Caveat Emptor: Managing Information Asymmetries Inherent in Venture Investing

Weekly Reflection
By Paul Asel

Six venture backed companies filed for IPO on Friday, November 13, including Doordash, C3.ai and Pubmatic — about 20% of the annual rate for US venture backed IPOs in recent years filing in just one day. With the recent spate of IPOs, many venture firms will soon make discretionary sale decisions on public stocks. This is a high class problem as venture firms typically enjoy solid returns on investments that reach the public markets, yet few are well equipped to make judicious decisions on volatile stocks whose price swings may materially impact fund performance.

As a result, venture investors typically adopt a consistent strategy and sell public holdings when liquid. This practice is informed by several prudent principles. First, venture firms are paid to invest in illiquid private companies, not public holdings. Limited partners are loath to pay hefty fees for public securities they could hold in diversified stock portfolios at lower cost with less risk. Public market investing is a different skillset best left to security firms armed with an armada of research analysts and sophisticated asset pricing models.

Public markets are designed to create a level playing field for investors. Regulations require disclosure of material information to all investors concurrently. Insider trading rules prevent trading on non-public information unless derived from a ‘mosaic approach,’ which applies research from multiple sources so decisions do not rely on company data. Regulation thus enables retail investors to invest in public securities on par with institutional investors. In such circumstances, venture investors forgo insider advantages upon an IPO while converting from preferred to common shares subject to the whim of market sentiment.

Yet savvy public market investors go to great lengths to create ‘alpha’ — consistent financial performance in excess of average market returns. Generating alpha is hard and some would say impossible for long periods of time. Arbitrageurs invested in expensive computer systems in the 1980s to identify and trade on price anomalies that existed for nanoseconds. Arbitrage disappeared when technology advances eliminated pricing anomalies. Investors tapped credit card data for advanced insight on where funds were flowing but that too became commoditized. Some investors used satellite imagery to count cars in retail malls as a leading indicator of economic health, yet this data is now widely available for a price. Today investors sift through big data from the Internet or sensors in search of ephemeral alpha.

While information asymmetries are narrow in public markets, they are rife in private markets. In the land of the blind the cyclops is king. In the land of sparse data, insight from proprietary information drives outsized returns. At NGP we invest heavily for such insight leveraging mobile expertise, our global perspective and network, access to Nokia, thematic investing and Q analytics platform to find, pick and win the best deals. The bar for insight driven investing is constantly rising as we ply highly competitive, increasingly information rich markets.

Yet information asymmetries persist. Management and existing investors have inside information, so new investors take queues from both on their level of commitment and enthusiasm. Founders selling interest is a negative signal. Pro rata participation from existing investors is a neutral signal, investing super pro rata a positive indicator. High performing companies are flooded with investor interest. Sparse interest is more likely a negative signal than a measure of investor insight. In such cases, a sanity check is ‘Why are we so lucky?’

We live in an uncertain world. Bad outcomes may come from good decisions and good outcomes from bad decisions. Investors seek to make consistently good decisions with all information available. We accept and account for structural information asymmetries — management and existing investors will always know more than new investors. But we seek to be fully informed knowing as much or more than other prospective investors.

Entrepreneurs and investors ultimately have a shared interest in company success. Entrepreneurs seek knowledgeable investors who can help maximize company potential. Investors seek to invest in areas in which they are knowledgeable to make the best investment decisions possible. Good matches occur when knowledge and opportunity meet.

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