Asset class boundaries are distinguished more by culture than by economics. In private equity, investors exchange cash for equity in private companies. In venture capital, investors exchange cash for equity in private companies. The substantive differences are differences in culture. Venture capitalists don’t like to use leverage, while private equity investors do. VCs focus on what a company can become (terminal value), while PEs focus on what a company currently is (cash flow). VCs prefer to take big swings and miss most of the time, while PEs look to book moderate wins in every deal.
A PE firm will struggle to invest in good VC deals because they don’t get the culture. The partners don’t have blogs or personal brands, and they don’t know the kingmaking angel investors. VCs, on the other hand, often lack the expertise to source add-on M&A targets, and aren’t well-networked with middle market coverage bankers.
The cultural divide goes deeper than functional differences. VCs relentlessly email prospects “Let me know how I can help.” PEs regularly forward random bank coverage maps and offer to finance “transformative M&A.” VCs wear Loro Piana loafers, kitesurf in the Caribbean, and talk about psychedelics on podcasts. PEs wear Ferragamo loafers, host dinner parties in Southampton, and take psychedelics in the privacy of their own homes. A seasoned PE-backed operator might find VCs in the boardroom fluffy, while a VC-backed founder might find PEs abrasive. But at the end of the day, both asset classes fundamentally provide cash for equity in private companies.
What is an asset?
I define an asset as something you can own that generates cashflow now and/or generates cashflow in the future. The coffee shop I’m sitting in right now is an asset. They have customers which generate revenues that exceed costs. This coffee shop produces cash flows. The building where this coffee shop leases its space is also an asset. The landlord has tenants which pay rent and generate cash flows. My startup is also an asset. It doesn’t generate any cashflow right now, but it might in the future so we can ascribe some amount of asset value to the probability of future cashflow.
To create and operate an asset, you need funding. This coffee shop needed cash to buy its first shipment of coffee beans, its landlord needed cash to buy the property, and my startup needs cash to hire developers.1
Finance is all about assets, and how to fund them.
A simple model for finance
You can boil all of finance down to three main participants:
Asset creators: These are the operators. They’re the people who come up with the ideas, provide the services, and create the cash machines. These include the small business owners, the real estate operators, and the startup founders. They do the production. They sell the mousetraps. They do the useful stuff that other people are willing to pay for. They are the people with the ideas who need cash to execute their visions.
Asset owners: These are the people and organizations with surplus cash that want to put their cash to productive use. They have money sitting in the bank that they want to turn into more money. Asset owners include individuals with money in the bank (retail), as well as the pension funds, sovereign wealth funds, and college endowments (institutional) that coordinate investment on behalf of a larger group or goal.
Asset originators: These are the organizations that comprise all of “finance.” Originators include the commercial bank that issued your local coffee shop an SBA loan; the private equity fund that backed your rich uncle’s medical imaging rollup; the real estate credit fund that financed the new apartment complex on 4th and Bowery. Their reason for existence is to serve as a middleman between the asset owners and the asset creators. They spend their days sniffing around for promising asset creators, and then structure deals to inject asset owner cash into these assets (origination).
Asset owners have the money, asset creators need the money, and asset originators help connect the two parties.
Why do asset classes exist?
Asset classes exist for two reasons:
Asset owners want diversification. To summarize modern portfolio theory, it’s a safer risk/reward tradeoff to have your portfolio spread across a bunch of assets, rather than a single asset. If your town has two coffee shops that are equal in almost every way, you’d rather invest 50% in each than 100% in one (unless of course you have differentiated coffee shop expertise or a way to influence the success of the enterprise). If one coffee shop gets struck by lightning, you’re glad you had half of your portfolio in the other shop. Taking modern portfolio theory to the extreme, the ideal portfolio is a basket of all assets weighted by market-value.
Asset creators are culturally dissimilar. Back to the thesis, asset originators need to specialize culturally in order to effectively originate the assets. All asset originators are selling the same green money. The onus is on the originator to meet prospective asset creators on that creator’s turf. Real estate operators think in terms of cap rates while private equity operators think in terms of EBITDA multiples. It’s simply too wide a bridge to cross for each to realize those two pricing metrics are reciprocals (cap rate = profits / valuation; EBITDA multiple = valuation / profits).
Asset owners and originations mutually agree on asset class distinctions. This agreement enables originators to assimilate culturally with creators and ensures asset owners get adequate diversification. Finance, in abstract, is just a coordination system to get cash from your bank account into the hands of someone with a business idea. Whether that’s done via equity or debt, bonds or loans, public or private equity, doesn’t really matter.
Asset classes are mental frameworks and cultural values, not physical or economic laws. I wonder, if with the use of new systems and better technology, we could construct more efficient ways of connecting pools of idle asset owner cash with innovative asset creators.2
The cultural divide blocking cross-asset allocation
Asset classes are just different people, coordinating the same capital in different ways. None are right or wrong, they’re just different. When investors step across asset class lines, it’s like stepping into a party in a different country. It’s still a party, but if you aren’t familiar with the customs, you might feel out of place.
My college roommate was from Norway. I walked into our dorm one day and found him watching “The Killers - Mr. Brightside (Karaoke Version)” on YouTube. An odd choice, I thought, until he explained to me why he felt out of place at American college parties. Towards the end of the night, college DJs inevitably switch gears to a standard singalong playlist comprised of early 2000s alternative rock and miscellaneous timeless classics like Neil Diamond’s “Sweet Caroline” and Outkast’ “Roses.” He didn’t know any of the words and felt awkward as the only one not singing.
The real reason investors don’t cross asset classes is not because they don’t like parties. It’s because they don’t know the words to the songs.
I don’t need any cash right now, but I thought the example was illustrative.
I’m experimenting with a slightly shorter form post. Curious how you all feel about the length of this post compared to previous posts and your thoughts about the topic? If readers are interested in this topic, I intend to write a post brainstorming how technology could shape the contours of asset class distinctions. It’s a bit philosophical, but I think a normalization layer could be interesting. Something that abstracts away from the cap rate vs EBITDA multiple definition or the other nuances that make comparison of investment opportunities and allocation of capital across asset classes complicated.