A year in which two extraordinary things happened: a phone arrived that may turn out to be the most important consumer product of the next decade, and the fixed-income markets began to crack in ways that suggest the next decade will start with a financial crisis. We have spent the second half of this year preparing for both.
On the Phone That Will Reshape Capital Allocation Within a Decade
The iPhone, released in June, is not yet what it will become. Its applications are limited, its keyboard is controversial, its carrier is unable to handle the data load it generates, and its initial price restricts its addressable market more than its eventual one will allow. None of these are durable problems. What is durable is that, for the first time, an internet-connected computer of substantial capability can be carried on a person continuously, and the implications of this fact will, we believe, be greater than any other technological development since the introduction of the personal computer.
We are now meeting founders whose business models begin with assumptions about always-connected devices that no investor was making in 2006. We are funding some of them. The category of company we expect to dominate the next decade is one we did not have the vocabulary to describe a year ago — a kind of consumer service whose value to the user is contingent on always-on access to the user's location, attention, and social graph. The category is not new in concept; it is new in feasibility. The companies that will compound from it are being founded now.
The harder question for our framework is what to do with our existing portfolio. Several of our companies were underwritten on assumptions about consumer behavior that the iPhone is in the process of invalidating. We have not yet adjusted positions on this thesis. We are watching how each company's leadership engages with the shift. Founders who are thinking ahead of the shift will adapt; founders who are responding to it will struggle. We expect to see both within the next eighteen months.
On the Cracks in the Credit Markets
Two Bear Stearns hedge funds collapsed in July. BNP Paribas froze redemptions on three funds in August. Northern Rock required intervention in September. Each event, taken alone, is anomalous. Taken together, they describe the early phase of a credit-market dislocation whose ultimate scope no one in the industry currently models accurately.
We do not have a precise view of how this resolves. We have a directional view, which is that the leverage in the global financial system is materially higher than the publicly available data implies, and that some portion of it will need to come out of the system in conditions that no one would choose. The mechanism by which leverage exits a system is rarely orderly. Our framework does not require us to predict the timing or the depth; it requires us to recognize that we are now operating in a regime in which adverse outcomes are more likely than the consensus is pricing.
We have, on this thesis, accelerated the rate at which we are reviewing portfolio companies' near-term capital plans. Companies whose plans assumed access to debt or to follow-on equity within the next twelve months are being asked to build alternative scenarios in which neither is available. The exercise has surfaced, in three cases, fragilities the management teams had not previously considered. We are addressing them now.
On the Liquidity We Have Been Quietly Holding
We have been over-weighted in cash since the third quarter. The decision was not analytically precise; it was the simple recognition that we have rarely been able to tell, at the start of a crisis, how deep it would be, and that we have never regretted holding more cash going into one than going out of one.
The opportunity cost of holding cash in 2007, by year-end paper performance, is meaningful. Equity markets continued to rise through October; venture-backed companies in our portfolio repriced upward in their late-2007 rounds; the comparable yields on Treasury holdings were materially below the returns we would have generated by deploying the same capital. We accept this. The framework that has us in cash now is the framework that will have us deploying aggressively in 2009. A framework that produces no opportunity cost in 2007 is not a framework we trust.
On the Investments We Refused This Quarter
Of the eleven later-stage opportunities we evaluated in the fourth quarter, we declined ten. The valuations did not adjust for what we believe is coming. We do not know whether we will be right. We know we are unwilling to fund pre-crisis valuations into a likely-crisis environment.
The one we did fund, we funded at a price meaningfully below the round's stated valuation. The negotiation took six weeks; the round closed because three other late-stage participants, encountering the same skepticism, declined at the original price. The eventual price was achievable because the founders required capital on a timeline they could not move. We do not enjoy negotiations of this kind. We engage in them when the alternative is participating at prices we cannot defend.
A Closing Note
One technology product is reshaping how human beings will use computers. One financial structure is reshaping how the global economy will absorb its next correction. We are paying attention to both. The 2008 letter will be, we expect, more interesting to read than this one. The 2007 letter is the one we will look back to in order to ask whether we were paying attention before the next year required us to.
The Partners
Winzheng Family Investment Fund · December 2007