To protect their investments, private market investors need to make every effort to reduce the information asymmetry that exists between them and their portfolio companies.

Significant information asymmetry exists in the relationship between an investor and his portfolio companies. What the investor sees depends on what the company chooses to present and predictably that tends to be the positive things. Successful product launches, new customer signups, and double-digit growth rates are likely to be reported as soon as they occur. Bad news such as key employees quitting, uncontrollably ascending burn rate, and deteriorating margins, on the other hand, are closely guarded by corporate executives to manage optics, attract capital, and potentially protect their careers.
This selective presentation of information can do serious damage to shareholders because when management decides to eventually lift up the curtain, it is often done when the business is already in a precarious position, if not hanging by a thread. What commonly ensue is investors are forced to inject more capital into the company, extending it with the runway that management needs to plug the holes and keep the business (and their investment) afloat.

Asymmetric Information (noun): information relating to a transaction in which one party has relevant information that is not known by or available to the other party

The question at hand is not how investees should be held accountable for such behavior, but what steps can investors take to safeguard against such untenable situations. Companies will always have the natural tendency to manage optics. It is, therefore, up to the investors to gain visibility into their investees and discern the difference between optics and reality.

In this article, we present three of the most important takeaways we have learned about how investors can subdue these asymmetries from our experience working with venture-backed businesses.

As mentioned, corporate executives have the tendency to selectively disclose information for various reasons. Yet many investors still only subscribe to just the CEO or CFO for their news feed. This has to change. Investors need to expand their source of information and make every effort to obtain unfiltered, timely, and accurate insights. They need to have the same visibility as the people working inside the company in order to gauge how their business is performing. As such, they need to be talking and developing relationships with people who are most connected to the day-to-day operations, who are the front-line employees. Salespeople, software engineers, account representatives, line managers, and floor workers are valuable resources that investors need to turn to because of their domain expertise and intimacy with the intricacies inherent in their company. They are not only more likely to be able to shine brighter lights on specific issues than the executives, but also help the investor understand the various moving parts in the business from the ground up. All of these insights will help the investor gain clarity into the developments inside their organization and minimize any blind spots that can affect the value of their investments.

We once spoke to a banker, who before building any spreadsheet models to approve credit agreements, would follow the CEO of the borrowing company for 2 weeks to study his behavior outside of work. Where does he spend time outside the office? Is he a compulsive gambler? Is he a lavish spender? The banker does this because he understands that the character of the CEO has as much influence on the company’s credit risk as its solvency ratios and that these behaviors are prescient indicators to whether or not the bank will get its money back. Similarly, investors need to pay more attention to these heuristic inferences, especially in the absence of reliable quantitative data. Paying surprise visits to portfolio companies and taking note of things like: did the CEO come to work, how satisfied are employees with their jobs, how are customers welcomed and treated on the premise, and is the company spending on things that don’t matter can be a highly enlightening exercise. These insights can never be revealed from reading management commentaries or P&L statements, but they can reveal a great deal about an organization’s health and its prospects.

The topics we have been discussing revolve around the effects of poor alignment between shareholders’ and managers’ interest. The key, it seems, then is to properly align this interest. The use of stock option grants and warrants have been widely adopted in order to motivate managers to think and act like owners. Their ubiquity, however, does not necessarily translate to their efficacy. Options and warrants do not expose managers to the same risk and return profiles as the shareholders. When a company’s value increases management profits from exercising their options. Conversely, when the company stagnates or is in trouble, management can simply leave their options unexercised and continue to collect their paychecks. Shareholders, however, do not have this luxury – they must ride both the ups and downs. Furthermore, these derivatives derive their value from retention of earnings, not return on capital. Management can simply reinvest earnings into a project that generates sub-optimal returns and let the power of compounding grow the bottom line without doing any significant work to increase return on capital. A more fool-proof approach, in our opinion, is to require managers to co-invest with shareholders. Managers should be asked to put their own money right alongside the rest of the shareholders either through direct buy-in or share repurchase plans. Weak managers who do not believe in the company’s prospects or their managerial abilities will gradually leave, leaving those with true managerial stewardship.

Companies operating in the private market face non-existent disclosure regulations. Poor bookkeeping records and management’s inexperience in dealing with outside investors further make investing in the private market that much more difficult. Thus, investors need to proactively work towards subduing the information barrier that exists between them and their investees. They need to not only expand the source of their information by getting as close to the insiders as possible, but also be more creative in the ways they gather and synthesize data. More importantly, they need to ensure that managers will do right by the shareholders regardless of weak structural restraints. Otherwise, the possibility of being blindsided by asymmetric information will persistently remain a genuine source of consternation.

Alpha Insights

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