The Next Berkshire Hathaway #48
Suthen's newsletter on the future of work, building businesses and financial independence
Happy Monday!
For this week’s post, I decided to look into Social Capital. They invest across all stages (from seed stage companies to public companies).
The firm was founded by Chamath Palihapatiya, a former Waterloo grad who grew up in Ottawa.
Chamath's evolution as an investor has been a big inspiration for me.
The Next Berkshire Hathaway
Chamath started off his career at the bank, switched to the technology/VC space and soon became the VP of Growth at Facebook. He's famously known for growing Facebook's user base to 1 billion users. Despite having ~$1B in stock options, Chamath left Facebook to start his own investment firm called Social Capital. Today, he's known for being the Chairman of Virgin Galatic (a company that I featured a few months ago) and a minority owner of the Golden State Warriors.
I first learned about him after watching this interview back in 2018.
The level of introspection he had done to understand when he's at his best and when he needs to make a change was very inspiring.
I think all of us have benefited and been traumatized by our upbringing. Doing some deep reflection can help you understand how your past traumas might hold you back.
Since starting Social Capital in 2011, Chamath has made some incredibly lucrative investments that required a tonne of conviction at the time.
This doesn't include the success of Bitcoin (in 2013 when Bitcoin was just $130) and the subpar performance of Box (in 2018).
More recently, he's started to publish annual letters. I've taken a crack at highlighting some of the key excerpts below but I'd recommend giving them a read to understand how Chamath viewed the world at that point in time.
2018 Annual Letter
Maturation of the Tech Ecosystem
Cloud infrastructure has become a common foundation for the entire industry. Initially misunderstood by many, it is now unlocking waves of innovative entrepreneurship, frenzied business competition, and newly created value for consumers. The same can also be said for the continuous deployment and improvement of mobile phones and wireless internet. With the majority of the world’s population now connected, and with our phones with us personally at every minute of the day, it is little surprise that every industry is being remade in the mobile Internet’s likeness: media, retail, transportation, and more.
While cloud adoption continues to grow at historic rates (e.g. Microsoft Azure continues to grow at 50% despite being a $50B business), COVID-19 has taught us that we still have a long way to go. There are still many services/products that have not been built yet for several parts of our population - especially the ones that are most vulnerable.
Big Tech will get bigger and will leave less room for obvious companies doing obvious things. The demands of innovation are going up, and the quality of the ideas and teams working on those ideas matter now more than ever in this David v. Goliath landscape.
I personally have mixed feelings about this statement. Some companies (e.g. Amazon) have done incredibly well while others (e.g. Facebook and Google) have been rather underwhelming. This has given the opportunity for companies like Zoom, Slack, Twillio and many more, to emerge and own categories that theoretically should have been led by the incumbents.
New Money
The quantity of capital that has made its way into the tech ecosystem seeking to fund the next generation of successful businesses has steadily increased. These mega-funds exist because there’s a real opportunity to act as a king-maker for growth-stage companies trying to be big companies. As a result, these “mega-funds” are likely here to stay. However, these mega-funds only tell half the story: there has also been a continuous surge of seed capital flowing into the industry as successful founders, builders, and fund managers reinvest their own money into the earliest stages of technology startups.
...The collective returns reflects the new reality that venture capital does not deliver a premium for its investors. In fact, the VC industry reliably trails the S&P.
This trend has, if anything, grown over the past couple of years. As I wrote last week in my feature on ARK, this has created an opportunity to invest in innovation in the public markets.
The Accelerating Treadmill of User Acquisition
We don’t necessarily know which channels they will choose or the particularities of how they will spend money on user acquisition, but we do know more or less what’s going to happen. Advertising spend in tech has become an arms race: fresh tactics go stale in months, and customer acquisition costs keep rising.
The lifetime of growth tactics continues to decline very quickly. A successful social platform/campaign idea can get copied in weeks or months, making it hard to have a sustainable marketing approach. Even companies with a core product have to spend time spinning up ancillary products at zero marginal profit to solidify their position in the market. No company has done a better job of this than Amazon, they seem to have built a machine that capitalizes on consumption.
Anything that anyone consumes is a potential product for Amazon.
The Shuffle Game
Part of the reason why American healthcare is so expensive is because insurers, who play a key middleman role in setting prices for medical care, have a fantastic two-sided business model. High prices, which ought to be a cost of doing business for them, are actually a key revenue driver. Why is this? High costs allow them to charge higher premiums, allowing them to pull steadily more and more money out of patients’ and payers’ pockets. As a result, the cost of medicine steadily rises, as do the insurers’ take. In the end, both patients and payers are the ones who end up as bag holders footing the bill.
The same thing is happening in today’s venture world. Highly marked up valuations, which should be a cost for VCs, have in fact become their key revenue driver. It lets them raise new funds and keep drawing fees.
Later in the letter, Chamath points out that there are two groups that foot the bill for the VC ponzi scheme - the future and the employees. As someone who's been in the shoes of an employee, I can see his point. Employees don't receive a discount against the massively inflated valuations caused by factors outside of their control.
Trends to Invest In
Artificial Intelligence
Over the next few decades, as more engineers are trained in artificial intelligence and as developer tools and frameworks get easier to use, we should see artificial intelligence successfully applied to problems that were previously too difficult using traditional software methods, such as self-driving cars, robotics, and drug design and discovery.
Computational Biology
Within a few years, we’ll reach a convergence point where our recent advances will start to overlap, and eventually blend, into our existing computing frameworks and infrastructure. This will have a profound and disruptive effect on many fields such as drug design and discovery, drug delivery, precision diagnostics and healthcare, engineered materials, ecology, agriculture, and much more. We’ll be able to work with biology in ways that increasingly resemble the way we work with software: as a platform for building tools, applications, and infrastructure.
I am most excited by the developments within biology. I think are still in the early stages of figuring out what this even means/looks like. I am only beginning to understand this space and make bets accordingly. More to come on this.
2019 Annual Letter
The Gilded Age
Over the past thirty years, we’ve seen our own version of the Railroads and have created our own Gilded Age. A few companies have done wonderful things with technology, creating a massive downdraft of costs and an attendant upswing in value - a consumer surplus like we could have never imagined. But it came with a cost.
For a few companies, entrepreneurs and their employees, massive gains in wealth, status and influence were realized. Meanwhile, for the rest, wages stagnated, insecurity grew and the cost of this lopsided economic allocation became increasingly obvious. Most people are now left to internalize why they won’t live better than their parents, and even more concerningly, that they won’t be able to give the chance of a better life to their children.
In turn, populism is on the rise. Whether its via surrogates on the right who want stricter borders and nationalistic economies or their equivalents on the left that demand universal social programs, increasingly loud refrains are being made for change - any change.
The idea of moving toward a progressive era doesn't scare me nearly as much as the amount of poor information fed into our system. We don't know who or what to believe and it has become harder to create signals of trust. We are unable to use any metric (wealth, income, status, likes, influence, power) as a proxy for trust. One needs to dig deep to understand what to progress toward.
This makes political chaos inevitable.
The Tightening of the Regulatory Noose for Big Tech
Phase 1: Across the world, governments are realizing a growing responsibility to act by stepping in and attempting to break up these behemoths, forcing divestitures, demanding transparency, and in the specific case of ad-based businesses, modifying auctions to limit artificial bidding wars and disabling broad scale data gathering and surveillance of people.
Phase 2: Governments will eventually demand that any revenues and profits generated by Big Tech inside of their borders from their citizens should be subject to local taxes. Exogenous events like the coronavirus pandemic will make stronger cases for more resilient national economies, less globalization and more restrictive borders and trade agreements.
Phase 3: Governments can do a lot to make it more expensive for Big Tech to hoard human capital and allow this talent to flow more naturally to small businesses and startups so that they can more effectively compete and create vibrant ecosystems. They can do this by making stock based restricted stock unit (RSU) compensation extremely expensive to companies above a certain size or profitability by taxing them more onerously and forcing GAAP reporting of stock based compensation.
Chamath's post above puts a lot of emphasis on the government and the regulation they come out with (specifically around anti-trust and taxation). I think we should also take a deeper look at the capital markets that support the big tech model. Up until now, capital has largely flowed toward 'businesses of today.' This is especially true for passive investment vehicles.
A big reason for this is due to the lack of long-term oriented investing. This then leads to the question as to how can we condition passive investors to have a more long-term orientation. I believe that there's a two part answer to this. The first one is that the people behind this system are compensated in < 12 months (and sometimes immediately) in cash and stock options. The second is that the general public is also able to profit on short term gains by buying and selling stocks/options.
Stocks is the only type of asset that allows for immediate profit taking despite the fact its underlying asset (the business) takes 10+ years to build. Imagine how convoluted our world would be if we can buy and trade shares in individual houses/neighborhoods/cities.
If we didn't allow the immediate liquidity of stocks (e.g. have a minimum holding period), then short-term fluctuations wouldn't matter. People would be more focused on what the world would look like in the long-term.
The Credit-Equity Bubble
Our simple framework is this: as money gets cheaper, the credit markets continue to expand because CEOs become motivated to artificially boost EPS. They do this by buying back stock, seek bad acquisitions, make poor capital allocation decisions or avoid taxes. All enabled by borrowing massive amounts of essentially free money.
Adding to the problem that Chamath talks about above is the fact that we fuel the entire system using the central bank. The past few months is a great case study. Stock markets continue to rise despite most of our population being un/underemployed.
Money Raised ≠ Value Created
Now more than ever, the practitioners of venture capital continue to decay in capability and the historical experience they draw from - they’ve never done anything important! They are increasingly motivated by the incentives of up-rounds, bigger funds and fee-based compensation. The flood of fast money has created a surfeit of these overnight practitioners with questionable sources of capital and even more questionable backgrounds. The most telltale signs of this trend are in the decaying governance in high flying unicorns and the ravenous capital consumption of some of these companies.
Big Tech raised a total of $1.345B in venture capital before going public of which $1.3B was Facebook alone. This means that Apple, Amazon, Microsoft and Google raised less than $45M combined before IPO. Even on an inflation adjusted basis, this is incredible and tells something very important about a raft of today’s startups.
As we’ve seen with WeWork ($14B raised), Uber ($25B raised), Lyft ($5B) and a few other hi flying private companies, the public markets will rationalize valuation and enforce a valuation model that won’t allow tech-enabled hybrids to be valued like pure-play tech companies.
Expect more of these valuation resets as companies stay private longer (dumb), have poor or negative unit economics to drive growth (dumber) and continue to be over capitalized (dumb and dumber to).
Chamath brings up a lot of interesting points here. The first being that capital does not equal progress. At Constellation, we've found that businesses benefit more from a disciplined approach toward capital allocation vs. spending large amounts of capital.
The second is around the idea of companies staying private. While this has worked for a select few (e.g. Stripe), I believe that there's some value in the fact that companies being publicly traded.
More recently, we've seen a push toward companies becoming public via a direct listing or a SPAC (special acquisition corporation).
In 2019, Chamath took Virgin Galactic public by merging it with $IPOA (which is now $SPCE). Here's his tweet at the time.
In terms of cash, Social Capital delivered $671M in both primary and secondary proceeds.
In terms of size, this represented the 11th biggest IPO of 2019.
In terms of holders, they had almost 20x the number of holders of the stock, giving many more people a chance to participate.
In terms of mechanics, because this was a merger vs a traditional IPO, we used an S-4 process vs S-1 which made things more streamlined, and allowed management to focus on running the company versus running an IPO process.
Earlier this year, Chamath raised two more SPAC called $IPOB, a SPAC that will target a technology company in the U.S. and $IPOC, a SPAC that will target a technology company outside of the U.S. Both SPACs are expected to acquire companies by the end of 2020.
While the terms are fairly ambiguous, Chamath's track record does speak for itself. I'd liken both SPACs as a call option (forward-looking bet) on Social Capital / Chamath.
In this interview with Chamath in May 2020, he gives the following outlook:
“Right now we are going to go through two or three years of pain. And then I think going into 2024 and out of it, we’ll have a political change, we’ll have an ideological change." He believes there will be deflation in the real economy and asset inflation at the same time, given the Fed’s recent moves to support financial markets. That might “unfortunately end in massive civil conflict,” Palihapitiya says. “The question is, how tumultuous is it from here to there? And can we get the next generation of leadership that keeps the lid on so that it doesn’t blow off?”
It's an interesting outlook and one that will vary by geography as each country has a unique combination of political strife, inequality, and demographics. As a fellow Canadian, I look forward to seeing the evolution of Chamath's thinking.
Here are some other interviews that I've enjoyed listening to:
Thanks again for reading this week’s newsletter. If you can just comment on what you think is interesting, what you find confusing, and what you think is boring or irrelevant, that would be really helpful.
Until next week,
Suthen
The Next Berkshire Hathaway #48
I knew his name generally, but did not know his background - thank you for sharing. The point about the ponzi scheme of management money is why I left the financial sponsor industry. Not only are the incentives such that bigger is more important than better, but the sponsors are often buying and selling to each other because there are no other buyers! Often the LPs at these various funds are the same people. Pure rent extraction versus value creation lining the pockets of the GPs.