Summer Reflection — a perspective on prudent investment practices
Bad Blood and Innocent Man illustrate five factors relevant for investors today.
August is typically a slow month for investing. For investors, August is a time for reflection, exploring new areas of technology innovation and other topics of interest.
This vacation my reading list was diversionary, intentionally far afield from investing. Baseball is a safe summer read and the Historical Baseball Abstract is a baseball analytics classic for the numerically inclined. John Grisham is summer reading royalty. I avoid his novels, but delved into Innocent Man, his first non-fiction emerging from his involvement in the Innocence Project. Bad Blood, a rare business thriller recounting the Theranos debacle, also made the summer vacation reading list, along with a few other books.
From these disparate sources emerged an unintended theme that is both timely and relevant to technology investing. Each book describes the psychology of commitment and fallacies that emerge with monumental consequences when good decision-making principles are overlooked.
“Each book describes the psychology of commitment and fallacies that emerge with monumental consequences when good decision-making principles are overlooked.”
This is timely as we are in a seller’s market that has strained venture investment practices. It is also central to the fiduciary duty we undertake as investors. When adjudicating investment disputes, courts apply the “prudent man rule,” a principle that dates back to 1830, directing trustees “to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”
In his Historical Baseball Abstract, Bill James, the scion of baseball analytics, established a framework that applies broadly to good diligence practices: “Baseball statistics are simplifications of much more complex realities. It may be unnecessary to say this because, of course, all human understanding is based on simplifications of more complex realities. Economic theories are simplified images of how an economy works, replacing billions of complicated facts with a few broad generalizations. The same is true of psychological and sociological theories; it is true in medicine and astronomy. The search for understanding, wherever it roams, is a search for better simplifications — simplifications that explain more and distort less. Even the understanding gained from experience is, of course, a simplification of experience into the generalizations that are distilled from many experiences. The difference between a good statistical analyst and a poor statistical analysis that a good statistical analyst understands this, and a bad one implicitly denies it.”
”It may be unnecessary to say this because, of course, all human understanding is based on simplifications of more complex realities.”
Bad Blood — hot companies gone cold
Bad Blood recounts one of the biggest business frauds since Enron. Theranos CEO Elizabeth Holmes wooed old men who brought credibility to the company. Henry Kissenger and George Shultz served on the Board attracting other political heavyweights, including Betsey DeVos and James Mattis. Each new luminary added to the aura and perceived authenticity of Theranos — and eroded vigilance of new investors. Investors, including Rupert Murdoch, Cox Enterprises, Fortress Investment Group, and Blue Cross Blue Shield, wagered over $900M on Theranos. Most invested without seeing the device, as rounds closed quickly and the secrecy of such an important invention was deemed essential.
Theranos is extraordinary for the size and scope of its fraud. But it is not as rare as we would like to believe. As Bad Blood author John Carreyrou concluded, “Hyping your product to get funding while concealing your true progress and hoping that reality will eventually catch up to the hype continues to be tolerated in the tech industry.” Hyping companies is so endemic that it is best for investors to ignore the financial projections in most company pitches.
Innocent Man — the injustice of just demands
While stakes at Theranos were high, the loss of innocent lives is a greater tragedy. Innocent Man is a story of Ron Williamson and Dennis Fritz, who were wrongly accused of the murder of a teenage girl in Ada, Oklahoma. In a quiet town of 16,000, local police were under immense pressure to solve the murder. They seized on a town drunk as their target. Surmising that two men must have been involved, they implicated Ron’s friend Dennis though no accounts had placed him near the crime scene. Prosecutors concocted a circumstantial narrative, involving testimonies from convicts and references to a dream while ignoring more concrete countervailing evidence. Ron landed on death row, served 11 years in prison, and came within five days of execution. DNA testing exonerated Ron and Dennis but matched the crime to Glenn Gore, who had initially implicated Ron and was the state’s main witness at trial. Sadly, Ron was never able to shake the stigma of his wrongful conviction in Ada and he died just five years after his release from prison.
The Fifth Amendment to the US constitution enshrines the principal that one is “innocent until proven guilty.” The presumption of innocence sets a high bar for prosecution so wrongful sentencing should be rare. A single juror doubtful of guilt is sufficient to free a defendant. But pressure to solve crimes and aggrieved jurors in small communities can sway opinion toward the prosecution rather than the defendant.
The Innocence Project was founded in 1992 when newly available DNA testing allowed plaintiffs to revisit felony cases. The Innocence Project has cleared over 350 people of wrongful conviction but not before they had spent nearly 6,000 years cumulatively in jail.
“The Innocence Project was founded in 1992 when newly available DNA testing allowed plaintiffs to revisit felony cases.”
Reading through summaries of the wrongful convictions on the Innocent Project website is a sad compendium of lives destroyed by the flimsiest of circumstantial evidence. As theologian Thomas Merton noted in his writings on truth, “an isolated witness is much more difficult and dangerous.”
Five factors that impede good judgment
What does the wrongful conviction of Ron Williamson have to do with investing? Why would a media mogul like Rupert Murdoch invest $100M with no evidence that Theranos could perform the blood testing it claimed? Bad Blood and Innocent Man illustrate at least five factors relevant for investors today.
“Bad Blood and Innocent Man illustrate at least five factors relevant for investors today.”
1. Deal Pressure: Absent pressure from the Ada community, Ron Williamson would not have been convicted. Testimonies were concocted a day before a filing deadline to placate a seething community eager for resolution of the murder. Likewise, deal pressure affects even the savviest investors. Warren Buffett acknowledged his worst deals were done with a thin investment pipeline when under pressure to invest billions each year at Berkshire Hathaway. Buffett advised people to invest as though they have only ten investments to make in life. As venture investors typically cast a wider net, it is not surprising that so few achieve Buffett-like returns even with much higher levels of risk.
“Likewise, deal pressure affects even the savviest investors.”
2. Short Timelines: The best deals go quickly, especially in a bull market. Thus, diligence diminishes as every bull market matures. Theranos exploited short deal timelines to reduce scrutiny. Long backlogs in police departments and our court system similarly invite shortcuts. As Warren Buffett has noted, “It pays to be active, interested and open-minded, but it does not pay to be in a hurry.”
“It pays to be active, interested and open-minded, but it does not pay to be in a hurry.”
3. Fear of Missing Out (FOMO): Technology is a momentum business. Theranos reached a $9 billion valuation through successively larger rounds though it never had a working product. Investors stretch to be in the buzziest companies and media fascination with billion dollar valuations or “unicorns” has made venture investing buzzier than ever. The temptation to skip the uncertainty and hard work of early-stage investing, and lasso a crowned unicorn, has much allure.
“The temptation to skip the uncertainty and hard work of early-stage investing, and lasso a crowned unicorn, has much allure.”
4. Relationships: Trusted relationships with prior investors offer access to competitive deals and neutralizes information asymmetry that any investor faces when evaluating a new company. But relationships may also discourage independent thinking and lower scrutiny and skepticism. Theranos manipulated this bandwagon effect with each new funding round. Friends of the initial investors who were initially skeptical scrambled to join future rounds as momentum appeared to build. Theranos had few healthcare experts who could have tempered this bandwagon effect. Similarly, case summaries at the Innocence Project are replete with misleading testimony by expert witnesses eager to assist the prosecutors with whom they had long-term client relationships.
“But relationships may also discourage independent thinking and lower scrutiny and skepticism.”
5. Premature Commitment: The most pernicious of psychological fallacies is premature commitment. Investors must compete to get into the hottest deal. But early commitment taints ongoing diligence, making one predisposed to affirmative information and dismissive of non-confirmatory evidence. The prosecutor in Innocent Man followed his initial hunch on Ron Williamson and became so wedded to his narrative that even subsequent DNA testing did not convince him of Ron’s innocence or of the guilt of his prime witness. This trait was common among wrongful cases overturned in the Innocence Project and we know it to be true in investing. An initial commitment — verbal or subconscious — thwarts all future diligence.
“The most pernicious of psychological fallacies is premature commitment.”
Search for Truth in an uncertain world
An investor’s duty, like that of a judge and jury, is above all to the truth. But truth is elusive. As Amy Herman demonstrates on her TED talk A Lesson on Looking, even when we are looking at the same picture, we rarely see it the same way.
At NGP Capital, an inverter reinforces vigilance and illuminates our blind spots. All our project teams include an inverter, who maintains a skeptical distance to balance loss of objectivity that can arise as a deal progresses. As the venture bull market enters the tenth year of its cycle, never has this process been more important for prudent decision-making.