Happy Halloween. True fear is something many of us have the luxury of not feeling on a regular basis. In the world of public market investing, some fear can accompany an unjustified selloff or the news of an activist in the boardroom. In private equity, we can get scared when a Giant announces investment in our space, or a competitor beats us to market in a photo finish. But none of this is true fear.
Great horror movies teach us that true fear is born of betrayal. Loss of trust. The sudden realization that the very people who hold our future in their hands are indeed not on our side. Think of The Purge’s Grace Ferrin, who saves the Sandins from a murderous gang only to prey upon them herself. While life and death are rarely at stake, the scariest state of affairs for an investor is certainly the dreaded CONFLICT OF INTEREST. The thought of a CEO, board member, or even fellow investor working actively at cross-purposes is certainly scary enough to justify a scary Halloween post.
The call is coming from inside the house
I have news for you. Conflicts of interest (COI) are already a part of your life. Ulterior motives run roughshod over almost every human interaction we have. In the immortal words of Bill Burr, “I don’t know what you’re up to, but I know you’re not trying to make less money.”
My first experience with a COI was when I consulted a financial advisor straight out of college. I had saved some cash from sundry exploits and knew enough to know I didn’t know enough. I trusted this advisor (associated with a major bank) to guide me in the right direction. I ended up with a portfolio of expensive stock and bond mutual funds actively managed by some guys my advisor “liked.”
You can probably already guess my error - this advisor was not a fiduciary (serving me on a fee basis) but rather was payed by the funds to whom he referred me. The fact that such a glaring conflict could exist inside a trusted institution is shocking, but this exact scenario plays out all over the US as a daily matter of course. I didn’t end up ruined, but I did do 5% in a 13% market year after all of the fees and inefficiencies added up. Needless to say, robots and passive indices do my public market investing for me now.
As investors, almost everyone we interact with has an incentive to give us inaccurate or incomplete information. Founders, understandably, want to present their companies in the best possible light. Writers need access, and are often forced to color their messages to preserve relationships. Even the ultimate third parties, ratings agencies, are vulnerable to the pressures of competition, as we saw during the 2008 financial crisis.
The sum of these conflicts and omissions are what is known as “information asymmetry.” Information asymmetry is the primary obstacle most investors, agnostic of space, face in making prudent decisions. In fact, one could sum up the mission of an early stage investor in just two parts: Get better dealflow, and reduce information asymmetry.
The scariest thing about conflicts of interest is simply that we need to live with them. COIs aren’t some boogyman to be flushed out and killed with a magic talisman. They’re unavoidable, built into the fabric of how we do business and even how we grow our personal relationships. Recognition and mitigation are first steps, but the only way to truly combat COIs is to design virtuous cycles into your life.
Five COIs that are more Trick than Treat
The first step to dealing with conflicts of interest is recognizing them. Here are a few that like to lurk in the tall grass:
1. Research from invested parties. Take a look at any research on Herbalife written by Pershing Square in the past five years. Crack open that Goldman analyst’s quarterly outlook on IBM. Read an ICO diligence report from any square of the internet. Every single one of them is impregnated with COIs at various levels of disclosure. For example, you know Bill Ackman is trying to sink Herbalife, but you read the report anyway to see if there’s new intel in there to vet and add to your mental model. Similarly, somewhere in the back of your mind you realize that Goldman has a position one way or the other on IBM, but do you really apply extra scrutiny to their dry outlook report? Finally, do you look deep into the appendix on the ICO research to find that the author is on a board which you discover promotes a protocol which is supported by the new coin? Is the author supposed to be a hypermoral superhuman? Or do you recognize the COI and seek truth elsewhere?
2. News with cognitive biases. The news you read wasn’t made for you. You’re not the primary consumer. When you pay for your news, the primary customer is the average of the subscriber base. When you don’t pay for your news, the primary customer isn’t actually a consumer at all — it’s the monetization engine (usually advertisers). Good investigative journalism can cut through layers of COIs, as did John Carreyrou when he wrote the articles that killed Theranos despite his boss’ $100M investment in the company. John is not the rule, he’s the exception. Far more news doesn’t make it to print due to COIs than does.
3. Non-fiduciary financial advisors. Plenty of red ink has been spilled on the internet regarding the distinction between fiduciary and non-fiduciary advisors. You heard my story above the break. Here’s Ryan Fuhrmann with a concise breakdown. TL;DR? It’s lunacy that advisors who amount to outside salesmen are positioned as mentors to vulnerable parties by some of the most trusted organizations on earth.
4. Ratings from vulnerable parties. During the 2008 financial crisis, the two major ratings agencies (Moody’s and Standard & Poor’s) were played off one another by the banks selling mortgage-backed securities. The end result was that the ratings and the bond qualities were entirely uncorrelated. (And we wonder why the technocrati are pushing for decentralization.) As usual, Michael Lewis does a better job explaining the phenomenon than I could. These same dynamics led to the degradation of CNET’s beloved electronics reviews from objective truth to uselessness. Recognize the complicated dynamics at play when the policemen are vulnerable to competition and financially dependent upon their subjects’ largess. Learn to view all ratings from “trusted third parties” as individual data points as opposed to codified conclusions. Only by building your own mental model will you be able to assemble a trustworthy picture.
5. Opposition discovery documents. The process of conducting due diligence on a startup is eerily similar to the discovery that occurs before a trial or arbitration. However, instead of being compelled by law to release any pertinent data, founders can broadly define what information makes it out of their systems and into the data room. Sure, they have a fiduciary responsibility to their investors not to outright lie to them, but omission is tricky business, and lawsuits don’t matter when the company goes under and there’s nobody to sue. So you have financial actuals going back to inception and your articles of incorporation are neatly in order. Big whoop. Where are the dashboard outputs that corroborate your user numbers? Where is the raw data so we can see if you used Monthly Active Users instead of Weekly Active Users because that dataset was easier to P-hack? Are you including email chains and purchase orders to corroborate the overwhelming customer interest you claimed in the deck? As always, the right attitude here is “skeptical, not cynical.”