"Social Leverage" in Venture Capital

I will soon be participating in a panel at Defrag titled "Is Social Leverage the next big thing for VCs?" with my friends Fred Wilson, Howard Lindzon, Brad Feld and Jim Tybur. This is an interesting question that can be interpreted a few different ways, so I thought I'd put a stake in the ground to spur my panel-mates to challenge my perspective.

The venture investing business is, without question, a social business. Working with entrepreneurs. Identifying good co-investors and advisers. Plumbing one's rolodex to help make connections. Cultivating potential business development opportunities. However, there are elements of venture investing that sometimes work against this social nature, e.g., scarce capacity in a "hot" deal, leading VCs to be quite anti-social and to block other participants. While I lack the data to back my thesis, my belief is that in true early-stage venture investing the value creation of an investment syndicate (assuming the co-investors are truly value-added) exceeds the value give-up of sharing scarce investment capacity. This is one aspect of "social leverage," as the non-linear increase in contacts arising from a right-sized syndicate can substantially de-risk an early-stage investment. I have put this into practice in much of my early-stage investing, and it has worked as expected: co-investors with domain expertise and a wealth of industry-specific contacts can drive tremendous value to a start-up, especially in its early, formative, high-risk period. Help with recruiting. Identifying and gaining access to early adopter clients. Different product use cases to help chart strategy. These are just a few ways in which getting a group of super smart people involved with financial skin in the game can help an early-stage venture. Bottom line: social leverage is alive and well in the venture capital business, provided VCs aren't piggy and are focused on what's best for the business, the entrepreneur and, in the long run, themselves.

Another take on social leverage is as an investment theme. Several examples can be found in my portfolio: bit.ly, StockTwits, TLISTS, TweetDeck. Twitter and Facebook are clear examples as well. These are companies whose value is partly driven by community, where the value of the platform increases in a non-linear way as participation goes up (I would posit that this value function looks like an s-curve, where value accelerates during a period of rapid growth, but then flattens out as network effects have largely been exploited). Now, this assumes that this increase in usage is managed well, from both technology and user-experience perspectives (sometimes we bemoan the growth of Twitter because of this, no?). But there can be little doubt that these companies are facilitating the growth of communities, building affiliations, and promoting social leverage through their platforms, I think this is an investment trend that will continue for some time, as more vertical applications of social leverage emerge to drive a richer user experience to those with common interests, e.g., StockTwits and investing. And more tools will emerge to help monetize these communities in contextually-specific ways, e.g., TLISTS.

So this is my story and I'm sticking to it. Now we'll see what Fred, Howard, Brad and Jim have to say...

Deal With It, Mr. Einhorn

David Einhorn is without question an exceptionally bright man and a very astute investor. However, the latest message being delivered from his bully pulpit, proposing a ban on credit default swaps (CDS), is misguided at best and dangerous at worst. Are his motives for putting forth this radical view pure, or perhaps informed by the complexity of being an equity investor in a world where the entire capital structure can be sliced, diced and priced? I have no idea. But banning CDSs is akin to banning Twitter. Are there some negative outcomes associated with using each of these tools? Sure. But do their overall benefits outweigh their costs? I believe so.

Here are a few extracts from Henny Sender's Financial Times' story on Mr. Einhorn's Letter to Investors:

“I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay”.

CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called “basis packages” buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors”, Mr Einhorn says.

********************

“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity,” he notes.

That’s because it is almost impossible to adequately capitalise against such developments. “There is no way a clearing house could demand enough collateral,” he says. “The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral.”

The crux of Mr. Einhorn's argument is that CDSs, by their nature, are negative tools, e.g., the holder wants the company to do poorly, and will do things to hasten this fact, and that merely putting CDSs on exchanges won't solve the larger problem of taxpayer support for "too large to fail" institutions. 

Are CDS negative tools? Sure. Is shorting stock a negative tool? Certainly. The ability to go long and short creates what I call "positive stress," e.g., it's stressful, but it keeps managements' focused and penalizes poor corporate decision-making. They both provide essential checks-and-balances in the financial system, provided they are not used fraudulently. The mere fact that an instrument is "anti-social" is no reason to ban its use: Mr. Einhorn knows this. And while he might argue that shorting a stock doesn't have as direct an impact on a company's need to enter bankruptcy, it might be that a poorly run company should be in bankruptcy with its assets better deployed by others. Also, the CDS market has been a kind of early detection system for the equity markets, providing a leading indicator of corporate woes before this information has been fully priced into stock prices. Taking away this kind of information hurts everyone, including Mr. Einhorn. And if bankruptcy laws need to be brought up-to-date to reflect the fact that a multi-trillion CDS market has emerged, then so be it. But to merely toss out the information value associated with the CDS market is ludicrous. In fact, I'd argue that the market should be bigger, more transparent and more liquid, which gets to Mr. Einhorn's second point.

Clearinghouses are not a panacea, according to Mr. Einhorn, because the CDS market is too big, their price movements too discontinuous and collateral requirements too difficult to quantify, invariably leading to private profits and socialized costs. One word: Garbage. Think about it this way. As one moves down the capital structure, from senior debt to junior debt to equity, price volatility and discontinuity goes up. Why? Leverage and the hierarchy of claims. A company's equity price can move all over the place while its senior debt trades in a narrow range. It stands to reason, therefore, that CDS should have price movements more stable, e.g., less discontinuous, than equity prices. Do stock prices gap? Yes. Can CDS prices gap? Yes. But because of the seniority of their underlying in the capital structure they should gap less frequently and less violently than stock prices. Yet Mr. Einhorn doesn't want to ban equity trading. What would become of his hedge fund?? The issue is one of liquidity and transparency. Discontinuity comes from opaqueness and thin trading volumes, both of which can be addressed through an exchange mechanism. And this is directly related to the collateral question. As the market becomes more liquid and more continuous, collateral requirements will be increasingly easy to set, far easier than they are today through the daisy-chain of over-the-counter margining arrangements. So at the end of the day, I find Mr. Einhorn's arguments specious and likely self-serving.

As a rule, turning back the clock of innovation is almost never a good thing, and it isn't here, either. Better to harness it and use it prudently than to pretend it simply doesn't exist. Mr. Einhorn knows better, which is why this whole meme makes me very curious...

Barking Up the Wrong Tree

After reading the news, participating in key industry conferences and doing some thinking, I've come to the following conclusion: the regulators - and Congress - are barking up the wrong tree. They would have you believe that the equity markets are rigged, retail investors are screwed and that the market structure is flawed. They would further argue that the equity markets are in need of dramatic new regulation, flash orders and high frequency trading are the root of all evil and that "dark pools" are something promulgated by Darth Vader. I have only two words to say to Congress, the SEC and the White House: Bull. Shit.

There are some problems to be sure, but they are not what the spin-meisters in Washington would have you believe...

Which markets stayed open for business every day in the teeth of the crisis? The EQUITY MARKETS. You know, the ones that are now in the cross-hairs of every member of Congress with a populist agenda in dire need of scoring points with their electorate. The markets that were virtually closed for weeks? The DEBT MARKETS, including the OTC DERIVATIVES MARKETS. Why was this the case? Uh, maybe because the equity markets are EXCHANGE-BASED and didn't have BS entities called RATING AGENCIES that lobotomized decision-making and facilitated hundreds of billions to be deployed in assets investors didn't really understand.

And which entities are receiving the most heat? The exchanges. The least? The OTC derivatives markets and the rating agencies. Why is this?

The exchange players have awful public relations. The come across as ultra-complex, technologically incomprehensible and in league with the reviled financial institutions and hedge funds. And clearly dark pools and high frequency traders fall into this category. Markets go up and markets go down. The main thing that matters is that they stay open, provide access to investors big and small and promote competition. The exchanges have done a masterful job of delivering on this for both institutional and retail investors. But Congress and the White House appear destined to focus on policies that ostensibly focus on the retail investor (though it is arguable as to whether the prescriptives will actually help; they most likely will hurt), though the retail investor has become increasingly less important in the overall scheme of the equity markets. Most retail money is handled through pension funds and mutual funds, effectively institutionalizing much of the potential retail flow. Further, the retail investor has never had better access or cheaper execution than they have today, yet the picture is painted that they are getting screwed at every turn. It just makes no sense.

In every era certain subsets of market participants made investments to gain an edge. Whether it was the stagecoach, the telegraph, cheap silicon, abundant fiber or co-location, innovators with capital have always sought to be one step ahead. It is this inexorable move towards better, cheaper, faster that delivers benefits to all, even if more benefits go to those who made the investments. Should the retail investor get the exact same execution as a smart algo that is the result of millions of dollars of development, leverages (and pays for) co-location and puts enormous amounts of capital at risk? Not in my opinion. If the ultimate goal is that every market participant, regardless of size, amount of investment or capital at risk is in the EXACT same boat, then we'll see what happens to innovation: It will plummet to zero. The populist denizens in Congress and in the White House are pushing towards the lowest common denominator: mediocrity for all.

Why, oh why, haven't the broken OTC derivatives markets and rating agency crimes been aggressively pursued by lawmakers and regulators? One reason: because they are far less sexy than the exchanges and don't DIRECTLY impact the retail investor. Not too many mom-and-pops have purchased a 5 year GM CDS or stop by Moody's for a report on the SocGen CMBS Non-Conforming Pool XII. They are far more likely to have a brokerage account, an IRA or a self-directed 401k. What's more systemically important, banning "flash orders" or mitigating the counterparty risk associated with tens of trillions of over-the-counter derivatives contracts? We already know the answer, since Mr. Geithner and his friends did a back-door bail-out of Wall Street with taxpayer money via the AIG gift. This was due to credit derivative counterparty performance risk, friends, not because they had a lousy stock portfolio that they couldn't liquidate. And why do rating agencies even exist? They have simply resulted in an abrogation of responsibility on the part of investors: THEY are the true WMDs, which is ironic considering Mr. Buffet's long-standing position in Moody's. Yet we seldom hear about this.

Sadly, we live in a world of sound bites, and Congress and the White House have found far better sound bites to attack the denizens of the equity markets rather than the derivatives and debt markets. And as usual, it will be this stupidity that will cost us all, except the Congresspeople who will have pandered to their constituents in order to get re-elected. Someday, perhaps, we'll have a vehicle for measuring the efficacy of elected officials, not on the basis of success in getting their measures through but in the worth of the measures themselves. There will be many perceived winners when Congress and the SEC enact short-term popular and long-term stupid regulation that increases costs (including to retail) and stifles investment. Quite simply, they are barking up the wrong tree.

This is why I seldom blog anymore. Because just thinking about the irrationality and long-term consequences of this stuff makes me sick...

   

Golden Opportunity - I Need a Technical VC Investment Associate

I am currently spending a lot of time evaluating companies targeting "big-data," predictive analytics, anomaly detection, machine learning, high-performance computing, data visualization and related fields, and am seeking an Associate to be involved in all stages of the early-stage venture investment process.

The successful candidate will be a key member of a small team of highly successful investors and entrepreneurs. This individual will be a highly analytical, innovative and driven self-starter with deep technical experience combined with business judgment.

Responsibilities:

• Create and support point-of-view on potential investments

• Conduct all stages of due diligence, including: financial modeling, market analysis, and primary and secondary research

• Source new investment opportunities through networking and strategic partnerships

• Identify emerging areas of strategic importance in and around the ecosystem

• Provide hands-on operational and strategic support to portfolio companies

Requirements:

• Strong technical background - Ph.D or other technical graduate degree strongly preferred

• MBA a plus

• Understanding of financial markets

• Experience with/understanding of the following a plus: machine learning, parallel computing, "big-data" analytics, computational linguistics, natural language processing

• Entrepreneurial operating experience a plus

• Proven analysis and research expertise

• Strong verbal and writing skills

• Ability to communicate at all levels from CEO to individual contributor

• Ability to analyze, evaluate, and quickly form independent judgments on a wide variety of businesses

• Exceptional organizational skills and a strong attention to detail

Please send inquiries to jobs@iaventurepartners.com. This is a pretty cool opportunity for the right person. If you don't exactly meet the spec but come pretty close and can make the case, then go for it. I  put off hiring help for a long time. I hired @bsiscovick this summer and that was a good move. But the time has come for me to get more leverage against my deal opportunities, and the time is now.

Fixing Wall Street? The Feds Blew It.

Today's press is constantly filled with bluster about "new" regulatory regimes, Executive Pay Czars and other gripping topics stemming from 20/20 hindsight and populist zeal. Sadly, they all miss the point. Wall Street's weakest link, it's super-leveraged capital structure and reliance on overnight funding, was laid bare in the depths of the financial crisis last fall. If not for the wide-open purse strings of the US Government, institutions ranging from Citigroup to Goldman Sachs would have gone down. No doubt. This was the moment in history when smart minds could have gotten together and projected - really projected - what a better, safer, smarter Wall Street might look like, a Wall Street that wouldn't have collapsed like a house of cards so completely in the face of the mortgage crisis and credit derivatives melt-down. Rather than mindlessly shoveling liquidity in the system to prop up a broken model and failed institutions, a concerted effort could have been made to call time-out, not with respect to the markets but with respect to the institutions whose functioning had just been shown to be dangerously fragile. Needless to say, this is not how it was handled and we are suffering the aftermath today.

What we have is a return to business-as-usual. Except it's worse than that. The US taxpayer has been systematically looted out of hundreds of billions of dollars, yet the press is focused on Andy Hall and his $100 million payday. Whether this is too much pay for Mr. Hall misses the big picture. Yes, the Wall Street pay model is messed up, and I recently provided an alternative approach. But how about the fact that Goldman Sachs is posting record earnings and will invariably be preparing to pay record bonuses, not nine months after the firm was in mortal danger? Whether anyone will admit it or not, without the AIG (read: Wall Street and European bank) bail-out and the FDIC issuance guarantees, neither Goldman nor any other bulge bracket firm lacking stable base of core deposits would be alive and breathing today.

Goldman is a great firm with a stellar culture, and in most circumstances it's risk management and funding practices have been second to none. Except when the crisis hit. It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities. And while it had a massive cushion of collateral, it would likely have been inadequate if the Treasury and the Fed hadn't come to its rescue. In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm. While JP Morgan Chase CEO Jamie Dimon prefers to poke a stick in the eye of the Treasury, seeking to negotiate down the payment to buy back the TARP warrants, Lloyd Blankfein smartly paid the full $1.1 billion requested. He looked like a hero for doing so, a true US patriot repaying the US Government in full for its lifeline, thanking the US taxpayer in the process. $1.1 billion... $1.1 billion...Hmm...something doesn't seem right. You know why it doesn't seem right? BECAUSE THE US TREASURY MIS-PRICED THE FREAKING OPTION.

There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman's equity could have done a digital, dis-continuous move towards zero if it couldn't finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren't discriminating back in November 2008. If you didn't have term credit, you certainly weren't getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let's just say that it is a tad north of $1.1 billion in premium. And the $10 billion TARP figure? It's a joke. Take into account the AIG payments, the FDIC guarantees and the value of the markets knowing that the US Government won't let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down. I thought the best way was to impose Good Bank/Bad Bank restructurings on troubled institutions, making plain the value of the assets, hiving off the most troubled and letting the healthy institutions live on and thrive with a healthier capital structure and significant US taxpayer ownership that would eventually be re-offered to the marketplace. An alternative would have been a more accurate and representative pricing of the option inherent in the bail-out given to Wall Street firms. But the US Government elected to pursue neither approach.

Where we are left today, dear taxpayer, is a lot poorer. Unless you are a major shareholder and/or bonusable employee of Goldman Sachs. Brains, ingenuity and value creation should be rewarded in all fields, Wall Street included. But when value created is the direct result of the risks borne by others for your benefit, the sharing of benefits needs to be re-allocated. This has not and apparently will not be done, and we, dear taxpayer, are the worse for it. Further, such a crisis could have provided the opportunity and the impetus for a re-look at capital markets risks, getting CDS users to support a central credit derivatives exchange and revised capital rules to incentivize better gap management. The banks lobby like hell against these changes, because it cuts into their fees, notwithstanding the systemic benefits such changes could have on the global financial markets. Banks now lobbying with US taxpayer dollars against changes that could protect the US taxpayer from more harm in the future. Something is terribly wrong with this picture, yet all anyone wants to talk about are executives getting paid too much. It's called missing the forest for the trees, and it is a fixture of both those trying to sell newspapers (get clicks) and run our Government, and it pisses me off.

Re-designing the Wall Street Trader Compensation Model

The recent flap over Phibro's Andrew Hall and his $100 million+ compensation package makes for good headlines, but fails to get at the essence of the real problem: the manner in which Wall Street trader compensation is calculated and disbursed.

But even more importantly, the talk of nullifying or modifying his contract simply because neither Citigroup nor the US Government like it brings with it dark and threatening implications. If contracts entered into legally and without prejudice are all of a sudden cast into doubt, the entire foundation of free and fair commerce is in jeopardy. Say what you may about a trader getting paid $100 million per year, but if you are a Citigroup shareholder: (a) you've known about this; (b) you've benefited handsomely from it; and (c) there are lots of contracts where Citigroup is paid a lot of money, and if they were nullified would bring grave harm to the firm. I wish muckrakers and whiners would use their brains and hold their tongues when talking about stiffing people pursuant to legally valid contracts. The issue should be "Are these contracts appropriate and do they create value for the firm?" and not "These pigs are getting paid too much money. We should tell them to go to hell." Because once you can simply say "I don't like this deal" and walk away, lawlessness and economic chaos is sure to follow. The Obama Administration should run as far away from this talk as possible, and even publicly stand behind the rule of law as an essential component of a free and fair society. As I tell my children: Think before you speak.

Back to Wall Street trader compensation. The issue is inextricably tied to risk-taking, where the Wall Street "heads I win; tails you lose" payout paradigm rewards excessive risks and places little to no premium on risk management. Further, given that current year cash payouts are a significant part of the trader compensation package, subsequent year losses have little impact on monies actually collected by the losing trader. It's also important to note that Wall Street traders effectively start at zero P&L each and every year, institutionalizing a short-term mind-set that doesn't create sustainable equity value for the firm. In short, the Wall Street trader compensation model is badly broken, in large part because of the agency effects of risking hundreds of millions to billions of dollars of "other people's money" (OPM) with a grossly asymmetric payout function (e.g., shaped like a call option where the trader's max loss is their base salary, while their max gain is effectively infinite and is a function of gross profits).

Like them or hate them, the hedge fund compensation structure has many positive attributes that can be instructive for Wall Street (especially when the lion's share of the trader's net worth is tied up in the fund):

• Diluted agency impacts. While hedge funds generally involve running large amounts of OPM, when much of a trader's net worth is invested in the fund their risk-taking directly impacts their financial wellness. This is not the case on Wall Street, where traders don't get to actively participate in their strategy on an ongoing basis.

• Compounding capital. As Wall Street traders get paid out on current year results, there is no concept of compounding gains from current year returns applied to prior years' capital balances. This is a huge disincentive for prudent risk taking and an emphasis on making profits in all market environments. It encourages a "swing for the fences" mind-set on Wall Street since each year stands on its own. Hedge funds, conversely, permit capital balances to accrete upward and benefit from lower levels of volatility in their IRRs.

• Long-term perspective. Since hedge fund traders are generally only able to withdraw a small amount of their capital each year, they have strong alignment of motives with their investors. Sure, while it can be argued that a hedge fund trader can take on huge risk, try and kill it and simply close down and start again if it fails, the fact that significant partner capital is wiped out with poor peformance makes this a less-than-likely outcome.

Personal investment in one's strategy. Compounding capital. Long-term perspective. This sounds like a much better model for Wall Street, and can also serve as a vehicle for substantially increasing transparency and more accurately measuring performance. The way most proprietary trading on Wall Street is done is not with committed, funded capital, but with "notional" capital. The concept is that internal traders get to trade using the bank's balance sheet and margin lines as collateral, but without a fixed amount of capital assigned to a particular book. How much leverage is a particular book using? No idea. What is the strategy's true risk profile? Hard to ascertain. What is a portfolio's actual risk-adjusted return? Since capital is unknown and risk is hard to calculate and attribute, computing returns is virtually impossible. Therefore, it is also hard to fully grasp a traders track record, not in terms of gross dollars but in terms of risk-adjust returns on capital. This is why proprietary trading returns are not able to be presented to institutional investors should a trader or team wish to raise third-party capital. The assumptions that must be made to compute performance are simply too many and subject to manipulation, making investment management attorneys very uncomfortable allowing such figures to be used in marketing materials.

But what if Wall Street moved to a model where books were actually funded (but would still benefit from risk offsets with other books across the firm), returns to capital tracked and auditable track records created? And what if traders were compelled to leave, say, 80% of the increase in their capital account in the fund, ensuring that their wealth is tethered to their performance over many years, not just a single year? This would more firmly align traders with shareholders, much more than owning stock would. Today most proprietary traders get a chunk of their annual compensation in company stock. Honestly, these traders don't care about company stock, and having lots of it does not make them feel more aligned to shareholders.They apply a huge haircut to this form of compensation. But if their compensation was in cash and reflected as an increase in the accreted value of their capital account, they would be much more likely to protect this than company stock. Traders would also get to benefit from the compounding of their capital balances, providing a huge carrot relative to the current economic model on Wall Street. Finally, since the performance is happening in a transparent fund structure with true capital, the track record can be used should the trader and the bank wish to spin them out as a separate hedge fund.

Structurally, trading businesses on Wall Street are designed as they are for capital and regulatory reasons. Banks get favorable capital treatment for trading books by running them as transparent (and able to be converted to cash in short order), value-at-risk based businesses. Fund structures - when applied to external funds - generally attract less favorable capital treatment because of the inability to compel a manager to reduce risk and because of less-than-perfect transparency. This wouldn't be the case here, since the fund structures would merely be a structural vehicle for delivering the benefits noted above but with the bank retaining the control necessary to secure favorable capital treatment.

Bottom line, the current Wall Street trader compensation system stinks. It is terrible for shareholders. It is bad for long-term equity building. And it isn't that great for traders. Moving to a funded-book structure with long-term trader investment scheme would eliminate most of the bad aspects of the current model while bringing in some new, positive impacts. A radical change? Yes. A rational change? Absolutely.

Why I'm Not Blogging

I've been at this since July 2006, doing my thing. Writing when I've felt inspired, irked, righteously indignant, touched, happy and sad. Blogging has become a significant and meaningful part of my life, one where I am able to express myself on my terms, write about issues rattling around in my head, and to connect with people across the world and from different walks of life. Discovering blogging has truly been a gift. It is hard to imagine living without my blog.

Then why am I less interested in blogging than I've been in nearly three years? While I'm certainly not the most prolific blogger, I've created a veritable War and Peace of content during my blogging career. 2-4 times per week, very consistently, with a few 2-week "vacations" and some jags where I've written nearly ever day for weeks. But I can honestly say that I've never felt less interested in writing than right now. I generally keep a list of potential topics and I currently have stuff on that list, but whenever I look at it I think, "That's work." Blogging has never been work to me, so that kind of feeling is both unpleasant and scary. Have I lost my inspiration? Has my well run dry? I have written a lot about a wide array of topics, and my writing tends to be pretty intense and detailed, not little pithy entries or linkfests, so maybe I'm just spent. Or maybe...something else is going on.

I know my feelings have to be anything but unique, but I am mainly interested in the "why." Has anything changed in my life over the past, say, three months, when the frequency of my postings has notably declined? Well, after passionate and enthusiastic writing about the economic crisis, the Obama Administration, the Treasury, Paulson, Bernanke, etc. I just got tired. Is it because of the "bear market bounce?" Maybe. Is it because I don't want to simply write derivative crap of the stuff I've written previously? Possibly. Is it because I don't feel anyone gives a shit what I say? I'm sure that plays a part in it, too. I tried really hard for a period to be heard by those in Washington, in positions of power, but to no avail. There were plenty of voices to be heard, and mine simply was not one of them.

But there has been some other stuff that has been going on as well. I've never worked harder at my investment business, IA Capital Partners. Between working on new investments, my Board commitments (which I take very, very seriously), some advisory work with some of my companies and considering taking some outside capital, it has been pretty time consuming. Also, my trading company, Kinetic Trading, has been taking lots of time. I've been very focused on building this business, and it has been going very well. Starting something from scratch is hard, and making the transition from a "virtual" company to an organization with a home base, employees, strategic partners and outside capital is very exciting but a tremendous amount of work. Finally, I've been super committed to my boys and their love of baseball. Coaching my older son's team and supporting my wife in her coaching of my younger son's team (and acting as their pitching coach) is a labor of love in the Spring, but man, does it take time. No complaints, but I feel as if I spend 50 hours a week on my feet. Oh, and then there is my Board work for my kids' school, Little Red School House/Elisabeth Irwin High School (LREI). Again, a labor of love and something I deeply believe in (progressive education, humanism, providing opportunities to children across the socioeconomic continuum, etc.), but I chair the Finance Committee (making me Treasurer), am a leader in fund-raising and other stuff. In short, I'm in pretty deep.

So when all of this is mushed around, I think my lack of interest in writing has less to do with time (I've never had any, anyway; I've always just created time to write somehow) and more to do with lack of mind share. My brain is pretty stuffed with all my current interests and responsibilities, and I simply don't have the opportunity to contemplate my navel and think deep thoughts right now. My thinking is much more task-focused, much more project oriented. And since my blog isn't a business for me, it is a passion and an outlet, I'm simply not compelled to write. It's sad, but true. While this is my current state, I am hopeful that when things calm down I'll once again feel the inspiration and have the mental capacity to get back to it. On a certain level I feel guilty about not writing; I feel like I'm letting my readers down. But even more importantly I simply miss it. I miss the feedback, the dialogue, the back-and-forth, the spurring of new ideas that come from those who comment on this blog. And if I don't write, I completely miss this dynamic.

In the immortal words of the Governor of California, I'll be back. I just wish I knew when.

The Quants Must be Crazy

As a number of historically top-ranked long/short managers have decided get out of the LP game, there is another pocket - a quieter, more stealthy pocket - of the hedge fund universe that is heating up to bubble-like proportions: high frequency statistical arbitrage trading. Where long/short managers were once the kings of the hill, the AUM titans that could move markets with the mere awareness of their interest in a particular security, the secretive, underground, geeky uber-quant crowd is now being feted by top shops looking for talent. Hedge fund strategies rise and fall in favor in a cyclical manner, as "hot" strategies become over-crowded and returns get compressed, while those out-of-favor are fertile ground for some truly differentiated alpha generation. Then those shunned strategies attract new assets while the previously desirable lose assets. And so it goes...

Generally, such strategy shifts are a function of alpha opportunity: investors will generally tilt towards strategies that can generate the most alpha in the current environment, and since investment conditions oscillate strategy allocations oscillate as well. But there is a new factor weighing on investors' minds (and pocketbooks) that is having a pronounced effect on strategy allocation: liquidity. Among the universe of hedge fund strategies, which is the one that has the best liquidity profile? High frequency stat arb.

With signal horizons measured in sub-seconds, minutes or sometimes hours, these strategies trade highly liquid instruments long and short and generally will end the trading day at or near flat. Money is made through rebate capture strategies, rapid-fire pairs trading and the like. They good high frequency books tend to have Sharpe Ratios that are multiples of those of long/short and relative value strategies, specifically because the volatility of these strategies is muted due to the microscopic holding period. But this gives rise to the big drawback of high frequency stat arb - massive capacity constraints. In general, these strategies don't scale well, and as the frequency goes up (with "ultra high frequency" being the moniker for the most silicon-intensive, millisecond holding period strategies) the capacity tends to go down. Books of $10-$20 million are not uncommon, and it is hard to build an ultra high frequency book north of $100 million. This compares to the multiple billions that can be profitably run via a value-oriented long/short strategy, where much more concentrated positions and much longer holding periods rule the day. But in today's environment, this is not what investors want. Long lockups and high volatility? Out. Short redemption periods and low volatility? In.

And investors are willing to grant much higher payout to such strategies, and for good reason. Gains are losses are realized daily, not weekly, monthly or yearly. The mismatch between strategy holding period and the payout of incentive compensation is the driver of the backlash by LPs towards many of the premier long/short funds, and it makes sense. If your strategy has a holding period that is 18-24 months, should incentive comp really be paid quarterly? There is no rational argument for why the industry has grown up this way, and my guess is that this feature will, over time, come to an end. Both the timing and level of incentive comp needs to be calibrated to holding period - when these finally come into line, there will be a true alignment of motives between GPs and LPs.

But back to the high frequency frenzy. Of course, there is no free lunch. The influx of capital into what is a fundamentally capacity constrained strategy will compress returns and strip the alpha out in short order. And unless these funds amp up leverage as they did in 2007/08 to try and keep returns constant while spreads were compressing (which is what contributed to the quant fund blow-up), capital will necessarily flow out and into strategies previously tossed to the side where alpha once again exists, e.g., long/short. This is simply the nature of things. But for the hedge fund industry to rebuild its asset base and develop a healthy relationship between managers and investors, the timing and level of fees has to match the strategy. A "one size fits all" approach is neither appropriate nor desirable. It's high time the LPs asserted their power and the GPs grew a conscience to do the right thing for the industry.

Twitter is our id, Facebook is our Ego

I was speaking with my good friend Howard Lindzon, my partner in several Twitter-related investments, about the differences in the way people communicate on Twitter and Facebook. Howard's sense is that everybody lies on Facebook; that people represent a kind of "false self," so that it is hard to really know what a person is like from their Facebook profile. He feels differently about Twitter, however, holding the belief that people's tweets are a much closer representation of their true self than Facebook. So that someone who is a jerk on Twitter is likely a jerk in real life, and someone who is thoughtful and careful in their tweets is also like that offline. After considering Howard's theory, I am convinced that he is right. Then it hit me. There is a framework for conceptualizing the differences in peoples' communication between these two media: Freud's structural model of the psyche. In short, Twitter is the id, while Facebook is the ego.

The Twitter experience is one of quick bursts, rapid-fire communications that flow from one's brain straight out to one's fingers and onto the screen. For most, there isn't a ton of premeditation that goes into one's tweets. As we've learned with email, there are things people will say in an email that they would never say to someone's face: this has cost large corporations hundreds of millions of dollars in fines and billions of dollars in lost market value resulting from thoughtless, unmediated behavior. An entire industry, email monitoring, has emerged from the disasters of Wall Street and other businesses where impolitic, hurtful and downright stupid communications have been dredged up in discovery associated with myriad lawsuits. While real-time messaging behind the corporate firewall is now aggressively monitored, the lion's share of message volume is out in public for all to see. And there isn't a ton of motivation for mediating one's tweets; also, given the bounded nature of the messaging, it often results in a quick stream-of-consciousness that reflects the need of the tweeter to be heard and/or their desire to impress or shock. Consider Freud's description of the id, circa 1933:

It is the dark, inaccessible part of our personality, what little we know of it we have learnt from our study of the dream-work and of the construction of neurotic symptoms, and most of this is of a negative character and can be described only as a contrast to the ego. We all approach the id with analogies: we call it a chaos, a cauldron full of seething excitations... It is filled with energy reaching it from the instincts, but it has no organization, produces no collective will, but only a striving to bring about the satisfaction of the instinctual needs subject to the observance of the pleasure principle. [Freud, New Introductory Lectures on Psychoanalysis (1933)

In short, it is all about me, I can't really control it, and it feels good. This seems to me to be a pretty interesting way to think about many peoples' use of Twitter: "I'm getting a coffee;" "I just had a lousy subway ride;" "Check out this article, it's really good;" "isn't Congress missing the boat on this issue?;" etc. I WANT TO BE HEARD. I WANT PEOPLE TO CARE. I WANT TO FEEL IMPORTANT. READ ME! READ ME! Do most people actively manage their image on Twitter, or is it merely a reflection of one's inner self? I'm going with the latter.

Facebook, conversely, requires a much bigger upfront investment to get value out of the medium. A user needs to create a profile, invite friends, join groups, and establish an identity. This is a deliberate process, one which prompts at least some thought (at least among those over the age of 21). It is clearly not the ADD Twitter experience, where one need take no more than 5 seconds to rip out a tweet off the top of one's head. The user has enough time to use their conscious thought to create and maintain a Facebook presence, leading to an output that is more reasoned and more calculated than their Twitter identity. This sounds a lot like Freud's description of the ego:

...The ego is that part of the id which has been modified by the direct influence of the external world ... The ego represents what may be called reason and common sense, in contrast to the id, which contains the passions ... in its relation to the id it is like a man on horseback, who has to hold in check the superior strength of the horse; with this difference, that the rider tries to do so with his own strength, while the ego uses borrowed forces [Freud, The Ego and the Id (1923)]

With a Facebook identity representing a stake in the ground, it takes on a sense of permanence, of solidity. This is something that begs for more time and consideration than the Twitter stream, a constant cacophany of jabs, jokes, jousts and jeers. A mountain versus a river. A stock versus a flow. Their characters are entirely different and appear to tap into different parts of our make-ups. It is the difference between what we want others to see and what we can't help showing. The ego and the id. Our mediated self and our raw, inner being.

Twitter = Discovery

As you may have read, Stocktwits just closed its Series A round with True Ventures. Tony Conrad, of Sphere and WordPress fame, will be joining Howard, Soren and I on the Board. I am very excited about our new partner, and know that Tony's entrepreneurial IQ and product development expertise will be a huge asset to the Stocktwits team.

I have shared my views about Twitter in the past, and have only become more wedded to the ecosystem through my investments in TweetDeck and bit.ly. Given the passage of time and my greater intimacy with the medium, I decided to do a re-read of my "foundation" post of October 2008 titled Twitter: Monetize the Apps, not the Platform. Here is an extract from that post; it still accurately reflects my feelings about Twitter, its promise and its shortcomings:

I love Twitter because of its immediacy, the "one to many" concept and the fact that culturally, so many of those on Twitter monitor and manage their messages with a vigilance far exceeding that of email. This is its power at the most basic level. But when you think of creating communities around Twitter, be they related to companies, brands, entertainers, common interests, politics, etc., it is easy to see the massive power that can be harnessed pretty quickly.

So what do you need? Groups. Perhaps human-curated groups. With hierarchies and sub-hierarchies to help people best search and discover pockets of people they want to follow. Much as AOL, iVillage and the other major portals did to help organize and target their massive horizontal audiences. This easily helps new users get engaged and get busy, as they can simply wade in and find relevant groups with a few clicks. Further, groups are great targets for future advertising and lead generation, as they've self-selected into particular areas of interest.

You also need vertical applications. Investing. Shopping - cars, music, etc. Travel. And on and on. With a sufficiently robust API, the developer community can innovate in much the same way as they have for the iPhone. Create a Twitter App Store? Maybe. But the main goal should be providing the environment for developers to come up with great stuff that will be used, that ultimtely people will be willing to pay for.

Interestingly enough, many of my predictions have come true. There has been an explosion of applications built on top of Twitter, attempting to make sense of its vast and disaggregated audience. To this day, if I go on the native Twitter site and use its search functionality, I don't get much out of the experience. I get infinitely more value from the apps that have been built courtesy of the Twitter API. The problem then as now relates to discovery: how do I find people who care about the stuff I care about, find people from my past just as I do on Facebook, build a universe of people whom I follow that creates real community as opposed to a series of disjointed entities? These are still questions that remain to be answered. At the end of the day people want connectedness and relatedness. Yes, news updates and worthwhile and I follow a handful of bots to keep me current, but my follow list is largely comprised of people whom I like and respect, people who create interesting content that stimulates my thinking and brings me new perspectives. But I'm sure there are many more people out there I'd like to be following that I simply can't find, and vice versa. This is a mega problem that will invariably be solved, but it hasn't been yet.

Stocktwits is merely one answer to the profound question that is discovery. In its domain, it is a category-killer product. But we need many more Stocktwits to drive value to vertical communities - and affiliates and advertisers - across the Twitter landscape.