pricing model is highly regarded, but it tends to underestimate how volatile markets tend to be in times of irrationality, be it on the upside or on the downside . While models estimate about four times volatility in periods of turmoil, historical data would suggest that volatility could hit up to 12 times regular price swings .
Finally, model risk is an equally important factor to consider for quantitative-oriented firms. There exists the risk that the model in question may be different than what actually occurs in markets, especially with such data-in, data-out models .
In a sense, the problem was not too much rocket science but not enough. The problem with the models was that they did not assign a high enough chance of occurrence to the scenario in which many things go wrong at the same time – the perfect financial storm. Apparently, the worst-case scenario envisioned by LTCM was about 60% of the one that actually occurred
. LTCM believed that its financial technologies and meticulously constructed hedges gave the fund a conservative risk profile, as spelled out in October 1994 in a proposition to investors. The paper contained a range of returns that the fund could aim for with the respective probability of loss if things went bad. For example, the table said that if the fund would be shooting for a 25% return, the probability that it would end up losing 20% or more was an insignificant 1 in 100. The table never even contemplated a steeper loss .
THE PERFECT STORM AND ITS RIPPLE EFFECTS
What occurred in August of 1998 was the financial world’s equivalent of a perfect storm: everything going wrong at the same time. Interest rates moved the wrong way, stock and bond prices that were supposed to converge diverged, and liquidity dried up in many markets .
Even though LTCM had little direct exposure to Russia , July’s debt default on short-term liabilities drastically reduced investors’ appetite for risk . The signal to international investors was clear. Quickly realizing that an emerging market label means little when the economy rests on weak fundamentals: lack of accountability, failure to collect taxes and pay employees, and excessive corruption. Moreover, “earning” 100% returns are insignificant if the borrower has no intention or is incapable of repaying back the loan.
1. Flight to Quality
What followed was a massive flight to quality as investors switched their investments into the safest haven they could find: the US market and the US dollar. As investors sold foreign, riskier securities, their prices fell while rates rose.
Conversely, US securities’ prices rose and rates fell. Most of the quantitative firms were betting on riskier, less liquid securities such as corporate and junk bonds.
Instead of narrowing, the spreads between risky and risk-less securities widened in virtually every market around the world, crushing Meriwether’s fund .
TABLE 3: DISASTROUS DEVIATION
2. Capital Inadequacy
Those who bled most were the highly levered firms, such as LTCM. When spreads widened in a disorganized tumbling market, gains on short positions were not enough to offset gains on long ones. Lenders demanded more collateral, forcing funds to either abandon the arbitrage plays or to raise money to meet margin calls by selling securities at fire-sale discounts . By September 2nd 1998, LTCM’s capital had fallen by 44%, to $2.3 billion , while still carrying over $100 billion in debt .
3. Liquidity Problem
Although LTCM did not have an internal liquidity crisis (fundholders could not after all withdraw their capital), it did suffer from one, especially after forcing many investors to withdraw their funds earlier given a lack of investment opportunities.
TABLE 4: LTCM’S BUMPY RIDE
4. Credit Crunch
The repercussions of a LTCM bankruptcy would have been far greater than anyone could have anticipated. LTCM’s investors were the managers of the fund, wealthy individual investors, big banks and large brokerage firms. Drawing the line between creditor and investor is hard: some of the banks that were lending Meriwether money under favorable terms had also invested in the fund. Considering that much of the fund’s funds came from banks, a bankrupt LTCM would have forced many banks to declare huge losses on their gambles (many had after all unsecured loans with the firm) . The potential for huge losses for so many different banks was too much to contemplate, leading to a credit crunch of huge dimensions. Others who eventually bailed the fund out maintain never having invested a penny in the fund, such as Deutche Bank . Nonetheless, the fund’s welfare was to have far greater repercussions than any other fund’s returns would.
Europe’s UBS was one bank which both lent and invested in the firm. The bank’s senior managers had so much faith in the gurus from Greenwich that it put up more than $1 billion at risk in LTCM, without even protecting itself against a decline in the value of LTCM. It violated the first rule of risk management: downside protection. When the mess was over at UBS, it cost them about $700 million and four top executives, including Chairman Mathis Cabiallavetta .
LTCM’s near death experience was the first internal shock to the US financial system. Although Asia, Russia, and now Latin America pose serious threats to the American economy, LTCM’s collapse would have been the uppercut to a shaky environment in the wake of Russia’s debt default.
SOLUTIONS
1. Federal Reserve Board and Alan Greenspan
For most of September 1998, LTCM hung on the edge of bankruptcy. The Federal Reserve was trying to avert the domino effects that a fast liquidation of the fund’s holdings would have on an already reeling global securities market. The Federal Reserve Chairman, Alan Greenspan appointed the Fed President William McDonough, who coordinated the process. He oversaw the negotiations and brought the creditors together. Every bank had sent its CEO or another top executive. While none of the participants really wanted to ante up the money, all dreaded a bankruptcy .
2. Berkshire Hathaway, American Insurance Group, & Goldman Sachs
Once the negotiations got underway, a curve ball was thrown to the Fed by Goldman Sachs, one of the many investors / creditors of the fund. Goldman Sachs was to join forces with Warren Buffett’s Berkshire Hathaway in a bid for the fund. Berkshire Hathaway would put up $3 billion, $700 million would come from AIG (whose head Hank Greenberg is a close ally of Buffett), and $300 million would come from Goldman Sachs . The bid was sent to Meriwether, who initially refused the deal because he said he could not get the other partners’ approval in time. He then argued that it was structurally flawed, whatever that meant .
Buffett has his own interpretation. His deal would have left LTCM’s managers with little money and no jobs . LTCM’s fate was uncertain because of the then abnormal market conditions. However, most participants had strong beliefs that the fund would eventually return to profitability. Meriwether’s problem was that he lacked the funds to meet margin calls. A large bank or Berkshire Hathaway (which at the time was sitting on $10 billion) has more than enough capital to weather the storm. The Buffett proposition went back and forth, but died eventually because Meriwether did not want to give up control of the hedge fund he started . Meriwether had a lot of clout in the decision-making process. He could have let LTCM go bankrupt, instead of giving up control.
Interestingly, Buffett’s investment strategy has always emphasized simplicity. He avoids technology stocks for this reason, and the same rationale would make one wonder why he would be interested in investing in such a high risk (highly levered), arbitrage-seeking investment vehicle. Firstly, Buffett had already saved Meriwether and Salomon after the Treasury bond scandal. Also, Buffett’s empire would surely have suffered had LTCM gone bankrupt, pushing several large banks into bankruptcy. Although Buffett’s bid was made because he knew that the fund would earn attractive returns with time, it can be argued that his decision to pursue the fund was also made to avoid the catastrophe that would have followed LTCM’s bankruptcy.
3. Consortium of 14 banks
Although Buffett’s bid made a lot of sense, it eventually died as Meriwether showed little interest. The Fed then had to orchestrate another alternative. When the dust settled, the hedge fund was rescued by a consortium of 14 banks and brokerage firms with a $3.6 billion infusion to restore capital adequacy in exchange for 90% of the fund, allowing Meriwether and friends to retain 10% of the fund . Each bank eventually invested $100 to $350 million .
By November, the consortium had begun to turn things around, albeit by a mere 1% increase in portfolio value . The fund’s net asset value has climbed about 14% from the end of September to the end of December . The portfolio has netted the banks and managers a healthy 10% . Although such returns would have called for a $50 million year-end bonus for Meriwether and friends (15% cut of all profits above LIBOR, as well as a 1% management fee on the $4 invested ), it turns out that the original managers will simply receive their base salaries of $250,000. The bonus money will cover the legal expenses of the bailout.
LONG TERM LESSONS…
Although private and institutional investors have lost fortunes on the markets with little or no compensation, the Fed did, in hindsight give preferential treatment on fears that the bankruptcy of a fund that owed upwards of $100 billion to banks would wreak havoc like never before seen. That second 25 basis point rate cut was done to further insulate the US economy from the international financial storm, but it was also done to keep banks from doing what they are suppose to do: lend and invest to stimulate growth. By keeping their cost of capital down, the Fed was ensuring that any potential losses from LTCM would not force banks to stop lending.
It is ironic nonetheless that the US Treasury department moved at such rapid speed to save a private boys club, even though it has taken extremely long to restructure troubled economies abroad where the lives of millions are at stake.
Most are urging the government to restrict leverage. While most typical hedge funds beef up their equity positions by 30%, LTCM’s leverage ratio was an atypical 25 to one ratio. Nonetheless, excessive leverage is often required for such technical bets to be profitable. Regardless, LTCM’s near-disaster proves that the risks from overblown leverage do not justify the rewards they can provide a few superrich traders and their bankers . Interestingly, Asia succumbed to crony capitalism and loose lending. The latter is also what rocked LTCM. While Japanese banks were lending capital against inflated assets, LTCM was borrowing thanks to its reputation and historical performance.
Another point is the lack of disclosure to shareholders. No one cried foul when LTCM disclosed little while returning above 40% to fundholders. Once things went bad, then investors and regulators began to expose the virtues of increased disclosure. Excessive restrictions on leverage, or urging further disclosure could force more hedge funds (and businesses in general) to relocate to environments were they are allowed to operate as they wish.
Many hedge funds weathered the storm because they had hedged themselves, they had not speculated by taking on too much balance sheet risk. Initially, many called this high-IQ hedge fund from Greenwich the hedge fund that was too smart to fail. Following their near-death experience, it turned out that LTCM was too smart to fail. It had, perhaps inadvertently, shifted most of the risks to their banker friends.
