Looking at microcap stocks
Back to my series documenting the story of how we tried to raise a new, innovative investment fund in a historically bad climate.
I wrote earlier about how we got started and how we put our team together. After a short time, we settled on a strategy. We decided to do something that hadn't really been done before: we would take the venture capital model to the public stock market.
What does that mean? First of all, I think of the venture capital model as one of being an active, engaged investor who works with a company to build value. You need to have a significant stake in the company and perhaps a board seat to ensure that your interests and the company's remain aligned. This is usually applied to private companies where the VCs own a controlling stake in a company. They usually buy a preferred class of shares to ensure that they get their money out first in the event of a sale or liquidation. Most of these private company ideas wouldn't work in the public markets. More on that below.
Our targets were public information technology (IT) companies that had market capitalizations between $50M and $250M. These stocks are largely ignored by public market investors and have low trading volumes. Until a company is worth about $500M, most money managers won't buy the stock. Public investors value their liquidity -- the ability to sell quickly. Like venture-backed private companies, these smaller public companies were not very liquid. You could definitely get in and get out, but you had to do it carefully and over time. Too much buy side or sell side pressure, and the stock could move a lot. Not good for your investment strategy or your reputation.
We wanted to be constructive and have a positive reputation with companies. Our approach was to identify companies that we felt were significantly undervalued in the public market as measured by both their financial metrics and their product offerings. This required more than typical public market diligence -- you had to evaluate their financials and look at their business and how it could be restructured or improved to increase value.
Once you find such a company, you have to approach management to see if they were receptive. Since we were 'constructive activists', we needed to get management, the existing board, and perhaps some of the larger investors to buy into our strategy for the company. We generally found a very positive reception, but sometimes the companies wanted to keep doing what they were doing, despite the lack of appreciation by the public market.
The companies we liked best usually didn't need more cash. So, we didn't invest directly in the companies. Instead our plan was to purchase shares in the company in the open market to build up a position. We found that we would have to work with trading partners who specialized in this type of transaction. They could buy stock in illiquid companies without driving the price up (or sell without driving it down). If we liked a company, our strategy was to buy 5-10% and perhaps take a Board seat.
We were planning to be long-term owners. We'd own the stock for 2-3 years. We didn't plan to short stocks -- we were 'long only.' This kept us on the same side as management and differentiated us from hedge funds. In fact, we were more like a late stage VC -- buying a position in a company that had revenues but had the potential for significant value creation. We'd hold onto the stock until we had built some value, which helped all the stakeholders.
The benefit of doing this in the public market was that you always had the opportunity to change your mind if you wanted. Although not always easy to sell your position, it was sellable. VCs generally can't sell their position in private companies at prices near the market value. When they do sell, there is generally a significant discount. Being able to control the exit timing was a critical element to this strategy.
Another benefit of investing in public companies is that you could chat with other investors to get their thoughts on a company. This isn't collusion, just a discussion of what you thought of a company's public information. We learned a lot by talking to other public market investors, particularly as we were new to the game. Our VC skills would help us once we invested, but there were nuances of the public market side we had to learn.
Our historical analysis showed that there have always been significantly undervalued public IT companies, independent of the overall market cycle. During down markets, there are just more of them, and they are even more attractive. We did put some money to work in some companies we liked, and we did very well. We struck up some constructive relationships with some management teams, but without outside capital, we couldn't build up a big enough position to have a real say in the companies. We'd need about $12-15M per deal and a $250M fund to make it work.
It was tough getting investors to appreciate what we were doing. One of our biggest problems was the 'bucket' problem. Most institutional investors have buckets, or categories, for their investments -- venture capital, buyouts, international stocks, real estate, etc. Our firm was a cross between late stage venture capital and public market investing. Some investors couldn't do any public market investments. In other firms, the two buickets were managed by different people. And, our public market strategy was different than what they wanted -- they valued liquidity in public stocks even while they tolerated illiquidity in private company holdings. It was rare to get an investor who understood VC and was willing to consider public stocks.
We did start to build some traction but were stymied by the market maltdown in September 2008. Our traction went to zero, and we waited out the worst of the market to evaluate our plans. Even so, it was frustrating to not get further before the meltdown.
In addition to the bucket problem, we also faced the first-time fund, first-time team problem. Investors are very wary of backing new teams (will they stick together?) and new funds (do they know what they heck they are doing?). These are valid concerns, and we had our strategy for overcoming them. But, it took a long time with each investor, and we didn't make it over the finish line before the race stopped with the market meltdown.
In looking back, perhaps we were wrong to try to do something new. However, it was also clear that investors weren't looking for 'more of the same.' That fickleness was frustrating and explains why it's so tough to get a new firm off the ground. There is still an opportunity for this type of microcap venture-style investment. Some VC firms dabble in this now, and perhaps someone will take our strategy and make a lot of money with it. That would be satisfying.