Working with management for investment success

Private equity and venture capital managers appear to play different roles in investments – PE takes over companies and VC buys small stakes. But the methods should be the same: to work with management to build better companies, writes Damien Lane.

At first blush, the links between Venture Capital and the much derided Behavioural Insights Unit of the Cabinet office (the so called “Nudge” Unit) are not obvious. Indeed, in this age of bank(er) bashing, bonus envy and apparent antipathy within political circles towards the investment sector, some may find any attempt to link the two as a bit of a stretch.

The Nudge Unit is inspired by University of Chicago academic, Richard Thaler, whose work on behavioural finance has recently attracted much attention in government circles. At the risk of reducing a lifetime of research and thought into a short sentence, one of Thaler’s ideas is that you can nudge people to behave in certain ways by establishing certain conditions. My personal favourite example of Nudge theory was the decision by the authorities at Schipol to paint a fly in each of the individual urinals at their airport. This simple act encouraged the users of the urinals to take more care (or encouraged the competitive male to “try and hit the fly”) and reduced “spillage” by 80 percent, reducing cleaning costs and improving the user experience dramatically in the process.

For those of us who spend our lives operating as the link between the investment houses and the companies in which they invest, the parallels and learnings are familiar. Bear with me: any investor, be that a private equity house whose multi-billion euro fund may control 90 percent or more of the shares in an LBO investment, or a venture capitalist with a 15 percent holding in the “next big thing”, will recognise the basic tenets of Nudge Theory.

A smart investor of whatever hue seeks to back a top class — or even world class — executive management team.

Damien Lane

In the minds of many observers (including, sadly, some private equity houses), if a private equity firm owns 90 percent of the company, the private equity manager can and will take firm control of the business, issuing diktats and riding roughshod over the views of the executive management. In this narrative, the CEO kowtows to the investor, because he or she knows that the private equity firm controls the purse strings and failing to do its bidding will result in a short-lived life within the business. By this reasoning, a venture capitalist needs to work in a different way. Constrained by the fact that she’s a minority investor (if it comes to a vote she loses), she needs to display different behaviours.

The reality is – of course — more nuanced. A smart investor of whatever hue seeks to back a top class – or even world class – executive management team. Most teams that fit such a description would not accept diktats from anyone, even a smart equity investor who held 90 percent of the voting stock. Losing a top class management team is a pretty good way of destroying value and throwing one’s weight around is a pretty decent way of going about it.  

The most effective investor directors (whether seed capital or PE investors) don’t dictate, they ask questions, introduce contacts, challenge preconceptions and most important, in the words of Thaler and Sunstein in their work “Nudge”, seek to eliminate the “wide array of routine biases that can lead to an equally wide array of embarrassing blunders”.  While this is an extreme expression of the reality, I think a moderated version neatly covers the role of an Investor Director.

At the risk of offending some of the more straight laced readers, better to paint a fly on the urinal than spend money building bigger urinals, or — heaven forbid — take a more active approach to the problem…

Trouble is, most entrepreneurs didn’t get their business to ready for a Series A round by listening to others. Most appear hard-wired to reject orthodoxy and ignore the naysayers. A stubborn streak and single-mindedness is a necessary – though not sufficient – condition for entrepreneurs as they seek to build an industry changing entity.

How the investor might go about this is a subject for another day, but nudging is better than hitting and persuasion works better than manual intervention.

As someone observed of Thaler’s work: It’s where economics meets psychology.

If anyone out there has a better definition of the VC’s role on the Board of an investee company, I’d be keen to hear from you.

Damien Lane is a director in the ventures team at Octopus Ventures.