More and more companies are asking us to accept their investment gains as a part of their ongoing business. This column has spent significant time over the past 18 months discussing the issue of "reported" earnings data -- spelling out my view of what makes them valid numbers or mere showmanship, and how an intelligent investor should factor them into some sort of disciplined investment approach. Here's latest monkey wrench being thrown into the process: corporate venture capital.
In the fourth quarter of 1999, 44% of
reported earnings came from
, its private equity arm -- while lending contributed 8%. Twenty percentage points of
30% earnings gain came from an increase in "investment income," representing returns from its $20 billion equity portfolio, which is conceptually growing by $1 billion a month in free cash flow.
reported a $596 million gain on the sale of its
stake, vs. $175 million from flying planes. Intel's blowout quarter also had a heavy dose of venture gains from its $6 billion investment portfolio -- and the company claimed that these gains were "sustainable."
So the question for investors is: How do you value and account for these gains? Is there really such a thing as "sustainable" investment gains? (Yes, this is a question that is still worth asking!) How should companies account for these gains so that investors can make their own decisions as to how to separate the core businesses from the gains business -- and value them appropriately?
These are huge questions for investors, if only because the numbers are becoming so huge. For the first three quarters of 1999, venture capital by corporations totaled $15.4 billion, according to the
National Venture Capital Association
, a number which I am sure is getting bigger by the day.
In the last three years, the number of companies with VC funds has tripled from 49 to 163, which again sounds understated. In just the past few weeks,
revealed a $1 billion fund,
announced a $500 million fund and even the "old guys" like
Kohlberg Kravis & Roberts
are getting into it. Even the $@%#&*
has announced a venture fund and started an office in Silicon Valley!
On one hand, it can be argued that this is a terrific thing. What has made this country the economic envy of the world can in many ways be traced to the entrepreneurial spirit of its people and its capital. We have a culture that tolerates mistakes (apparently, no matter how disastrous) and we have a marketplace that (most of the time) fluidly connects ideas with capital.
Even enlightened big corporations are still big corporations and eventually get bogged down in layers of decision-making. By going independent, a company can break free of the bureaucratic sand trap that says "if it was not invented here, it can't be any good."
Despite the current logic driving drug company mergers, it makes intuitive sense that a lot of real innovation happens in small groups, and companies need an outlet for creative thinking that may get strangled inside a bureaucracy. It can also be argued, particularly in the technology world, that it is easier to buy rather than build -- and therefore taking stakes in a boatload of conceptually crazy ideas can yield some terrific results that would not occur under the main corporate roof.
That said, is this really a "sustainable" business that should be valued at the going corporate valuation rate -- or are these really one-time gains that produce essentially cyclical returns? When things are hot (which is the understatement of a lifetime in today's environment), returns are enormous. But when things are not so hot, these returns evaporate -- or worse, they become losses as investments are written off.
Naturally, in a corporate world where stock prices are high (in many cases), and the pressure to meet and beat already-high expectations is intense, the focus is clearly on getting while the getting is still good. I think it is absolutely incumbent upon company management to clearly report investing gains and let investors make their own decisions. Accounting rules are generally tilted toward this disclosure, reporting gains and losses "below the line," which means below the operating income line on an income statement.
But clearly the practice is not universal. There have been numerous instances where a company reports great numbers in their press release, and then when the
rolls out a few weeks later, it is revealed that part of the results came from a gain of some sort.
, for example, has never truly broken out its gains from
from quarter to quarter, arguing that it is their business to produce gains and therefore it reports them "above the line."
I don't think GE's integrity is at stake -- and they are not alone in this -- but when a company sells at 43 times earnings and hits its earnings
quarter to the penny, there has to be some pressure to manage when and how the gains are taken and reported. And this can distort the volatility of earnings for the underlying business.
There clearly is some inherent value in a corporate VC effort, as GE and others have generated terrific returns from VC and other investing for over a decade. And who wouldn't like to have wired insiders at
and Microsoft investing on their shareholders' behalf?
But I just can't shake my belief that these gains are cyclical and the getting is as good now as maybe it will ever be. If everyone and his brother is starting VC efforts, isn't there a basic rule of economics that too much supply chasing deals will drive down returns as money gets thrown at lower-quality deals? And now -- even your younger brother is doing deals!
The technology-industry rag,
The Weekly Standard
recently reported that one Josh Newman, a junior at
is in the midst of raising $10 million for a VC fund premised on the idea of "why wait until we graduate?"
The fund will finance college-based start-ups. This idea has some basis given the fact that
and the big daddy of college start-ups, Microsoft, were founded by college students.
After all, the reasoning goes, the really smart guys are still the smart guys in college. And aren't college students the people who really have the time and lack of responsibilities to sit in front of a computer with an endless supply of pizza and Coke for 20 hours a day? It is clear whether the fund will focus strictly on those who are on a path to graduate -- or will focus on those efforts where the upside is so large that only an idiot would stay in college to finish.
Doesn't all this recall the corporate culture of Japan during the boom of the late 1980s: excessive corporate stock trading to boost profits to justify market prices that in retrospect turned out to be simply silly?
Now, I know that it is a stretch to compare corporate daytrading and dollar-yen spreads to what is sometimes highly strategic corporate investing. And I am not suggesting that it is unintelligent for a company to have a VC fund for the reasons mentioned above.
But what I am suggesting is that it takes hubris to suggest to the investment community that a VC arm of a corporation has somehow solved the investment riddle whose answer everyone is searching for -- and can now convert this knowledge into a predictable stream of cash flow.
But the investment community is equally guilty of self-deception if it buys this. With the overwhelming weight of very recent history, it seems obvious that we are in an environment where outrageous gains can be produced seemingly from nothing more than a cocktail-napkin business plan and some adventurous investment bankers. It is equally obvious that this will not always be the case, and that the billions pouring into the venture capital business hasten its demise as a corporate strategy -- at what probably is a geometric rate of progression.
Jeffrey Bronchick is chief investment officer at Reed Conner & Birdwell, a Los Angeles-based money management firm with $1.2 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value Fund. At time of publication, RCB was long Microsoft, GE and Time Warner, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at