D.F.A, or Please Do, #4

The Golden Age of Venture Capital: Interest Rates and Inflation - Part I, Our First Major League Baseball Interview (Stephen Piscotty) & Some Super-Rare Clash Demos & Outtakes

Oct 20, 2022

The response to our 3rd newsletter was bigger than we expected. We’re now the 3rd most popular newsletter in venture capital, with about 123k subscribers, nearly all accredited investors. Don’t these readers have other people to get bad financial advice from?

In our fourth newsletter, we have:

A great article on the Golden Age of Venture Capital and Risk Premiums
An interview with Major League Baseball player (and Stanford grad/investor) Stephen Piscotty
Some Clash Demos and Outtakes You’ve Never Heard In Your Entire Life

I’m in Chicago and New York every 6 weeks and can always meet in SF or L.A. fairly often. To book a time to chat, and to look over the deals we’re looking at, click here.

The Golden Age of Venture Capital: Interest Rates and Inflation - Part 1

I know, I know. This sounds like the title of a Yes album that got left on the cutting room floor in 1973, right? Believe it or not, The Golden Age of Venture Capital: Interest Rates and Inflation - Part I was the original title of Yes’ magnum opus, but they changed it to the more psychedelic Tales from Topographic Oceans, in hopes of appealing to a more mainstream audience. Whatever, hippies.

The past three decades have been a mind-blowing run for buyout and VC funds, according to Morgan Stanley (exhibit 3: Investor Commitments to U.S. Buyout and Venture Funds, 1980-2019). Why the heck is that?

Before trying to explain this 30-year VC investing boom, let's consider investment choices of the typical 50-year old U.S. citizen, attempting to plan for a comfortable retirement.

Option One: Invest your retirement funds in something guaranteed to earn 10% per year for 10 years

Option Two: OR in something much more variable that ranges from -45% to +55%, but averages something close to 10% over a 30+ year timespan.

Option Three (a way less attractive option): Now, change the guaranteed annual returns to 8%, then 6%, then 4%, then 2%, and finally 0%. Think about how interested you are in that highly variable 10% return as the guaranteed rate of return drops.

You probably know where this is going, but I'll spell it out for you anyway:

Of course everybody wants Option One above . . . 10% guaranteed returns, rock and roll!

The more volatile alternative varies so dramatically from year to year that you may not get very much of a return at all, even over a 10-year period. You'd much rather have a guaranteed comfortable retirement than a 60% chance that you'll have a comfortable retirement, even if that includes an outside shot of retiring with far more than you really need.

But 10%/year guaranteed . . . is that even possible?

Yup, it is. And you don’t even have to collect rare Yes albums to get it.

There was a good long while between 1979 and 1985 when you could purchase 10-year U.S. Treasury notes yielding 10%. Since my Bar Mitzvah was in 1990, 5 years after this gold rush ended, that’s why I’m still writing newsletters.

It’s the third question which is way more interesting. It’s not only an intuitive take on some foundational concepts of investment theory: returns, risk, and risk premiums. It also helps to understand much of what’s gone on in the financial world since 1992.

The annual return we're talking about is 10% in (Option One) above. We consider what happens if the annual return is lowered in (Option Three) above by increments of 2%.

We compare this to a variable return (Option Two). Publicly traded stock returns, as expressed by total returns from the S&P 500 stock market, have indeed varied, from anywhere between -45% to +55% in any given year since 1926. Sounds a little nerve-wracking, right?

The risk of something as variable as the stock market is that we might not get this return. The risk premium is how much extra you are getting paid, on average, to take on risk beyond the risk-free rate of return, as expressed with this formula:

(average expected) Variable return - Risk-free return = Risk premium

U.S. Treasury notes are about as close as one gets in the current world to a "risk-free" investment. They are not quite as risk-free as mainstream investment theorists would have you believe, but, for teaching purposes, we're going to assume they're risk-free so we can talk about risk premiums.

In (option 1) and (option 2) above, we had a 10% variable return and a 10% risk-free return, so the risk premium was 10% - 10% = 0%. No rational investor should settle for a risk premium of 0%. If you're going to take on risk, you need to insist on returns that are WAY higher than the risk-free rate of return.

In (option 3) above, it becomes a little more interesting to invest in the variable 10% if you're only getting 8% risk-free returns. Maybe 2% is not enough of a risk premium for you, given how uncertain it is you'll get the 10% you're hoping for. But as you lower the risk-free rate further and further, to 6%, then 4%, then 2%, it gets increasingly enticing to go after those variable 10% returns rather than settle for the ever-diminishing risk free rate.

Finally, if the risk-free rate is 0% - why on earth would you want to earn no return at all? So, of course, you are going to want to go for the variable 10% return, unless you need your money really soon, or if you have reason to believe the economy is going to be deflating for years to come. In that case, your "real" returns for holding pure cash would be positive as your purchasing power increases, right? Heck, you might even be willing to pay double for that 10% return, effectively reducing it to only 5% annually, which is still a heck of a lot better than 0%, right?

So if this is supposed to be an article about the Golden Age of Venture Capital, why are we reviewing the basics of returns, risks, and risk premiums?

Because the risk-free rate of return, the yield on 10-year U.S. treasury notes, is at the root of understanding all of investing and economics. And yes, that includes venture capital.

Look at the graph below (courtesy multpl.com):

Since 1870, 10-year treasury notes have usually yielded between 3% and 6%. However, rates were far above that 6% for most of time between the late 1960's through the early 1990s. Since then, interest rates have been in steady decline, and for the past decade has been at extraordinarily low levels.

You can see the impact of these low interest rates in many charts, graphs, and text in the 82-page Morgan Stanley Report referenced earlier. If you love 3-hour Yes albums, you’ll love that report. Or, you can just read this 5 sentence summary:

The 20-year period of very high interest rates ending in the early 1990's (around 1992) caused individual and institutional investors to become accustomed to a high risk-free rate of return.
After many years of this, investors, especially institutional investors, collectively assumed fairly high long-term rates of return (Exhibit 9).
However, as the risk-free rate of return declined, it became increasingly difficult to attain such high rates of return without taking on more risk.
As shown in Exhibit 4 of the Morgan Stanley Report, you can get higher returns by taking on more risk, and the alternative asset classes of venture capital and buyout funds appeared to offer higher returns than stocks, for similar amounts of variance in returns.
Therefore, large pension funds and endowments, and to a smaller extent, individuals, gradually increased their capital allocations to these alternative asset classes, or took on other forms of risk, to achieve their long-term targeted return rates.

Alternative asset classes? Wait, I know a guy!

So, there you have it. 20 years of abnormally high interest rates gets everyone trained to expect high investment returns, followed by another 30 years of declining interest rates which forces individuals and institutions to take on more risk to achieve those same returns. Venture capital works for that.

Thus, the Golden Age of Venture Capital was born.

And it works! Investors are happy if they can generate higher returns. Startups are happy to get the extra funding. The economy benefits from new technology or other kinds of innovation.

It works so long as interest rates go down and stay down. And Jerome Powell’s into that Bad Medicine like Bon Jovi.

The only reason interest rates need to rise is to counter inflation. With a handful of short-lived exceptions, it hasn't been necessary for a long time to raise interest rates. However . . .

Inflation has returned. To be continued….in Interest Rates and Inflation, Part II, next week.

Note: This two-part series is a collaboration with my friend Joe Golton who ran a small hedge fund of socially screened, public equities from 2000 to 2006. He has also been involved with a few startups in the Food, Internet, and Sports sectors.

Interview: Stephen Piscotty, Outfielder, Cincinnati Reds AAA Affiliate, Louisville Bats

I was really lucky to have my son, now a second-grader, play a great little league season this past year, where he was able to play right field and second base for most of the season. One of the highlights of the year, for him, was going to an Oakland A’s game with his team, and seeing Stephen Piscotty play. Over the last year, I got to know Stephen and his brother Nick through the startup community. Below is a short interview about the challenges of being an investor and a pro athlete at the same time. You thought your schedule was kind of crazy? Read on.

It’s hard enough to run a business and be an angel investor, but how do you manage a career as a pro athlete during the major league baseball season with an investment portfolio, especially if you have to meet with founders, perform due diligence on investments, monitor your portfolio, etc.?

During the season I like to have things outside the game of baseball to engage another part of my brain. A dynamic that I really loved at Stanford while playing ball and studying for my engineering degree. Angel investing has been a new intellectual outlet, an excuse to meet with some of the smartest people, and an activity I genuinely enjoy. Fortunately, we play mostly night games which leaves a nice large chunk of the day to spend time following markets and learning about companies.
Business professionals have gotten to see a lot of cities since things have calmed down a bit as Covid-19 vaccines have developed, but pro athletes travel probably more than anyone I know. Which cities have fully rebounded, and which ones would you say have the most work to do, to get back on their feet, in terms of business and tourism?
Seattle comes to mind. The pandemic really weighed down the city, but it also saw the biggest resurgence. This is purely an anecdotal observation from traveling there. Seattle was always one of my favorite places to visit and the ballpark is top notch.
You and your brother both invest in startups, and I know plenty of brother-brother or brother-sister angel investor combos, but I know very few where one is a professional athlete. How would you say being an athlete colors your view of how you select founders or companies to invest in, as opposed to how your brother chooses his investments? Do you see a difference in strategy?

I feel like my brother Nick and I are very aligned. To be honest, I feel like he is my coach for angel investing. With a masters degree from Duke in business he’s an easy person to trust. He has also networked and worked incredibly hard within the industry to pick up on some valuable nuances. As far as strategy, I’d say he is very focused on enterprise SaaS, while I like to take a broader approach and am interested in all industries.
Verticals for 2022 and early 2023: In the current economic climate, are there any segments that you’re keeping a close eye on?

Such a good and challenging question. From a macro perspective, we could certainly have some choppy waters ahead in these next couple years which makes early-stage valuations difficult to pin down. One thing is for sure though, enterprise SaaS will only continue to grow and innovate particularly with advancements in machine learning and AI.
Now that you’re living in Louisville and playing for the Bats, what’s in store for you for the next 6-9 months or so?
I am spending the offseason in the Bay Area and will be beginning training for next year soon. I am optimistic that the success I had in Louisville with consistent at bats will lead to some opportunities for next year.

🎸 Bad Tunes:

If you were able to get through all of those articles and interviews, you deserve some of the best stuff in the D.F.A. Music Vault. Here’s a link to one of our best collections of Clash demos, outtakes and alternate takes. Most of the tracks are from ‘77-’78, and are the Clash’s Polydor demos, alternate mixes, B-side outtakes, British TV outtakes, promo video shoots and demos done by Mickey Foote, who produced the first Clash album. None of these tracks are available on Spotify or any streaming service. I’ve been able to chat recently over email with Tricia Ronane, who managed the Clash for two decades, until 2011, as well as a film director who had the opportunity to work with Clash guitarist Mick Jones a couple of years ago, and it’s been a lot of fun. In light of the recent amazing Dolby Atmos release of 11 songs from Joe Strummer’s Mescaleros years on Apple Music, there’s no better time to listen to this. Crank it!

We’ll see you in a week or two.

Regards,

Adam and the D.F.A. gang

P.S. If you’d care to chat about D.F.A. Capital, feel free to book a time here.