The NASDAQ peaked in March, and by year-end the question is no longer whether we are in a correction but how much further it has to run. We were not prescient, but we were patient, and patience is the only edge that compounds. This letter is about what we are seeing as the water recedes.
On the Year We Stopped Adding to Positions
By March our pace of new commitments had slowed to roughly half its 1999 rate. By June it had slowed to a third. By December we made one new investment in the entire fourth quarter — and that one over more internal debate than any check we have ever written. Several friends asked us, in the second half of the year, whether we had decided to stop investing. The honest answer was that we had not decided anything. The pricing simply made the framework return fewer matches than it had in any previous quarter.
This was not foresight. It was that prices, almost everywhere, had moved further from value than our framework could justify. When the framework and the market disagree, we trust the framework; we have no other option. The discipline does not feel virtuous; it feels obvious. We will, by the time this cycle resolves, almost certainly have missed several investments that would have produced excellent returns. We will also have avoided a category of loss that we believe is about to become widespread.
One thing the year has taught us about ourselves: the temptation to deploy is more emotional than we had previously admitted. Sitting in cash, when peers are reporting paper marks, generates a kind of social pressure that compounds week over week. We have built, this year, a deliberate practice of not reading other firms' marketing materials during the months in which we are most tempted to deploy. The practice is small; the discipline it preserves is large.
On the First Time the Word "Distressed" Crossed Our Desk
Three companies we declined in 1999 came back to us in the second half of 2000 at one-fifth of their prior asking valuations. We funded one. We turned down the other two — not because the prices were wrong but because the businesses had not improved between rounds, and a bad business at a low price is still a bad business.
The seductive error of crisis investing is to assume that low prices imply margin of safety. Low prices imply margin of safety only when the underlying business will continue to exist. For roughly half of the companies that have come to us at distressed valuations this year, our reading is that the underlying business will not continue to exist; the price reflects the market's correct assessment of survival probability. Funding them now is buying a lottery ticket, not a company.
The one we did fund had two properties the others did not — a real customer base that had not deteriorated during the correction, and a founder who had taken a personal capital position in the recapitalization at terms that were no better than ours. We have come to weight founder co-investment heavily in distressed situations. It is the simplest test we know of whether the operator believes their own pitch.
On the Companies That Will Not Survive
We estimate that approximately forty percent of the companies funded in 1999 will not exist as independent entities by 2003. The lesson, when it arrives, will not be about valuation discipline. It will be about a more uncomfortable truth — that the business plans themselves were undifferentiated, and that the market provided cover for that lack of differentiation by funding everyone.
The category most exposed is the one that received the most funding. The internet was real. The companies built to monetize it, in many cases, were not. The market did not adequately distinguish between companies that were building infrastructure layers that the internet would require, and companies that were building user-acquisition machines whose moat was the marketing budget. Both got funded at similar multiples. Only the first kind will be remembered.
On the Ones That Will, and Why
The survivors will share a property that is difficult to describe in advance and easy to identify in retrospect: a customer who depends on the product. Not a customer who has signed up for the product, not a customer who is using the product, but a customer for whom the product's removal would be a meaningful business problem.
We are now spending more time talking to our portfolio companies' customers than to our portfolio companies. The conversations are clarifying. In several cases the customer's view of the product is meaningfully different from the founder's. Where the customer's view is more pessimistic than the founder's, we discount the founder's forecasts. Where the customer's view is more optimistic, we ask why the founder has not yet repositioned around the strongest use case. Both kinds of conversation produce better information than the standard quarterly review with the management team alone.
A Closing Note
This is the first letter we have written in which the year has clearly moved against us, and we feel — perhaps for the first time — that we are doing the work we were founded to do. Discipline in good times is theory. Discipline now is practice.
We will end this letter the way we ended last year's, because we mean it more rather than less: the families who emerge from this correction in the strongest position will be the ones whose discipline now is indistinguishable from their discipline a decade from now. We intend to be among them. We are closer, this December, to knowing whether we will be.
The Partners
Winzheng Family Investment Fund · December 2000