In This Issue

1. Survivorship Bias & Investment Expectations (main story)

2. News Roundup

‼️ TOP STORY
Survivorship Bias & Investment Expectations

Startup Investing

There are a lot of reasons to be excited about equity crowdfunding and the increased accessibility of investing in private companies.

One, it provides avenues for impact investing. A collection of retail investors can turn many small capital contributions into significant support for a founder, business, mission, or problem that needs solving.

Two, more avenues for raising funds also means that a more diverse range of founders and companies have a shot at getting consideration for investment.

Three, companies that allow their customers and audience to invest through “community rounds” can add an entirely new dimension to the relationship with their most dedicated customers and community members.

Four, it allows smaller investors to get in early at lower valuations. This opens up the possibility for a level of returns that is extremely difficult to impossible to get in the public markets.

However, it’s this fourth item where care is needed.

Setting The Trap

One of the most famous startup investing stories is Airbnb. For the few venture firms that backed the company during its seed round, their returns upon Airbnb’s IPO were simply eye-popping.

Putting $1000 into a good idea, waiting 10 years, and cashing that in for $5M basically sounds like the dream for any investor, especially for anyone hoping to get rich moderately quickly.

With that kind of return, you can be wrong 99% of the time and still have a nice return. Investing $1M and having $999,000 of them be complete duds but having one turn into $5M is still a 5X. Not bad! Right?

Well, here’s the thing.

We can pretty much say for sure that isn’t going to happen for anything you’re investing in.

A rush of objections might be forming already - but why? It’s happened before. It’s actually happened plenty of times. All the early investors in major companies like Airbnb made huge profits!

Which brings us to survivorship bias.

Survivorship Bias

Put most simply, survival bias results in an incorrect expectation of what the realistic potential outcomes of something are.

Expectations are skewed because we unintentionally make our assessments with a biased sample of data. Those that “survive” are more likely to be noticed or included and thus have a disproportionate effect on how we view things.

Let’s try a sports metaphor.

Let’s assume the statement “Any Quarterback that plays in the NFL for more than 10 years is basically a lock to get into the Hall of Fame” is true for this example.

So, does that mean the Hall of Fame criteria is basically just a count of how many years you played in one or more games? That a player that plays in one game a year for 10 years would be a likely candidate?

Something is clearly wrong here.

The issue is that the statement is true because it inherently filters out many players. Think about it - how hard is it to be on an NFL team for even one season?

Only the best players in the world can compete for those limited roster spots. Then how hard is it to do that consistently for years at a time? Many players that have one or two good seasons disappear from the professional levels, unable to consistently execute at that caliber.

That means to be able to play in the NFL for 10 years, you actually have to be among the best players in the world for that entire time. So, our original statement sneakily speaks of only a small, elite fraction of athletes in the sport.

Imagine if we had instead said “Any Quarterback that can be among the best in the world at the position and consistently hold their own against professional competition for 10 years is almost a lock for the Hall of Fame.”

Now, that doesn’t sound so crazy, does it?

How Does This Relate To Investing?

Now, consider the following illustrative statements, while thinking about survivorship bias:

• “The average exit valuations for companies in our industry are between 8-12X yearly revenue.”

• “Investors that got in during the seed round of companies that eventually IPO’ed saw an average gain of 25,000%.”

When you see them, they sound very enticing. It feels like you’re setting yourself up for a really big win. You’ve found an amazing opportunity.

And maybe you have. But, statements like these are misleading your expectations with their survival bias.

Sure, maybe companies in that industry do tend to get acquired for that much. However, what percentage of startups actually have enough of a product and business fit to get acquired in the first place?

This is an illustrative example, so we can’t really investigate, but I feel fairly confident saying that it’s a whole lot less than 50%. Maybe less than 10%. Imagine seeing this instead:

“There’s a 90% chance this turns into nothing, and a 10% chance we can exit for around 10X our revenue. Even then, that’s only a nice return if we can substantially grow revenue over the next few years.”

I bet you’d think a lot more before making an investment if you saw this version instead of the original.

Conclusion

It’s great that we continue to see a democratization of access across alternatives, including investing in startups and private companies.

However, while there is great potential upside, it’s important to remember that many of the facts and figures about potential exits and returns are laden with survivorship bias.

It’s important to realize that and to have grounded expectations about the risks and rewards (or probable lack thereof) when making investment decisions. Otherwise, it’s easy to get overly excited and make a poor decision based on unrealistic and improbable expectations.

ALTERNATIVE INVESTMENT NEWS ROUNDUP
🏠 Real Estate

Outlook Still Uncertain

As we discussed last edition, it seems there’s still no consensus on which direction the real estate market is heading.

Scott Rechler, who leads RXR Realty and is member of the Board of Directors for the Federal Reserve Bank of New York has an interesting take on it.

He likens the market upheaval in commercial real estate to the stages of grief and suggests that we have now arrived at acceptance. What is being accepted? The end of the post-2008 paradigm and the beginning of a new one.

Perhaps the reason there’s so much disagreement over the market direction is because not everyone has accepted the end of the old paradigm. Even among those that have, there’s considerable uncertainty surrounding the new one.

Here’s a roundup of other interesting takes we saw:

Bullish

• A Business Insider piece documents a few bullish threads. Most notably around a potential decline in interest rates and sentiment being overly negative.

• Axios documents some improvements in the commercial real estate market. They report that the pace of dealmaking is slowly starting to pick up. Things are still slow because there are many banks (holding ~40% of all US commercial debt) are hesitant to make a deal that forces them to realize a loss.

• Goldman Sachs is going to resume investing in US commercial real estate again as they believe we are at or near the bottom.

Bearish

• An executive at Brookfield Asset Management believes there’s an oversupply of office space in the US. The mismatch between supply and demand they believe is the worst in the world.

• An article in The Wall Street Journal covers the lack of forced sales of office space. Given all the doom and gloom around the market, you’d have expected many companies were forced into financial positions that required them to dispose of their office space to stay afloat, even if at a loss. This underpins the headline that the “fire sale” in office space hasn’t even begun in earnest yet.

NAR Uncertainty

Late last year, the National Association of Realtors (NAR) lost a pivotal court case relating to their commission practices. While the loss was substantial on paper, it lacked an immediate impact.

Now, several months later, that impact is emerging. A settlement addressing nation-wide claims against the NAR was announced on Friday. The settlement must still be approved by a judge. If approved, changes could go into effect as soon as this summer.

The settlement sees the NAR dropping long-standing practice of setting and advertising buyer’s agent commissions on listings. It is believed this will open cost negotiations for buyers and ultimately reduce the cost of real estate transactions in the US.

On the other side, detractors believe that this will lead to an exodus of real estate agents and ultimately more time, confusion, and mistakes by under-educated buyers going DIY for the first time.

Other

It seems that the Chinese government has no intention of bailing out their fraught property development industry.

The impacts of this are likely to remain unclear for a long time. However, given how significant China is to the global economy and that this same industry was once 30% of their GDP, there’s a good chance it will cause issues beyond their shores.

🎵 Music Royalties

• As Billboard reports, it sounds like underpaid streaming royalties from 2018-2022 will start to be released in May.

• It looks like UMG may no longer be alone in their dispute with TikTok. The National Music Publishers Association has informed its members that it expects to let its license with TikTok expire at the end of April. See our previous spotlight on the TikTok and UMG dispute here.

• Members of The House of Representatives have introduced a new bill that would effectively raise royalties paid from streaming. It’s unclear if enough industry or political support exists for the bill to go beyond a simple proposal.

🎨 Other

• Jerome Powell indicated that high insurance rates are a factor keeping inflation high. Much of this ties back to extreme weather and climate change. These seem likely to continue to pressure the insurance markets and provide upward pressure on insurance pricing. That could make climate change and its aftereffects a consistent headwind resulting in higher inflation over the long term.

• The US House of Representatives passed a bill that would require either the ban or divestiture of TikTok from its Chinese parent company. It’s unclear if this will make it through the Senate, or even how this would play out if it became law. Given its cultural gravity, this is a story worth watching.

• Elon Musk recently had his $56B pay package struck down in court. Now the lawyers are asking for hefty compensation for their win - $5.6B. That sum could set a record. As the ceiling for legal fees increases, does litigation financing become more appealing?

• Amazon has levied a new round of fees on the independent sellers that use their platform. Based on Fortune’s reporting, sellers feel the potential impact is catastrophic to their businesses.

• Crowdscale recently discussed HR 2799, a bill that would substantially change - and expand - the definition of accredited investors. However, it seems the bill has no chance of becoming law.