Philanthropic Mindset in Angel Investing is Bad for Everyone

Being Nice Without Boundary Will Poison the Well

Author

Fred Yu
August 20, 2024

I've just passed my second year as a private market investor supporting the Australian start-up ecosystem, both as an angel investor directly backing start-ups and as a limited partner (LP) in funds that make investment decisions on my behalf. After the honeymoon period of angel investing wore off, the reality quickly became brutal and, at times, ugly. Even though I approached the private market with caution—partly influenced by private investment critic Cliff Asness, certain aspects of the start-up ecosystem are still off-the-charts bad.

This post isn’t exactly a year in review post similar to last year’s, but rather focusing on a particular subject that has bothered me for some time - the philanthropic mindset of some angel investors.

Characterising Angel Investors

Contrary to what one might think, the bar for private market investing is low—both for capital providers (angel investors, family offices, limited partners) and for investment managers (syndicate leads, general partners). Low sophistication in this ecosystem magnifies some of the worst biases in investment management. The latter group deserves a separate discussion, but Andrew Ang’s list of issues in the context of PE and VC remains largely accurate today.

Hopes and dreams

Maybe if we can get that one lucky investment—the next Microsoft, Apple, or Google—we can solve our funding problems today. VC investing, in particular, has an allure of changing the world and making money at the same time. It is true that portfolio company returns are highly skewed, with one or two winners subsidizing ten or more losers. But the high-flying returns of the rare success do not offset the overall damage to the average investor’s portfolio. Thaler and Sunstein said that “if consumers have a less than fully rational belief, firms have more incentive to cater to that belief than to eradicate it.” What is true for consumers is just as true for institutional investors.

Information is poor

Contracts are opaque and contain hard-to-understand fees. Loftis is absolutely correct that PE contracts are “incomprehensible to the average taxpayer.” Phalippou (2009) says that all PE information—including true returns and total fee payments—is “shrouded.”

Selective reporting

“Every private equity firm you talk to is first quartile,” says a large pension investment manager. But they’re not lying. By selective reporting of IRRs, multiples, and even the vintage year, all PE firms can indeed be first quartile. Investors are fooled by dubious quality performance measures.

Duped by industry propaganda

Maybe asset owners are led astray by industry claims of good PE performance. They don’t know about survivorship bias, infrequent trading bias, selection bias, and all the other issues involved in measuring PE returns. Or their consultants haven’t read (or understood) academic studies tackling these issues.

Investor myopia

Even if investors have the ability to dig up all this information, they just ignore it.

Inability to learn

Or perhaps not wanting to learn? Either way, most asset owners don’t have Swensen’s “superior fund-selection skills.” Some investors even delude themselves in thinking that current contracts are optimal. Of the prevailing 2/20 contract, CalPERS says, “When this compensation structure is used, the financial interests of the General Partner are aligned with those of the Limited Partners, including CalPERS.”

Nonpecuniary incentives

There are reasons to invest in PE on a basis other than optimising returns. For example, banks make lots of money by selling other services to PE firms and by this means recoup their losses on PE investments. The ordinary asset owner doesn’t have this luxury.

Mispricing

Finally, perhaps investors pay too much for PE. There are too many LPs investing too much capital in too few PE firms. In the long run, investors may wise up and then PE prices will come down. Some PE firms are making adjustments to a forecasted decline in business. Large buyout funds such as Blackstone, Carlyle, and KKR have diversified into hedge funds and advisory work that looks like investment banking. Magnanimously, some have even launched mutual funds, thereby enticing a new class of investors—moms and dads—to earn subpar risk-adjusted returns.

True angel investors — those who write direct checks without paying the so called “syndicate leads” — can escape monstrous fees, which gives them a leg ahead. However, they face their own issues. Besides external/objective factors like limited access to the best deals, inadequate due diligence due to lack of information/skill/time, and insufficient negotiation power on terms, their well-meaning intent to be nice to founders can lead to bad outcomes not only for themselves but for the entire ecosystem when certain beliefs are taken as gospel.

I’ve met angel investors who said they expected to lose everything invested in start-ups and were okay with it because their funds were fuelling Australian innovations. I’ve also met angels who said they just wanted to help founders at all costs. Some of these angels had no meaningful careers and limited resources. While I admire their voluntary sacrifice, it truly benefits no one — not even the founders.

Marginal Buyers Determine the Market Price

In any market, there are different levels of investors with varying reasons to invest, different timeframes, and most importantly, different return expectations. Irrational investors may be small in percentage, but in a low-liquidity environment, they can effectively set the price for the entire market.

Let me illustrate with a simple example. Suppose an investment opportunity offers a payout of $5 per year. How much would you pay for it? Investors expecting a 20% payout would pay $25. Those expecting a 10% payout would pay $50. Investors satisfied with a 1% payout would pay $500. If enough investors are satisfied with a 1% payout, the market price for such opportunities will be $500. For most rational investors, this is too low, so they will stay out - I think this is actually a reason why the private market investing is still not mainstream, which I will cover more in the next section. The ones still investing are either misinformed or irrational. Unfortunately, in the start-up world, angel investors with these characteristics aren’t a minority. In the start-up world, success probability is like the payout ratio in the example. Rational investors assess the likelihood of success based on the conditions that need to be met, while irrational investors focus on whether success can happen, not the likelihood of it happening, and they price everything at an unreasonable level. “If an (idea-stage) start-up has the potential to reach billions, then a 7/8/9 million and a 2/3/4 million valuation makes no difference.” Believe it or not, many people in the start-up ecosystem actually hold this view.

From wanting to be nice to those making a difference in the world, to creating an investment scene where the terms become predatory, the gap isn’t large. For angel investors, in particular, the most misinformed people often set the market price under the guise of being nice to founders and respecting their time, making the entire market undesirable for more mainstream and rational investors.

A Sustainable Ecosystem Needs to Make Economic Sense

Australia is known for its love of property. In the start-up ecosystem, I frequently come across opinion pieces on social media criticizing property investing and mocking property investors. Some even go further, suggesting that property investment returns should be lower. This reminds me of what my old supervisor told me when I expressed concerns about fierce competition for scholarships—make yourself competitive, rather than hoping for no competition.

Interestingly, property returns aren’t extraordinary — property as an asset class can expect 5%–7% per annum in capital appreciation in the long term, which I think we can all agree isn’t crazy. What makes property investing special for an ordinary person’s portfolio is a combination of several factors I detailed in an earlier piece.

If the bulk of Aussies are pouring money into the property market despite unimpressive returns but not into the start-up market, the only rational reason is that its risk-adjusted return doesn’t really stack up. If it worked, it worked for a tiny minority of people involved, which we can’t say for sure is due to being fairly compensated for the risks involved. Here’s an unpopular view I hold: the fact that start-up investing hasn’t gone mainstream isn’t due to its illiquidity, but rather because of its subpar risk-adjusted returns. Start-ups, as an asset class, have a portfolio-level return that is mediocre, if not negative; this is a huge red flag. From an investment perspective, it’s actually a good thing for the public to not fund start-ups in an uncontrolled and unregulated setting. Even David Swensen, the inventor of the Yale Model who pushed private investing into the mainstream in the U.S., warned against it.

In the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from private equity investments.

David Swensen

If something is called an investment, it should be assessed as such. Philanthropic mindsets among angel investors are making start-up investing unattractive to mainstream investors. If an investment doesn't make economic sense, it will inevitably face perpetual funding shortfalls. What's even more unfortunate is that those who continue to support this uneconomic ecosystem are often the ones who care for it the most. Ironically, the key to making start-up investing more attractive is to introduce greater neutrality by accurately assessing the appropriate returns for the underlying risks, and to move away from the artificial and misplaced kindness that is ultimately damaging the entire ecosystem.

Reference

Ang, A., 2014. Asset management: A systematic approach to factor investing. Oxford University Press.

Swensen, D.F., 2009. Pioneering portfolio management: An unconventional approach to institutional investment, fully revised and updated. Simon and Schuster.