Investment Filters: Simple Rules to Hit Investment Targets

Investment Filters set boundary conditions and provide simple guidelines for investments consistent with fund strategy. Filters coordinate fund activity to focus on investments that matter most while permitting flexibility to pursue moonshot investments.

At 2pm on May 10, 1996, guide Rob Hall and his client Doug Hansen hit their turnaround time, the agreed time by which they needed to stop climbing and start their descent. But the summit of Mount Everest was just a tantalizing 150 vertical feet away. Hansen had attempted Everest with Hall the previous year but had turned back just shy of the summit. Knowing how much the summit meant to Hansen, Hall ignored the turnaround time and continued climbing. They reached the world’s highest peak two hours later. But the ascent is only half of the climb. Weakened by exhaustion and exposure to the ‘death zone’, altitudes at which low oxygen levels sap strength and mental acuity, their descent halted amid blizzard conditions. Hall made radio contact with base camp and spoke with his pregnant wife in New Zealand telling her not to worry. Hanson and Hall both died that night stranded not far from the summit.

Summit fever afflicts entrepreneurs and investors with potential consequences as perilous as those for climbers caught in a deadly storm. Warren Buffett, a paragon of investment discipline, acknowledged that his worst mistakes were attributable to deal fever. Deal fever results from the fear of missing out, especially when considering a new investment following a long dry spell. Deal fever, like summit fever, clouds judgment causing one to overlook contrary signals and opinions. Recognizing these risks of deal fever, Berkshire Hathaway established a few simple processes to reduce the risk of biases infecting investment judgment. They use Investment Filters to establish boundary conditions for investment and help focus attention on the most relevant investment opportunities. Investment Filters are the equivalent of the climber’s turnaround times. Berkshire Hathaway uses investment checklists, which are monitored by an independent observer, to ensure prospective investments adhere to the Investment Filters.

Investment Filters facilitate fast decisions while reinforcing consistent investment practices across the firm. Investment Filters preserve energy and help cohere efforts focusing on higher potential investment opportunities. As Buffett observed, “We really can say no in ten seconds or so to over 90% of all the things that come along simply because we have these filters.”

Investment Filters differ from investment criteria. Investment criteria describe the qualities sought in any investment. Investment criteria too often morph into wish lists: all investors want to invest in great teams pursuing large opportunities with differentiated technology, strong growth and compelling unit economics at fair prices. Investment criteria function as a to-do list that elicit wishful thinking. Investment Filters takes a counterfactual approach highlighting company traits that one should avoid. Investment Filters are a not-to-do list that promote rigor and discipline. When twinned with investment criteria, Investment Filters offer a more balanced investment approach providing guardrails to eliminate most investment opportunities at the outset and offset early commitments that dim due diligence processes. Investment Filters align the interests of investors and entrepreneurs by creating a more efficient investment process for both capital providers and recipients.

Investment Filters: A Shortlist Menu

Investment Filters should rank in order of importance the few boundary conditions that qualify prospective investments. Following is a rank order of four filters applicable to venture investing.

1. Circle of Competence: Warren Buffett emphasizes the importance of investing within one’s circle of competence. Buffett scrupulously avoided the technology industry for decades while delivering venture caliber returns in traditional sectors. Firms and individuals must have an edge to deliver consistently superior returns in the highly competitive venture industry. Expertise in a market segment is essential as the venture industry expands in scope and scale. The trick is to establish a sustainable circle of competence that remains relevant as the tech industry evolves. The circle of competence requires focus to establish distinctive expertise in an area with sufficient breadth to permit portfolio diversification. Focusing on investments within a circle of competence helps one avoid chasing investment fads while seeking opportunities in overlooked sectors. We have found that thematic and thesis driven investments enabling pattern recognition across a portfolio of investments made over multiple fund cycles reinforces and sustains a circle of competence.

2. Valuation and Stage: While the largest funds now invest across all stages, most venture firms focus on one of three categories: seed, early and growth stage investments. Skills and practices differ markedly across these three stages. Seed stage investors are more technical, have deep founder networks, and are adept at team building, devising creative go-to-market strategies, and the art of finding product market fit. Growth stage investors are more financial, have deep investor networks, and are skilled in scaling businesses, funding and exit strategies. Recognizing these differences, experienced investors establish clear boundaries to resist stage creep. Multistage funds typically have different teams that focus on early and growth stage investments. I respect funds who clearly delineate their boundary conditions as it signals a disciplined approach to investing. One of our seed stage funds applies a maximum valuation threshold for new investments as an Investment Filter to avoid chasing high priced or later stage deals.

3. Geographic Boundaries: NGP Capital is a global investor, yet we focus on core markets and must have a trusted local partner and prior success in the sector to consider investments outside these regions. Despite these preconditions, core investments outperform those in other geographies. Investing in core markets has many advantages: (1) deep local networks enhance due diligence; (2) local market knowledge reduces blind spots; (3) we can supplement teams with local talent; and (4) a local presence enables us to triage when an investment goes sideways.

An investment in the Middle East provided a painful example of the risks of investing outside a core geography despite a reputable local partner and prior success in the sector. Spurred by a charismatic CEO who attracted talent and customers, the company expanded rapidly and reached $100 million in sales faster than any other firm in our portfolio. Yet the company operated inefficiently as our calls to recruit a proven COO went unheeded. Ultimately, unbridled growth led to breeches in service quality and loss of key customers. The collapse of the company was avoidable as a capable COO readily available in our core markets could surely have solidified operations and rectified the problem.

Investments far afield are obvious exceptions, yet similar challenges arise when investing on the periphery of core markets. Silicon Valley, New York and Boston are deep technology markets with access to vast talent pools, yet the situation just a hundred miles away could be quite different. Local networks and market knowledge attenuate rapidly. Hometown advantage may disappear beyond the friendly confines of the local metro area, so determining relevant geographic boundaries may require more granularity depending on the nature of the markets served.

4. Team: The team is the most important success factor for a company. Nothing is even a close second. I have written extensively about how to assess founder market fit. Beyond founder fit, I propose two team Investment Filters that may seem counterintuitive initially.

First, avoid corporate executives as leaders of startups. I respect the perspective offered by corporate executives, who often bring valuable experience to a growth stage Board or executive team. But the requisite skill sets for leading a startup and corporation differ fundamentally. Startup leadership requires adaptability, speed and execution with limited resources. Corporate executives command an army of resources to deliver predictable quarterly results. I have seen too many successful corporate executives flummoxed by the quest for product market fit to encourage them to leave their safe havens for the siren call of startups.

Second, avoid family run businesses. Sibling and marital partners share long histories and may better withstand intense startup pressures. Yet the history of family run businesses in the tech industry has been disappointing. Cisco Systems was founded in 1984 by Sandy Lerner with her husband Leonard Bosack, but they were replaced in 1987 long before Cisco went public in 1990. Bentley Systems was founded the same year as Cisco and may be the only U.S. publicly traded, family run technology firm, but it grew slowly and took 36 years to go public. As Wasserman observed in The Founder’s Dilemmas, founder issues are a leading source of troubled startups. Family founders often resist executive additions into the inner circle, required changes in roles and responsibilities, and open communication with the broader team that high growth tech startups require. In our experience in a half dozen startups cofounded by siblings or married couples, family founders too often balkanize a startup and obstruct needed change to scale the business.

Moonshots: The Red Flag Rule

A cardinal sin of investing is passing on a fund making startup. Venture returns have power law distributions with outsized returns from exceptional innovations. How do funds apply Investment Filters while remaining open to unusual fund making opportunities that defy standard investment parameters?

Funds may consider two options to remain alert for such exceptional opportunities. One option is to allocate a percentage of committed capital for moonshots, which are atypical investments with outsized potential. This provision is consistent with standard limited partner agreements, which typically allow funds to invest 10–15% of committed capital outside the scope of normal fund parameters. A second option to operationalize moonshot investments is to permit each partner one red flag investment per fund, which is reserved for proprietary, high conviction investments with extraordinary upside potential.

Related Concepts

Investment Filters offer a thinking fast process to distinguish signal from noise and focus on investments consistent with fund strategy. Investment Filters describe boundary conditions summarizing a Not-to-do list for prospective investments. Investment filters reinforce thesis driven investing and counteract escalating commitments that can lead to deal fever.

Investment Filters may be summarized in checklists, which sponsors and inverters use to confirm that a prospective investment conforms with fund strategy.

Resources:

· Peter Bevelin, Seeking Wisdom from Darwin to Munger. Describes the investment strategy and processes of Warren Buffett and Charlie Munger at Berkshire Hathaway.

· Lawrence Cunningham, The Essays of Warren Buffett and Alice Schroader, The Snowball: Warren Buffett and The Business of Life. Investment philosophy of Warren Buffett in his own words and in a biographical review.

· Donald Sull and Kathleen Eisenhardt, Simple Rules: How to Thrive in a Complex World. Technology professors from MIT and Stanford show how simple rules such as investment filters enable leaders to navigate effectively in complex, rapidly changing environments.

· Noam Wasserman, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup. Sheds light on founder dynamics that to often waylay promising startups.

· John Krakauer, Into Thin Air. Detailed description of the 1996 Mount Everest summit bid and subsequent mishap.