Adam Capital Management

Adams Capital c be Fund IV Joel Adams, founder and full general follower of Adams Capital instruction (ACM), a $700 million early-stage game slap-up firm investing in the information engineering science, networking base of operations, and semiconductor industries, glanced up as his fellow general matchs trooped into his exp unrivallednt on a brisk December morning in cc5 for their one-year retrospective and planning meeting. The main handic on the agenda was a unused one, ?would 2006 be the right sen ten-spotce to launch their fourth storage?Since late 2000, ACM had been deploying its $420 million third gear fund, using its trade places prototypical schema, an approach that determine and sought to manage advantage of discontinuities within the common chord industry segments it tar confirmed. Having invested in a come with exploiting such(prenominal) a change, the general partners then command the investment through a five-point structured navigation system. I n November 2005, ACM diabetic sold a portfolio company and made its front distri exception to its limited partners (Lips).The funds portfolio withal had 18 former(a) operating companies that were showing steady growth, ND two sensitive investments were in the due diligence phase and preparing for lowest negotiations. The question as I see it, say Adams to his partners, is whether we need to drop dead more than than companies and generate additional distributions to our Lips before we start raising ACM Since Scams maiden fund had unappealing in 1997, the investment environment had gone from buirdly to hysterical to deflated and now, fin in ally, to what appeared to be a modest recovery. Likewise, Scams performance had been whipped roughly.Fund I was nigh top-quartile, Fund II could return jacket with a hardly a(prenominal) breaks, ND Fund Ill, a 2000 vintage fund was too unused to tell, Adams noned (see Exhibit 1 for performance data). The firm had adopted its schema in part to differentiate itself for authorization Lips. But the partners also believed that the concentrated opportunistic approach of many reckon firms?where each general partner was often given wide leeway in determining which, and how many, securities industrys and affair cases to invest in?could cause the firm to lose sight of the portfolio as a whole.Without a markets first strategy, through which the entire firm hold upon the markets of interest before engendering individual companies, the partners felt that firms would invest more on the basis of the fashion of the moment than on business fundamentals or market analysis. In Fund Ill, ACM had taken more profound self-will positions than in the past?typically 35% or more? lead any deal, and held a seat on every mature. In 85% of the funds investments, it was the first institutional money in the company.Adams believed that this was the however(prenominal) way to do to the sharply reduced volatility of the casualty capital market prove a collection of really good companies and own decorous f them to matter. Associate Ann Lemon wrote the original version of this case, Adams Capital solicitude ring 2002, HOBS Case No. 803-143 which is being replaced by this version prepared by Professor Field Harmony and Senior Research Associate Ann Lemon. HOBS cases are developed solely as the basis for class demonstrateion.Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective focal point. Copyright 2006 President and Fellows of Harvard College. To order copies or request authority to reproduce materials, call -800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http//www. Hobs. Harvard. Due. No part of this popularation may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmittable in any form or by any meaner?electronic, mechanical, photocopying, recording, or early(a )wise?without the permission of Harvard Business School.This document is authorized for use only in FINDINGS Alternative Asset Classes SSL/2013 by Jason Zen at University of red-hot South Wales from March 2013 to September 2013. 806-077 ACM k immature this strategy was not without its risks. Fund Oils portfolio contained more or slight rinsing companies, but, Adams said, When you own a real chunk of the company and it doesnt do well, that hurts the fund. Going to market with a good down(p) early fund, a struggling second fund and a yet unproven third fund might not be easy. The Lips may want to see why we dont go back to taking smaller positions in more companies, he noted. L progress to to be able to give them an answer. game Investing in 2005 The first half of the 21st century had unfeignedly witnessed the Dickens best and worst of times. The final years of the sass had seen an odd run-up in venture action at law. ever soy matter had add-ond?the amounts of capital raised, the management fees paid, the amounts invested, the prices that companies could command, the give out valuations received, and the speed with which investments became liquid. As the century changed, so did the venture environment.The NASDAQ reached its peak in March 2000 and by 2001, the party had come to a grinding halt. by and by a decade marked by continuously rising amounts of capital flowing into venture funds, 2001 raised half of sasss record of $71. 7, and 2002 and 2003 raised only 10% ($7 billion and $8 billion, respectively). L (See Exhibit 2 for fundraising data). By 2005, the numbers of deals, their price levels, and the size of the rounds had all fallen advantageously from their peaks in 1999 and 2000. Since the precipitous drop, though, they had steadied (see Exhibit 3 for trends).The initial decline, termed a train wreck, reflected the fact that al to the highest degree three years of record-breaking venture activity had funded too many companies chasing to o few customers in nearly all engine room customers had cut their capital expense budgets, and on top of that, were suffering from a backlog of earlier engine room investments that had not yet been fully implemented. Spending on technology fell off sharply. As a result, portfolio companies significantly underperformed expectations, often forcing their investors to resort to inside rounds for delayd financial backing because all firms were trying to fix their own troubled portfolios.Thereafter, activity had resumed albeit at a lower level. A further complication for the venture capital (PVC) industry was the longer path to liquidity. The Initial Public Offering (PIP) market dried up in 2001, only to revive?at least to a degreein 2004 and 2005. The number of venture-backed mergers and acquisitions had stayed reasonably steady in the vicinity of 300 transactions from 000 through 2004 and even wagered likely to continue for 2005 based on first-half data, the number of Ipso had pl ummeted from 264 in 2000 to 41 in 2001 and a mere 24 and 29 in 2002 and 2003.Although this number had tripled in 2004, to 93, sasss first half saw an uninspiring 20 Ipso, a number nevertheless close to the come for all of 2002. 2 By mid-2005, though, glimmers of recovery pierced the gloom. PVC fund- raising for 2004, at $1 5 billion, equaled the sum of the prior two years total. Firms had triages the worst of their problem companies, by selling them for the intellectual repertory, merging them with other weak companies, or shutting them down.Technological evolution provided market opportunities for materialisation companies and some older ones, weaned off the easy-money of the bubble, had brought their products to market and were profitable. Disclosed prices for mergers and acquisitions locomote to the highest average since 1 Abstracted from data from Private Equity psychoanalyst and Asset Alternatives. 2 Thomson Financial/Venture Economics, Venture Backed M&A Volume Holds St eady, www. Nava. Org, accessed December 8, 2005. 2 IQ 2002. 3 The approach to the PIP market, blown off its hinges in 2004 by PVC-backedGoogles debut, reopened, with new companies set their offerings almost every week. The pace and valuations of deals had swotn, and with it, investor confidence. Its not that PVC has become hard, said one veteran venture capitalist. Its Just gotten back to normal. Adams Capital Management Joel Adams, founder of ACM, grew up in Phelps, New York, a small townspeople between Rochester and Syracuse. My dad owned a dairy farm, recalled Adams, and his and doing chores. Adams was 15 when his aim passed away, leaving his father with no choice but to delegate most of his wifes responsibilities to the three children.Looking back on those days, Adams said At the time the meeting of events was a hell of a wake-up call for a teenager, but I learned invaluable lessons about money and time management. After graduating from the University of buffalo in 1979, Adams get together nuclear submarine manufacturer General Dynamics, where he became a test engineer, the lead engineer responsible for starting and examen a subs nuclear reactor and re bring outing General Dynamics during the Navys sea trials of the new boats. In 1984 he moved to Pittsburgh to attend the business school at Carnegie Mellon University (UCM), lured by its surd program in enterprisership.During Adams second year at UCM, he worked part-time for Foisting Capital, a small PVC firm that invested on behalf of the Fosters, a wealthy Pittsburgh family. Adams Joined Foisting after graduation as a Junior partner, with the firms new $14 million fund. Shortly thereafter, the firm and Adams became confused with PAP/Foisting l, a Joint venture formed with Patricia Co. To manage the $40 million fund that the state of Pennsylvania wanted to invest in PVC. In 1994 after nine years with Foisting, Adams, SCOFF Andrea Joseph, longtime secretaire Lynn Patterson, and former partner Bill Hulled armed Adams Capital Management, Inc. O cover the Foisting portion of the $60 million PAP/Foisting II, raised in 1992. In 1997, ACM raised its first fund, the $55 million ACM l, with its markets-first investment strategy. Discontinuity-based investing Ever since he had Joined Foisting, Adams had been dissatisfied with what he considered a lack of contract and discipline in the firms investment strategy. Heres a nuclear engineer, walking into this industry, with a very small fund in Pittsburgh whose strategy was to be alter by stage, by industry, and by geography, Adams recalled. After about a year, I said, This isnt a strategy at all? you could do anything. He was especially nonplussed by the method of developing deal flow. Rather than nurture about markets and then targeting specific deals within them, he said, The approach at Foisting was to open the mail in the morning to see what business plans had arrived. two of Adams experiences at Foisting acquainted him with the power of targeted investing. The first was his implyment with Sharper Corporation, a developer of software applications for technology product data management. l tacit the issues of engineering data management from my says at General Dynamics, Adams said. L was a practicablely smarter investor looking at an industry that I knew. Not only was he a separate investment manager and board member, he realized, 3 Ibid. 3 but he was also a better negotiator. Entrepreneurs are passionate and biased about their businesses, he said. If the first time I hear about a market is from the entrepreneur, Im at a mountainous disadvantage. His second revelation was even more powerful. Seeking a com indueer in 1987, Adams happened to learn about a mail-order operation in Texas called PCs Limited that custom-built in the flesh(predicate) computers and undercut retail prices.After speaking with the companys CEO, Adams invested $750,000 in the future dell data makeors first outside venture round. Had the firm held this position, it would have been worth $382 million as of the end of September 2005. Adams realized that dell had make waterd such an explosion of revalue by exploiting a discontinuity ? a spectacular and sudden change in a large and established market. In this instance, the discontinuity mixed distribution. The ascension of direct distribution surprised the large personal computer manufacturers, which had super entrenched outworks of retail dealers.These networks, Adams noted, couldnt be unwound overnight. Dell could constitute a multi-billion dollar business from scratch because his large and sleepy competitors could not respond to this distribution discontinuity in time. As ACM expanded, Adams resolved that any new partners would be engineers, and thus bring their technical training to bear in thorough examinations of a few promising markets (see Exhibit 4 for partner biographies). Scams strategy evolved to decoct on investments in markets that t he partners already knew well and had already identified as attractive.A few initial prerequisites had developed over time. The first was that the companies in which ACM invested would sell to businesses, not consumers, and their value propositions would be driven by return on investment (ROI). Thats ROI for the customers, not us, said Adams. Our first question is, If somebody is going to buy this companys product, what does the Chief Financial Officers recommendation look like? The second measure was that the business was fragmentation applied technology, or one of the first companies to use a specific technology for a specific application.Given the partners engineering backgrounds, the firm centre on the information technology (IT) and telecommunication/ semiconductor industries, areas that were, in their view, experiencing significant discontinuities. The most important criterion was that, as in the case of Dell, Scams portfolio companies would exploit discontinuities in existi ng markets, shifts that would crap opportunities for start-up companies to become market leaders. In the IT industry, the partners anticipated that the need to create practical(prenominal) enterprises on a global scale would force companies to look for highly alineable systems.The telecommunications industry, confront with global expansion in bandwidth requirements for data, seemed to be faced with an entire rethinking of the existing technology and infrastructure, while reaching the limits of current ti technology appeared likely to revolutionize the semiconductor industry. Within these areas, Scams partners sought to discern four primary causes of discontinuities (see Exhibit 5 for more on discontinuities) 1 . Standards. Despite the emergence of a technology technologies in an attempt to salve their captive customer base.Even as customers demented the old-hat, the existing manufacturers perceived it as a threat to their oligopolies market positions, and were reluctant to ad opt it. One such example was FORE Systems, which built communications devices that conformed to the ATM (asynchronous transfer mode) standard for communications in wide-area networks. The big players at the time, AT&T/ luminous and Northern Telecoms, each had proprietary protocols for those communications. These manufacturers clearly had the technical prowess and market muscle to 4 exploit ATM as well, but they were abate to do so for fear of cannibalizing their own racket shares.In April 1999, FORE was acquired by GEE Pl for $4. 5 billion. 2. Regulation. Unexpected regulatory changes could force market players to adapt cursorily to a new market reality. An example of such a dislocation had occurred in the U. S. Cellular market where a host of new opportunities and networks had emerged after the governments creation of the PCS spectrum. From a technology point of view, the new spectrum provided a chance for GSM, the cheaper and more easily-deployed base station technology popular i n the rest of the world, to gain ground on the unwieldy proprietary technology dominant in the United States.GSM equipment manufacturers and the upstart carriers who provided their services used their elation in the new regulatory environment to challenge the giants. 3. Technology. A technology-based discontinuity could take two forms. In one, it could appear as a whiz-bang package that took big competitors months or years to duplicate, such as Apples Macintosh operating system. Alternatively, it could involve the convergence of technologies that had hitherto been separate, requiring launching to allow these once-disparate systems to interact.An example here was the rise of bodily remote access, which forced companies to buy technology that would connect the public carrier telephone networks to the corporations internal local area networks. 4. Distribution. Dell Computer in the earlier example provided the ultimate example of a distribution-based discontinuity?the rise of mail-or der completely surprised existing personal computer manufacturers, to the great enrichment of Dell and its shareholders. This top-down approach to identifying markets was crucial in helping ACM achieve consensus about and control over where its partners would invest.Adams firmly believed, Market due diligence is the only due diligence you can do independent of a transaction. If you present the partners with the industry and market dynamics ahead of time, then we can all talk about each others prospective investment. Scams approach to identifying discontinuities included its Discontinuity more or lesstable, a group of advisors that met periodically with the ACM partners to identify and discuss market discontinuities that could lead to generative investment theses. The 20-person Roundtable comprised industry experts and observers who attended meetings depending on the topic at hand.Among their number had been Clayton Christensen of the Harvard Business School known for his research on how innovation affected markets George Symmetry, inveterate entrepreneur and founder and backer of over 200 companies Attic Razz, former CEO of MAD, the chip-maker that competed against Intel and Mike Maples, former COT of Microsoft. The process required partners to write discontinuity white papers that advanced the investment thesis and to present them to a Roundtable of appropriate experts drawn from the pool.The group would discuss the merits of the thesis under consideration, normally greening to pursue two or three of the eight to ten papers presented in a meeting. The meetings would also identify other avenues for future exploration. Once an investment thesis was well vetted by the Discontinuities Roundtable, the ACM partners would systematically search for deals in that domain. Sometimes this took the form of identifying pockets of virtue in the appropriate technology and supporting entrepreneurs in forming a company.In other cases, it was a matter of identifying and s orting through several existing potential investments. This process eve the partners deep knowledge of these companies opportunities and therefore made ACM more attractive as an investment partner. 5 Structured Navigation In addition to a systematic approach for identifying markets, ACM also developed a system for managing its investments, called structured navigation. The system was born out of the observation that early-stage technology companies shared many of the same benchmarks and needed many of the same elements to succeed.Jerry Sullivan, who had Joined the firm from MAC, Tektronix and Phillips, explained Our investments typically have high development costs bring together with the direct sales Orca characteristic of companies at these stages. The majority of our investments? 90%?are software-based, so resource planning and allocations are well understood by all of our general partners. We feel that our structured navigation strategy applies to all companies within the mode l. Aspects of the structured navigation included 1 . Round out the management team.Like most other PVC firms, ACM was deeply involved in helping its entrepreneurs complete their management teams. Almost 85% of the management team without capital, Martin Neat, a former executive vice president with IBM and now ACM general partner, said. People are going to Join a company that has some capital behind it, so we fundamentally believe that if youve got a great opportunity thats well-funded, youre going to attract a lot of talent. ACM consecrate significant resources to the creation of its Services Group, which helped its portfolio companies in this area. . Obtain a corporate partner or endorsement. The notion that an early stage company, hoping to exploit a sea change in a large existing market, could puzzle out a partnership (an endorsement, a distribution deal, or an equity investment) with one of the very players from whom it hoped to steal market share mimed entirely contradictor y. But the ACM partners believed that this should almost always be possible. From Scams perspective, forging these relationships early would often create other exit opportunities. . Gain early exposure to industry and investment banking analysts. pains analysts such as Garner, Gaga, and Forrester often created the first wave of market interest in a new technology. This groups validation could speed the acceptance or application of a new technology. While industry analysts could help create a market for the technology, analysts at investment banking firms could create an exit for the company, and ACM tried to make sure they met the portfolio companies early. First of all, the good analysts really do substantiate the businesses of these little companies, N. George Sugars, a general partner in the Silicon valley office, said. But the second thing is, bankers are in the fee business, and they need to put marriages together. Introducing the two parties early is a tactic that will set you up for deals after on. 4. Expand the product line. A first-generation applied technology company would be confronted by sigh initial costs of development and sales.In such a case, Bill Freeze, a general partner in Scams Boston office, observed, The marginal cost of the development for accompanying products or the next sale is much lower. Once a new technology product had been developed and a base of customers secured, the costs of leveraging that technology into another, connatural product and selling it into a base of existing accounts was comparatively small. But sometimes the entrepreneur hasnt thought that out yet, he noted. Our approach ensures that the companies are adequately focused on this value creation opportunity. 5. Implement best practices. Scams partners felt that their entrepreneurs should focus on developing products and selling them to customers, not on structuring stock pick packages or compensation 6 plans. After working with dozens of companies with si milar structures, the partners felt that they should be able to provide boilerplate versions of plans that worked. ACM used these five step (in no particular order) to manage its investments, complete.The process, the partners felt, not only made their investments more winnerful, but also provided the partners in four offices across the U. S. With a molly understood internal barometer of a companys progress (see Exhibit 6 for offices). If ten months into a deal you cant attract talented people, corporations dont care, and you cant get the bankers interested?youre tuition something, observed Sullivan. And maybe you ought to get out. Defending the Strategy Was it really demand to formulate such a rigorous strategy for investing in early- stage businesses?Adams admitted that, to a certain extent, the strategy was motivated by the practical necessities faced by a small firm based in Pittsburgh raising a $55 million fund in 1997. We had to get ourselves above the muck, and the way y ou do that is with a well-defined, market-centric strategy that you execute in a disciplined manner, he said. It had also given a small partnership, scattered among offices in Pittsburgh, Philadelphia (later Boston), and Austin, Texas (Silicon Valley was added in 1999) a common diction and approach that facilitated communication.Adams balked at the conventional wisdom about PVC and venture capitalists?namely, that PVC was a personality-driven business, and that successful venture capitalists were all genius dealers whose visual modality turned everything they touched into gold. L just dont buy the rock star model that many venture firms promote, Adams said. Instead, he wanted to build a venture firm in the same way that most businesses were built ? with a structure in which any of its employees were, in principle, replaceable. We wanted to develop a system where you could throw anybody out of here and the thing will passive cook along, he said. We wanted to build a system for in struction execution this business. Were engineers, we think that way. Were not rock stars. We have a system for conclusion areas that are of interest, getting deals, and making them valuable. Thats what we do. The Funds Since 1997, the partners felt that strict adhesion to strategy, combined with the systematic portfolio management that navigation provided, had served the firm well. They had grown from a $55 million fund to managing $700 million and from one office in Pittsburgh to four in areas in which 68% of all PVC activity in the U.S. Occurred. Each fund had been invested according to plan, although the results had not been entirely anticipated. ACM I had invested in 15 companies for a total cost basis of $55 million. Information technology accounted for 49% of the portfolio electrification for 30%, checkup devices for 11% and networking infrastructure for 10%. As of September 2005, the fund was fully invested and had exited all but one company, distributing stock valued at $122. 7 million for a net IR to its Lips of 46% Oust below the upper quartile).The general partners hoped to achieve at least $140 million in total proceeds by the end of Fund Xis contractual life. With its smaller size, ACM I had aimed for percentage ownership in the low teens. The firm had held a board seat in 67% of its original 15 companies, and its positions could get cut if it as 7 unable to participate fully in subsequent rounds. However, as Adams said, This was the home-run era of early stage PVC investing?significant returns were almost the norm. We had our share, with three acquisitions and three Ipso. That was a good fund. Based on the early success of Fund I and the frenzy around PVC, ACM had closed the $1 50 million ACM II at the end of 1999, followed quickly by the $420 million ACM Ill at the end of 2000 (see Exhibit 7 for fund statistics). In the over-heated environment of 1999 and early 2000, though, the partners found that the game had changed. At first it seemed that home-runs were still possible, said Adams Putting money to work was paramount. Unfortunately, this meant that we had less time to investigate new markets and we therefore had less diversification in the portfolio.If the big companies were looking for drop-add-multiplex-switches, that was what we backed as all of them were being bought because every big company needed its own drop-add-multiplicities. We ended up with a lot of similar companies. Our goal was to own around 20%, and we usually had enough money to keep our position, which was not always the best thing in retrospect. Fund II had stayed the strategic course. Of the 14 companies in the portfolio, three had been acquired, five written off, and six were still active and showing strong revenue growth.The firm had moved away from investing in medical devices though. Information technology made up 45% of the portfolio, semiconductors 38%, and telecommunications 17%. Although Fund Siss value currently stood at a 40% ignore to cost, Adams hoped that, with a few breaks, it could return the Lips capital. Fund Oils approach of taking large position had been adopted in response to the changes that the partners noted in the market in particular, a reduction in volatility. As Adams explained, The days of the coherent home-runs are gone.Reduced volatility meaner that we need to build portfolios that are more equilibrise and consistent in their performance. Were not looking for xx returns, although we certainly wouldnt retract them. I Just dont think thats the norm anymore. Instead, were looking to build a solid portfolio that yields xx to xx returns based on operating success?positive cash flow and net income. We look to own enough of each company that every deal is an impact deal, both for us and for the company. And here, because outcome volatility has fallen so substantially, we need to have mixed bag among our companies.You might say that beta has fallen so we must increase alpha. We had to assemble an interesting collection of really good companies that addressed significant discontinuities in the market and own enough of them to matter. Weve done that. Weve also added value to them through the ACM Services Group, which provides corporate partnering, recruitment and financial management guidance. By September 30, 2005, Fund Ill had called 74% of its committed capital. Information technology accounted for 59% of