Economics & Finance

So one of my clients is a venture capital fund in Silly Valley (my name for Silicon Valley). And being that I use to be in the high tech investing game, it’s a nice trip down memory lane.

Remember back in the day when they said it was a good idea to buy a basket of stocks in a hot sector, and needing only one of them to become the next Microsoft for the whole investment to pay off? Well, boy did these guys ever – they’re the real deal. The fund began with $100 million, and one of their first investments was an early round investment in ABC Networks for $5 million. Five years later, at the height of the tech bull market, they distributed shares in ABC Networks to their partners (cashing out in VC speak) with a gain of over $625 million.

Think about it for a minute. It’s the same as buying shares at $1 and selling it at $126 for a gain of $125. That’s a 125x return on the original investment. In percentage terms that’s a 12,500% return over 5 years, or roughly a compounded return of 265% per year over 5 years for their investment in ABC Networks. Overall, the original $100 million fund made over $850 million in capital gains for its investors. Or to put it simply, they turned $100 million into almost $1 billion. Takes your breath away doesn’t it?

Capitalism at its finest.

Note: Names and figures have been changed due to the information being privy to the fund and its investors. The figures used are fictional. However, I’ve maintained the magnitude of the figures for illustration purposes.

As a side note, there’s plenty one could critique – i.e. the market was a euphoric bubble, the investors may not have sold once they received the shares and rode it down, we’ll never see a market like that again, etc, etc. I wanted to give an inside peak at a VC, what can go right, and a reason why people invest in venture capital funds. Hope you enjoy.

Update: I forgot to mention, the standard fees the GP would charge to manage a fund is in the ballpark of 2.5% of capital committed per year and 20% of profits.

Update2: Here’s a good article about Google and its relation to the IPO/VC world.

Over at The Corner, Mark Krikorian suggested spending funds Bush earmarked for job training on “immigration enforcement” at work sites. The idea is to make cheap immigrant labor less available, and thereby to make domestic ex-convicts more attractive to employers.

But how about streamlining immigration procedures instead? If immigrants will work for lower wages than ex-convicts, artificially restricting the labor market to benefit ex-cons amounts to an indirect and inefficient subsidy. Krikorian ignores the costs to business, and hence consumers, of immigration restrictions that drive up labor costs.

He also ignores the possibility that employers prefer immigrants for many jobs at a given wage level. In that case the better course of action might be to eliminate, or at least lower, minimum wage rates that price less-productive and higher-risk workers out of jobs.

It’s obvious that most immigrants come to this country because they want to work, but we shouldn’t forget that American employers want to hire them. It should be easier for hard-working immigrants to come here without first spending years jumping through bureaucratic hoops.

Prison reform is a separate issue. Ex-convicts may be made employable via training programs (as Bush proposes), by lowering the minimum wage, or even by directly subsidizing employers who hire them. Attempting to increase demand for ex-con labor by driving illegal immigrants — many of whom are illegal mainly because it’s prohibitively difficult and time consuming to become legal — out of the labor market, is a poor alternative.

My last client was for a spin out of a small manufacturing business of an oil equipment giant. This subsidiary’s business isn’t really related to the parent’s, so they’re trying to create value through an IPO. I was there for the diligence part of “due diligence”, so really got to know the operations inside out. (The cynic in me says the partners are there for the “due” part, which is to collect the bills due, but that’s another story in itself.)

One thing that really stuck out in my mind through this assignment was that this was one of the last great American manufacturing jobs left. By which I mean a relatively uneducated employee could start on the company’s manufacturing line with a salary of around $22,000 a year, and work their way up. With hard work and patience, they could eventually work their way into a skilled job up the line with a respectable annual salary of $50,000 – $70,000 a year. Granted it would take many years, but it’s an accessible on-ramp into middle class for literally someone with a high school education. If the person were really dynamic and had the brains, they could even swing themselves into a management position at some point. The company had good benefits, including retirement and all the usual goodies. In a nutshell, a worker’s paradise for lack of a better term.

Looking over what they do and what they make, there isn’t really anything – save social responsibility on the company’s part – to stop them if they wanted to transplant their entire operations to China or India. They would save a bundle on labor costs, and given the highly automated nature of their machines, you really don’t need that much skill on the part of the workers. At the very least, none of the skills involved are above the aptitude of an eager Chinese or Indian. The double edge sword of modernization is also that since you want to make everything automated and dumb it down to the n-th degree to maintain high quality, you get to a point where you can literally take the brain out of the equation. So pay a Chinese or Indian $100 a month, and you decrease your biggest operating expense by more than 90%.

Maybe it’s because a lot of them are wrong. (1 Euro was worth about 1.22 US dollars when I made this prediction and is worth about 1.27 dollars now.)

It’s a truism that market trends often continue beyond our expectations. This is especially true in currency and interest-rate markets, because these are dominated by governments that have the resources to make markets go where they want them to — at least for a while. The Euro is backed by nothing more than political expectations about the behavior of the European Central Bank; the Euro’s current historically high valuation vs. the dollar is largely a function of the Bush administration’s economic ineptitude and politically-driven dollar bashing. These factors are subject to change and sooner or later the Euro will lose value against the dollar. I don’t know when this will happen or how high it will go first.

UPDATE: Paul Johnson makes a strong case for the Euro’s coming downfall, and argues that the U.S. should cultivate relationships with European countries that share its interests:

I’ve always maintained that the moment France finds theEU to be no longer of use, it will break it up. A German revolt against the payments system could provide that moment. Hostility to the EU is rising in France anyway, to the point where no referendum on the proposed EU constitution can be held there for fear it would be voted down heavily.

U.S. policymakers’ aims should be to forge close links with in-dividual countries that have strong common interests with America in wide areas of policy. Such nations include Britain, obviously (though not Ireland, which is sure to do the opposite of anything Britain does), Spain and Italy. The latter two are deeply resentful of French-German behavior and are anxious to have a powerful friend outside the EU to redress the internal balance of power.

Johnson’s argument isn’t new, but it appears that events may at last be catching up to it.

Lex and I had an exchange of emails about Bush. Lex argued that Bush is doing a great job all around. I agreed he is doing well on the war, but argued that he has been irresponsible on the economy and that I am concerned he might sign a reauthorization of the gun- and high-capacity-magazine ban in Clinton’s 1994 crime bill (which sunsets in 2004). Lex has blogged his response to me, and what follows is an edited version of my rejoinder to his response.

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