On due diligence and the concentration of investment power

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This is not just another article about the WeWork debacle.  There has been much written about what not to do in the wake of WeWork.  There has also been much written about the other culprit in this story, the mega investor, SoftBank, and why the deflation of the tech bubble it created is a good thing.  And for the most entertaining, as long as you’re not a sorry start-up investor or employee, this half serious and half satire piece is a must-read.  Take your pick, who’s the victim and who’s the villain, though most observers would argue for two villains! 

Rather, I’ll focus on two important lessons.  The first for investors, both GP and LP, and the second for start-ups and entrepreneurs.  In the first instance, I would like to highlight the importance of due diligence (DD) as this important milestone has sadly been often overlooked; and secondly, to warn about the recent trend of concentrating enormous investment power in the hands of a few.  The best example being Softbank’s giant Vision Fund.

On due diligence

If there is one lesson to draw from the WeWork debacle, it is that there is no substitute for investors to commission independent, professional, and specialist advisors to conduct DD prior to investing, rather than the pervasive follow the herd mentality or worse, rely on gut instinct approach when chasing high-value targets.  LP’s contributions to GP’s funds should be made conditional of transparent and honest third-party DD prior to each investment.

Bloomberg’s Matt Levine commented “private markets are the new public markets”.  This highlights in my opinion more than ever the importance to let professional and independent DD serve as a guide for private investments. 

Was WeWork really a tech company to justify the lofty multiple it earned?  How unique and how difficult to recreate was its tech platform? The answer to both questions is probably not so much.  Had its bubble not deflated yet, perhaps we wouldn’t be having this conversation today.  But it did and it’s important to draw lessons.  FT’s Henny Sender argued “many entrepreneurs say SoftBank financing has become a negative brand and that a coalition of other investors can be more effective than SoftBank in equipping startups to survive in increasingly competitive environments”.  He added, “the fact that these are more sobering times for tech should be celebrated rather than lamented. If some of the froth is now blown off the sector, that will make a more violent correction in valuations less likely later, which can only be a good thing.”  As I write this though, SoftBank, rather than writing off or at least writing down its investment in WeWork, has decided to double down.  I cannot wait to see in a year or longer, if WeWork remains solvent by then, whether SoftBank managed to right the ship or created even more losses for its investors.  SoftBank has relied in this case on chemistry, bold ideas, and yes craziness, to make investments, rather than professional DD.  But not every investor has a fund as large as Vision Fund and therefore can withstand the losses of billions. 

DD should be performed as part and parcel within the investment process and decision to invest or not, rather than a rubber stamp procedure often commissioned at the very last step prior to a transaction, no matter its outcome.  Furthermore, the DD team should be invited to present to the investment committee being called to evaluate the deal and approve or disapprove it.  These are rules that should be enforced by LP’s.

On the negative effect of concentration of investment power

Focusing on Asia, which I observe more closely, it is troubling to witness the pervasive investment by the same mega players, especially from China’s own internet stars and Softbank.  A look at the diagram Actel Consulting has compiled below shows the extent of investment in the hands of a few and how intertwined it is across multiple promising start-ups, all unicorns, particularly from South East Asia and India.  This illustration is not meant to be exhaustive, rather to serve as an example of how pervasive these investments have become.

For a while now, the industry has been experiencing frosty valuations fuelled by the abundance of cheap money and the dearth of alternative viable investments.  The concentration of investment in the hands of the mega-sized few does aggravate matters. 

A tide lifts all boats, so all is well until it isn’t anymore.  Recent examples are aplenty, the most sensational being WeWork, but Uber and Lyft, to name a couple others, although much less dramatic, prove the point too.  It is no doubt that unicorn founders, and their existing investors, should be having concerns at the moment.  These entrepreneurs must be revisiting not only a more realistic and defensible valuation for their start-ups, but also how much and from whom they accept further investment, should it be needed. 

The fact that SoftBank is reportedly struggling to raise more money for its second mega-fund called Vision Fund 2 is a welcome relief.  The last thing the industry needs is another mega fund with enormous and often irrational investment decision making.

The message to investors is: please give more importance to transparent third party DD and include it as part of the investment process rather than as a tick-the-box approach; and to entrepreneurs: beware of the lure of the mega-fund that pours money onto your startup as this is a double edged sword.  Just ask WeWork.  

Written by Claude Achcar, Managing Partner, Actel Consulting


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