Letter #10: Josh Wolfe and Peter Hebert (2020)
Lux Capital Coronavirus Memo
Hi there! I go by KG, and I love studying the history of business and investing. I’ll be sharing some notes from one Investor/Shareholder letter per weekday (mostly from my compilations) here.
Today’s notes are a fun one: Lux Capital’s 2020 Coronavirus Memo written by Josh Wolfe and Peter Hebert.
For those of you who follow me, Josh needs no introduction, but for those of you who are new, see the following tweetstorm and check out my Josh Wolfe compilation here.
Now, I don’t tweet about Peter as much (simply because he hasn’t written as much or as consistently as Josh), but is just as integral to Lux as Josh is. He is the Yang to Josh’s Yin, the eternal optimist to Josh’s eternal pessimist. Peter started his career as an equity analyst at Lehman before teaming up with Josh to start Lux (and everything after). Here’s a tweetstorm on something he did publish publicly.
You can find the entire memo in my Josh Wolfe Compilation. This particular memo starts on page 233.
You can also find this memo in my Corona Memos Compilation. This particular memo starts on page 8.
If you have any thoughts on what you’d like to see, let me know!
Notes
In preview: we have been conservatively prepared to defensively handle underappreciated risks and offensively prepared to seize on underappreciated opportunities. We share some observations and philosophical frameworks guiding our thinking that may lead to decisions we make and actions we take. We end with tactical things we are watching for—and doing now.
Four Flows
There are currently four flows, all connected in complex ways, that matter: (1) virus, (2) people, (3) information, (4) capital.
You can tell Josh is a (good) scientist from here — an actual readable abstract. It concisely lays out what this paper will discuss and introduces the main theme (flow) of the paper
(1) Virus
Tiny things have immense impacts — especially when everything and everyone is connected and vulnerable.
Not sure if this is coming from the scientist (Lux differentiated themselves when starting out by publishing a 500 page nanotech report) or the philosopher (butterfly effect) in J+P.
As cases mount, as world governments struggle to adapt to the spread of the novel coronavirus, and as reporting emerges of local, city and state efforts to treat and contain it — it must be reaffirmed that this is most importantly a humanitarian problem before all else. In times of economic crisis, it is easy to forget the legion of doctors, nurses and healthcare professionals running into uncertainty often without masks — the selflessness and heroism of these people are the reason the rest of us stand a fighting chance.
Honestly was a bit surprised here… given Lux’s expertise in deeptech, I expected more of a focus on the technology front of the coronavirus battle. However, J+P decide to focus on the humans — calling it a “humanitarian problem above all else”
Singapore and South Korea, which both took quick coordinated action, show promising signs that the coronavirus can be fought in republics — but only if they are able to effectively coordinate the entire apparatus of government to defeat this threat.
No comment…
the politicized, sedate and dysfunctional public health response has revealed glaring vulnerabilities in our healthcare system’s ability to handle the load of a full-on pandemic. Strong leadership during a crisis with an abundance of fear and uncertainty demands providing what is scarce: trust, and accurate, honest and timely information. Clear plans of preparedness that can create high confidence. Conversely, attempts to manipulate the public to avoid fear by suppressing information, downplaying or spinning statistics only serves to create distrust, fear and outrage.
Be prepared — but as the sayings go: “shit happens” (Forest Gump) and “everybody has a plan until they get punched in the face” (Mike Tyson)
Notice J+P write “clear plans of preparedness that Can Create high Confidence. They don’t say plans work, plans are the solution, anything else. But they do give people hope.
(2) People
The virus itself is indifferent and indiscriminate. The vector that gives the virus velocity is people. That is why the most effective tactic in restricting the rate of spread of the virus is restricting the flow of people and their ability to interact as carriers — social distancing.
Interesting observation. Early reports showed that Corona was closely related to the ACE-2 receptor… meaning some people (as a group) WOULD BE targeted and more susceptible. Age and health also play a big factor, but point taken. Everyone needs to be careful.
Also surprised they emphasized social distancing and didn’t mention masks. Granted, at the time, the WHO+US government were publicly saying masks had no effect — my belief is that they knew there was a shortage and wanted to ensure front-line workers could get first priority — important, but deception nonetheless.
On avoiding meetings and travel for Lux, there are two considerations (1) health and (2) moral.
The main reason to avoid meetings or travel for health reasons is to decrease the risk you are exposed or infected (or a family member—young or old; or a colleague)
The main reason to avoid meetings or travel for moral reasons is twofold: (1) to decrease the risk that any of us unintentionally serve as a vector that contributes to amplify the virus’s spread. And (2) to decrease the risk that any of us or our immediate network currently healthy become sick and consume scarce healthcare resources.
In other words, health. Physical health, community health, and mental health . (Can you imagine the mental pain you’d be in if you caused a loved one to catch, or worse, die, from corona?)
Out of an abundance of caution, effective immediate, all firm travel, domestic or international, is discouraged and should be reconsidered until further notice. We are not putting a ban because we do not have a good answer related if we placed a ban at what point would we lift the ban.
The principle of inertia: an object at rest stays at rest. An object in motion stays in motion.
Drawing parallels here to pricing — if you make something free, hard to start charging for it (am I stretching this metaphor too much here?)
out of an abundance of caution for the next week as this all unfolds we are restricting in-person meetings (including entrepreneurs) and will instead coordinate these meetings to take place over video (Zoom).
Willing to move virtual and continue to take meetings — many investors, especially those at the early stage, vowed to not invest until after either (a) Corona blows over or (b) they have a mental model for the new normal
Halting the virus by halting people also halts economic activity. The “liquidity” of human movement is temporarily freezing — creating twin shocks on the supply side from productivity loss as well as on the demand side from a drop in consumption.
See any of Josh’s Real Vision interviews, and you’ll know he’s obsessed with all things liquidity.
If people are prohibited by employers or governments from traveling or flying, lowering interest rates does little to induce demand. Airlines are projected to lose over $100 billion in revenue this year in base case models, which are constantly being revised down, cruise ship stocks have cratered, as have lodging and hospitality names.
Printing money doesn’t solve the underlying problem of demand — If people aren’t flowing, capital isn’t flowing.
There’s an old saying, “Don’t fight the Fed.” There’s a reason this is a saying. If the Fed prints money, if the Fed stays at 0, don’t even think about “regular” market movements
Stan Druckenmiller (an early Lux LP and one of Josh’s mentors): “The number one principle would be do not look at the world today, what’s happened in the past and happening currently, is in the price. Try and think how the world may look differently in 18-24 months from now and try and base your investments on that and not what’s true today. It’s amazing what that single little exercise can do”
Bill Ackman: “No business can survive a period of 18 months without revenue"
Targeted bailouts will be politicized and likely — as will their expectation in the markets.
100% correct and what has happened
In contrast to Global Financial Crisis, this biological contagion has caused a reduction less in the flow of capital, but more so in the flow of people — and a halt of commerce from cessation of spending which can then tip over into individual company working capital and debt default issues. Capital crunches may result
Hm. In a sense, a stop in the flow of people should also result in a stop in the flow of capital — although this is also clearly not true with the Fed printing money.
(3) Information
But information — and misinformation — doesn’t need physical exposure. It travels faster, through more media, replicating, mutating, catching contagion faster than biology can. When it comes to the health information about what is happening now, we expect information to be collected locally and transmitted to central leaders for factual dissemination to the masses. For everything else, global markets are the main repository for reverberating information which influences expectations which then gets reflect in prices.
See Steve Jurvetson and Tim Draper on “virality” — I only recently just learned the Jurvetson and Draper actually coined the term virality in respect to the internet and fast transmission across the internet (if there’s interest, I will cover that paper in a future newsletter)
It’s always better to make observations than predictions. And in times of high uncertainty it is key to make observations of other observers. Both the facts about fundamentals that they have access to and the expectations they are forming based on that information.
Hmm… I think observations should be made before predictions — but I don’t think one should only make observations and not predictions
I do believe that observing observers is important — in a sense, isn’t that basically what the stock market is? We all talk about “fundamentals,” but at the end of the day, it’s liquidity that moves the markets.
Another Druck Quote: “I focused my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”
As primates already prone to seeing patterns in clouds or on toast when none exist — things get more serious in times of uncertainty, when as social primates we look to others for a signal they know the way from danger or toward safety.
Should have added the example of venture capitalists asking “who else is investing” as their first question haha
Make no mistake: those who calmly waited and reflected while others panicked in our ancestral environment were eaten by tigers. But in markets, dispassionately observing the emotions of others in a crowd — especially when those emotions are based on others’ emotions and not new information — is a competitive advantage.
Be patient
Observe other observers
(4) Capital
Historically, full rate-cut programs have consisted of 500 basis points of reduction. Today we don’t even have 100 basis points. And so the Fed will turn to alternative measures: Odyssean guidance that would further test the credibility of those monetary high priests; or yield curve control or further quantitative easing (as signaled on March 12) — either precarious gambits that could risk stagflation in the downside case.
Lol. This is reading more like a hedge fund letter at this point that a VC one. @Josh, @Peter, when’s the Lux internal hedge fund coming??
If you don’t know what Odyssean Guidance is, go read this from the Federal Reserve Bank of Chicago.
Markets may be pricing in expectations of central bank bailouts of targeted at-risk industries or markets and lower Fed rates — but less appreciated is the growing chance credit spreads actually widen and rates spike for corporates aggressively as many investors and companies seek to de-lever, the precise thing often done when taking down risk, all at the same time.
Again, when’s the new fund launch, and can I invest?
We expect that venture lenders’ rates will come in but so will dollar volumes they put out (in aggregate and to individual companies) — likely by half. The top reason may be less related to topline revenue economic performance of the companies (as many have tepid revenue) and more related to subsequent equity financing risk.
Yep.
Nearly two years ago we took a counter-consensus view (that proved correct) that rates might fall:
When rates are high, fewer things get funded, and they tend to be more near-term focused (with a higher assessed chance of paying back). Necessity becomes the mother of invention and companies become more scrappy, clever and fiscally responsible
Has Josh ever been wrong (early?) apart from Tesla? — Tesla x Josh is a fascinating relationship… Check out page my compilation Josh Wolfe_Volume 2; start on page 380. All I can say is Josh is a vocal advocate for truth — he’s good friends with famed short seller Carson Block, who is responsible for one of my favorite quotes of all-time, “And look, I hate the auditing profession. I think it has absolutely bamboozled investors and continues to do so. Because up until the moment something goes wrong, Partners move, people move freely from one entity to another. They’re seconded. And money moves freely. And the global partners will make money off of these local affiliates. The moment something goes wrong though, the story totally changes. “Oh, no. That was our local affiliate. You can’t hold us in the US or in the UK, the global groups, you can’t hold us responsible.” Notice Carson also focuses on the “flow” of people and money.
Per Seneca: our fears are always more numerous than our dangers. Which is to say: Failure Comes From A Failure To Imagine Failure. More things can happen than will.
Honestly, I’ve always been confused — I’ve heard Josh quoted as “Failure comes from a failure of imagination” as well as “Failure Comes from A Failure to Imagine Failure.” Although they sound the same, that one word (the second Failure) makes a BIG difference in meaning
Over the past decade, low rates have doubled levels of both outstanding high-yield credit ($1.3 trillion) and investment-grade credit ($6 trillion). Half of that $6 trillion is BBB-rated. What if it gets downgraded in a recession scenario, causing investment-grade funds to mechanically sell-off while forcing the high-yield market to absorb additional down-graded paper?
I’ve been thinking about this a lot… will the seemingly normal low interest rate environment of printing money lead America down the path of Japan (balance sheet recession) or the path of China (lots and lots of growth and stimulation)
Yale + Yule
Is it fortunate, then, that allocators have shifted record proportions of their portfolios into private equity over the past several years? These GPs may be well-positioned— but only insofar as LPs are able to continue to fund them. In a globally representative survey of 113 LPs taken in December 2019 — just as the first sing sof outbreak were materializing hin China’s Hubei province — 80% of North American LPs believed they were not ready for a recession
Yikes, remember when after the GFC everyone piled into non-vol strategies to convince investors they would never again be supremely susceptible to another recession? Lol yea, I remember that too — I’m guessing most don’t
While capital call defaults are rare, additional corrections might herald the return of the denominator effect, further exacerbating this liquidity issue, ultimately constricting the future supply of allocator capital to GPs. For historic perspective: in 2009, 66% of LPs had little or no capacity for new fund commitments
If you want to understand the VC industry… follow the flow of capital to the LPs.
In a coronavirus-induced downturn, a handful of LPs failing to re-up might only cause minor annoyance to most GPs. Liquidity issues are innocuous in isolated cases, but if unknowingly synchronized, however, they could spell disaster for unprepared GPs and LPs at large: a diversity breakdown by outbreak
This makes the argument for decentralization. If things are too centralized, when one center falls, everything falls
Diversity Breakdowns
Diversity breakdowns, whereby previously heterogeneous agents end up inadvertently acting in lock-step, cause bubbles and busts
Bridge example: Bridge had to be shut down — researchers found that the very act of walking, innocuous by itself, had caused a diversity breakdown when unknowingly synchronized — just 160 pedestrians walking at the same time was enough to cause major trouble
The Yule Distribution
What underappreciated risks might occur? In an inevitable flight to quality, mediocre upstarts will die as their easy-money life support expires. The same company in one venture fund’s portfolio, relatively insignificant and about to end-up on a triage list with scarce reserves, may be a critical returner and in another VC’s portfolio. Older vintages of VC funds may be cash-strapped with limited reserves causing a Darwinian struggle for resources among their portfolio companies.
Franchises without consistent performance and clear succession plans might suffer from the same evolutionary struggle for capital facing their portfolio companies —but from the finite universe of LPs
Why investing is not (necessarily) a zero-sum game — a trade doesn’t necessarily have a winner and a loser. The seller could be selling for a 5x gain, and the buyer could be in for a 10x gain. Sure the seller may have missed out on the upside, but they still made a good chuck of change.
Follow the flow. Always follow the flow.
Historically, similar flights to quality have occurred among GPs in other asset classes, with LPs culling their managers and consolidating their positions, writing larger checks to their best managers. Perhaps this consolidation might best be modeled by a path-dependent phenomenon called the “Yule” distribution, whereby capital allocation decisions accrue to managers according to how much they already have
Tl;dr: The rich will get richer.
It also explains why the top 10 hedge fund managers control about 80% of the AUM of the entire asset class. In the 1990s, the top 60% of active equity managers enjoyed inflows. In the 2000s, the top 30% of managers did. In the 2010s, only the top 10% did. The Yule distribution is even more pronounced among passive equity managers, whereby the top 3 index fund managers manage 82% of all inflows over the past decade
Tl;dr: The rich got richer
We venture that the phenomenon we have described in the past of Minnows and Megas will result in a dramatic contraction and consolidation with 50% or more firms ceasing to functionally exist in the next few years.
Traditional venture funds may cease to exist, but it seems like microfunds and scout funds are increasing like crazy. However, just because there are more funds doesn’t mean there is more capital. Remember: follow the flows.
As written in Minnows and Megas:
Late last year we discussed a dichotomy we dubbed the “minnows and the Megas.” This is what we called the two-sided barbell, with one side having (a growing) large number of small funds and the other side having a small number of very large funds (e.g. Softbank and Softbank-induced super-sized global pools of capital). As a matter of strategy for Lux, the former are a source and supply of investable opportunities and talent, while the latter are a source of later-stage (and potentially) lower cost capital or liquidity”
Wow. This is beautifully written. Couldn’t have worded this any better myself
We expect to see mass consolidation of the Minnows, combining together or being absorbed into larger platforms.
Of the nearly 900 funds managing $100M or less, we expect half to fade away in the next 3 years
I wonder what the breakdown of that will be… more <10MM funds?
Wonder what will happen in the public markets… will there also be a consolidation of capital?
At it’s pre-crisis peak, the total amount of capital raised by U.S. venture funds larger than $1 billion was $8.3 billion. A decade later, the total was $22.3 billion. Thus, we expect many of the Megas will also be fine and some will get much larger — but with an entirely different LP base (more pensions and retirement plans than savvy endowments or sophisticated family offices), and with size they will have very recognizable respected brands, but more modest returns — the same phenomenon that occurred in private equity and hedge funds. They will expand product offerings into growth, debt and beyond — and they will be chosen more frequently by LPs than by entrepreneurs.
We’re seeing this everywhere already — Blackstone started a growth fund, Altimeter is investing more heavily in privates, and Coatue started up an early stage venture practice
Relatedly, we also expect an amplifciation of the most important factor in venture: dual-selection. Unlike most other asset classes, where the manager solely has to worry about picking the right security, in venture, the security (the entrepreneurs) also must pick the manager.
This is fascinating. I’ve never thought about it this way — the security has to choose the manager. What an interesting thought… I’m going to stew a bit on what this actually means…
Micro to Macro — and Tactics
security selection in venture (finding the best entrepreneur developing the best technology in the best sector) is like picking the best dish on the best menu in the best neighborhood of the best city of the best state of the best country — the ultimate micro decision. And just as you are about to take a bite — Godzilla steps onto the city. Ignorance to macro forces and complex capital flows is no virtue.
PAY ATTENTION
The obsession with founder-turned-VCs is dangerous when said founders don’t understand macro forces and capital flows
Investment Pace
We have been fairly deliberate over the past few years as we’ve publicly expressed concern over valuations and expectations that were running ahead of themselves
It is all relative, but we have been in more of a conservative and disciplined (rather than momentum) mindset for at least eight quarters.
Speaking in quarters seems like a very hedge fund thing to to do… most venture funds seem to publicly talk about months, years, decades. These guys run a tight book
Cash Management
Some of our companies are already communicating they are cutting costs — but of course one company’s cost is another’s revenue — so we also expect there may be two quarter delays or longer for pipeline and critical deals that may have been near closing that will be delayed, or in some cases, disappear — causing hits to growth.
CASH IS KING
Talent Management
It is a necessary time for CEOs and founders of our companies to show leadership, be honest about risks and clear-thinking, clear-communicating on strategy and course-setting. It is a time to be a trusted resource for employees and their families, getting them or loved ones information and access to healthcare or assistance if they need it. It will be critical to retaining and attracting top talent. As some companies falter there may be great opportunities to seize on great talent additions.
The value investor in Josh here really shows… tough times are opportunities to grow. However, notice J+P write FIRST AND FOREMOST that they must take care of their existing family, before they go out and bring in more.
Supply Chain
Many of our pre-revenue technology- or biotechnology-driven companies have had some hiccups in supply chains… The silver lining is other Lux companies who have technologies for remote access, robotics and automation are already seeing renewed interest and demand as other companies assess and rethink their own risks — we await to see if and when the interest converts into order and cash.
Don’t count your chickens before they hatch… A perfect example of the relationship between Josh and Peter… cautiously optimistic.
Valuations
The process of closing financings (and rounding up syndicate members) has taken longer and especially now we ascribe a higher probability to broken financings. But valuations have still not come down to what we would view as a new normalized level as there is some lag period before it materially impacts private markets… we have a handful of companies at risk that we are paying close attention to, largely owing to financial difficulties but also business underperformance… we have and will continue to write down or write off our underperforming or weaker companies
I think most people would gloss over this paragraph when reading this memo… but to me this is one of the most telling of Lux’ character, and you can see they value intellectual honesty (and the “Lux” name of light and truth)
Lux acknowledges they have underperforming companies (they don’t try to blame anything on corona), and also have and will continue to write down companies (I’ve heard of and know of funds who refuse to write down some companies until they are FORCED to)
There will surely be surprises — but we have been vigilant for so long now that we feel like the outlier in the boardroom urging preparation, conservatism and risk-thinking.
Lol shots fired. I interpret this as “most people aren’t vigilant” — interesting to hear J+P consider themselves contrarian for urging preparation (but this is because I subscribe to the same school of thought as Josh and know it’s not “normal.”)
Special Situations
We find it pernicious the view that only 10 or 15 companies per year matter, and so the price you pay does not matter. The price you pay is the main thing that determines future returns. If marginal price-setting capital dries up, we may again see great companies with sound balance sheets and impaired capitalization tables present special situations as they did a decade ago — getting Series C or D stage companies at Series A stage prices
Aahahahahahahahahha. Shots fired directly at a16z. Hahahahahahha. I’m pretty sure this is Josh here… although I guess he’s mellowed out a bit… he once called out — by name — investors (VC/HF alike) and politicians as “biofools” and “commodiots” (although I won’t do that here haha).
Please call or email us any time — to share non-obvious intel, views and correct or solicit ours. We appreciate your continued support and partnership.
Again, you see Lux’s values on full display here:
1) Please call or email us any time = we are accessible and here to support you
2) share non-obvious intel, views = we’d love to learn more but don’t waste our time or yours; we’ve been looking and thinking about this deeply
3) correct or solicit ours = if we’re wrong, let us know. Happy to change our minds (Druck’s superpower — see some quotes below). And again, happy to help improve your flow of information if needed/desired
“Probably one of my greatest assets over the last 30 years is that I’m open-minded and I can change my mind very quickly.”
“When you’re betting the ranch and the circumstances change, you have to change, and that’s how I’ve always managed money.”
“If you make a big bet, be open-minded, if the situation changes, you must change.”
“One of the reasons of my success was open mindedness to various asset classes. It gives you the discipline to not play when you shouldn’t be playing. If you look at bonds, currency, equities and commodities, if you are involved in a whole bunch of different asset buckets and open-minded you tend to only play when you should.”
Wrap-up
If you’ve got any thoughts, questions, or feedback, please drop me a line - I would love to chat! You can find me on twitter at kevg1412 or my email at kevin@12mv2.com.
Please DM or email me any time — to share non-obvious intel, views and correct or solicit mine. I appreciate your continued support and partnership :D.
All compilations here.
Last sentence well-played. Does Josh ever talk to you in person?