When you study the financial support for innovation the way I do, you find out interesting things. You find out that the reason why innovation struggles to supply an 80% adoption greenfield is that of the massive deployment of subprime risk by Venture Capitalists. And when you then wonder why Limited Partners allow Venture Capitalists to deploy such ill-fated risk, you find that those asset managers (as they are called) have a warped understanding of investment risk themselves (more on why they are allowed to in another blog soon).
My study of the status quo and flows of money explains why the relationship between Limited Partners and Venture Capital secured by long investment cycles remains challenging to rattle (if it exists), they are entangled in some costly pre-nuptials. To put it more bluntly:
Having spent the last four years in the company of some prominent asset managers I can best compare their understanding of investment risk with the musical chairs game many of us have played at least once in our lives.
Before I go into specific parallels with the musical chairs game, let me explain briefly how asset management works today.
Trust but verify
Many large institutions (companies, pension funds, university endowments, family offices) have piles of monetary reserves (predominantly some derivative of public money) they want to put to work to make their reserves grow. They either directly invest as a limited partner or indirectly through fund-of-funds in a variety of asset classes (venture, fixed assets, private equity etc.) and deploy money to firms and funds staffed with general partners with specific domain experience in each, to produce returns compatible with the limited partner’s return expectations during a particular period (usually 10+ years).
In an ideal world where everybody is concerned about the greater good, that process could work well. In reality, the model falls apart not dissimilar to the way and pace with which many young celebrities have gone bankrupt. They gave check-writing privileges to business managers, who adequately diversified were more out to build a glorious life for themselves.
The litmus test of risk
Most celebrities have learned a valuable lesson many asset managers still have not. And that is that you cannot accurately assess the viability of horizontal diversification of risk across diverse asset classes when you do not have an accurate assessment of risk and control in each asset class (we refer to as pancake economics). And the vast majority of asset managers fail the fundamental litmus test of asset management, by their inability to answer the following question succinctly (I have repeated on this blog more than once):
A laissez-faire deployment of risk (that by economic principle defaults to subprime) in each asset class will by definition lead to an inaccurate assessment of risk and exposure across all asset classes.
A celebrity who is foolish enough to have others sign the checks is just as silly as an asset manager who does not understand and control the risk in each asset class. The even bigger fool is the asset manager who expects the subprime deployment of risk to yield anything but subprime returns. The outright dumb asset manager is the one who leaves the asset class because he correlates the subprime returns with the opportunity available to the underlying asset. Good riddance.
The latter escapist asset managers should realize that no subprime deployment of risk can accurately tap the prime opportunity of the underlying asset, regardless of the asset class in question. And without deep-dive control in the asset class, they will continue to run out of options to create viable returns, just like in the musical chairs game.
And the winner is
Many (not all, analogies always fall apart at a certain level of normalization) facets of the musical chairs game remind me of how asset managers deploy financial risk today. Let’s start with a definition of the game of musical chairs copied from Wikipedia:
“Musical chairs is a game played by a group of people (usually children), often in an informal setting purely for entertainment such as a birthday party. The game starts with any number of players and a number of chairs one fewer than the number of players; the chairs are arranged in a circle facing outward, with the people standing in a circle just outside of that. A non-playing individual plays recorded music or a musical instrument. While the music is playing, the players in the circle walk in unison around the chairs. When the music player suddenly stops the music, everyone must race to sit down in one of the chairs. The player who is left without a chair is eliminated from the game, and one chair is also removed to ensure that there will always be one fewer chair than there are players. The music resumes, and the cycle repeats until there is only one player left in the game, who is the winner.”
In my analogy between asset management and the musical chair game, the chairs are the asset classes, and the people are the investment managers investing in them. The music is the economy, with its rhythm and stops and starts as the “economic cyclicality” complete with aberrations. The non-playing individual represents the government, in control of the said economy.
When the music stops
As the music plays all asset managers behave similarly, they follow each other around the room paying attention to asset classes (chairs) close to the next that strike their fancy. They all quickly sit down when just one of them thinks the music has stopped, often atop each other to tap into the same opportunities. The last mover without a chair gets kicked out of the game. Because of their lack of control within each asset class, one asset class (chair) after the other disappears by failing to produce viable returns. In the end, the asset manager with the most cunning hopping strategy (in & out emerging market strategy) wins the musical chair game.
Financiers who deploy musical chair diversification strategies, unaware that the flawed risk they implement in each, will consistently deflate the opportunity for the underlying asset and industry. And each time the music slows or stops, they lose another asset class. Not because the inherent greenfield opportunity fails, but because the financial arbitrage a top, stacked ten levels deep, systematically fails to recognize the many prime opportunities subprime arbitrage will never be able to detect.
We are responsible
In the end, most of us blame the non-playing individual – our government – forever stopping the music.
And while our government certainly has a vital role in defining how the game is being played, it should not be held responsible for the financial malaise that is the result of our misguided application of risk. Yes, we do lack an economic framework that protects the interests of our country over the selfish interests of finance. And yes, I will provide some analysis and solutions for that as well.
But in the game of musical chairs, finance, and life no matter who plays the music, or what music is being played, the buck stops with ourselves.