Interview: The VC's process with Rohit Krishnan
Investor Interviews #3
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Some businesses are a bet that the future would look the same as the present,
while some are a bet on a different future altogether.
Both are different sorts of call options on the future.
One’s a boring one though, and therefore also gets short shrift.
Rohit Krishnan writes Strange Loop Canon - one of my favorite finds of 2021. Rohit’s bio is equally fascinating. “I'm an engineer and an economist, ran a hedge fund, worked in 4 continents, and currently am a venture capitalist.” (Sounds a bit like Iron Man) I’m a fan of his thematic articles on:
What it takes to build a great company or organization
How to identify and nurture genius
Lessons from history for investors
In this interview, I picked Rohit’s brain about how Venture Capital works, how to identify great companies to invest in, and protecting against risks in perception-based and innovation investing. He drops a lot of actionable insights along the way, so read the whole thing - But if you’re short on time, here are some key takeaways:
VC is the attempt to build a portfolio to solve two equations: Getting 3-5x MOIC (Multiple on Invested Capital) in a decade or less with early-stage companies and reducing your failure rate.
Metrics help in tracking performance. But the real learning is in comparing what you think is important vs what turns out to be actually important.
You maximize the chances of finding great companies if you pick a lane and stick to it. While you build a narrative to say yes to the company, also check financial health to ensure that there aren’t reasons to say no to it.
Dividend investing is completely undervalued - It aligns the incentives of the business and the investor, but growth investing has better PR these days.
In any model of the future, identify the moving parts to project bull and bear cases, and understand how things can turn out. This is especially useful when it comes to perception-based assets like crypto.
A small group of people can have an outsized impact on the world. Most people will respond if you reach out!
Let’s dive right in…
Since life experience is probably the investor’s best resource, can you tell me one thing you took away from
Running a hedge fund
That improved your investing framework?
Ha, this is a perfect example of an irreducible problem, since I don’t know any easy way to disentangle what I learned from each space. But taking a wild stab I’d say that
Engineering was great because it taught me that while I love systematization and science, I’m not temperamentally suited to bug fixing or soldering.
Economics was great because it taught me the power of toy models, fantastic for investing (and dangerous).
Running a hedge fund taught me that while playing a video game for a living is great fun in the short run, it can get boring.
Though I do look back and wonder about the road not taken. But that said one thing I do take very seriously is systematizing my thinking on even private investments and trying to keep a log across metrics, so I know if I'm an idiot or more likely how exactly I'm an idiot.
Which space are you interested in as a VC?
I look primarily at enterprise software companies, which end up being B2B SaaS quite often, Fintech that’s more on the infrastructure side, open source, database companies etc.
Morgan Housel said VC is like indexing but with compressed timelines - with higher risk-reward as well. How would you describe what you try to do in VC?
Well, I have a general thesis that VC is interesting in finance because of two things:
It’s primary capital deployment, pushing capital into the company to help it grow.
It’s looking to get 3-5x MOIC in a decade or less.
Everything else is a solution for this equation. You need to create a portfolio because the survival rate for young companies is not that high. And you need young risky companies that are growing fast because that’s the only way to get these MOIC numbers.
So yes, it’s kind of like indexing, in that you have a bunch of bets with the distribution of outcomes being a steeper power law in VC, and with a higher degree of death rates in VC. But the fact that it’s primary capital makes this a different bet - Also frankly a more fun bet because it's actually something being built partially because of you!
What core metrics do you track? How have you systematized this?
I use a number of metrics to evaluate companies, which you can access in this Google Sheet (I have anonymized the names of the companies, but my process can be seen there - Check the metrics tab). The true impact was on what I thought was important vs what turned out to be actually important.
(Note from MS: Getting an inside look at how a VC investor picks their companies is a rare opportunity - If you’re interested in identifying great companies and are working on your process, I highly encourage you to take a look at the sheet!)
Great companies and management
What makes for a great company? How do you go deeper into studying companies? What should you look for?
Now, what’s a great company? Well, it’s an easy question because the answer is nobody knows. Literally nobody. High-risk high-reward is a true idiom except it looks the same as high risk, no reward. The only ways I know how to distinguish are to play in my lane (look at companies in spaces I have some clue about). This is very similar to reading, in that I use my curiosity as a guide, and this is why it helps to look at spaces that you personally find interesting.
And also it’s important to do the smell test to make sure that something is working in the business (sales, unit economics, marketing efficiency, etc). A lot of this is using the data to make sure you don’t need to say no while looking for reasons to say yes - which is to figure out a narrative where you can figure out if it’ll be a huge company one way.
There seems to be an unsaid understanding that a “rockstar” or prominent leader is a good thing for a company - Steve Jobs, Zuckerberg, Elon Musk, etc. But is that true?
I’m not very sure about this. You do see a lot of prominent leaders, and sometimes they’re exceptionally good and often bad, and many times just middling. Steve Jobs, it’s worth remembering, got kicked out of his company! The danger for investors is that wilful rockstars are less receptive to feedback often, are headstrong, and can often lead the company off a cliff. But the pro here is that occasionally this is the exact cluster of characteristics that leads one to create extraordinary value!
So to me, this is a portfolio construction question. Rockstars are great if you have market tailwinds and strong execution, which makes them particularly attractive for ventures. It's worth noting Apple’s meteoric rise was under Tim Cook, for whom charisma is kryptonite.
It seems like cutting-edge developments these days are happening mainly in interdisciplinary areas. But how do we tell apart the generalists who have something from the over-simplistic generalists who lack know-how (every wannabe Elon Musk/Steve Jobs)?
I do feel that we should absolutely be focusing way more on creating better interdisciplinary collaborations. It’s a core belief of mine that this is core to progress! Santa Fe Institute here is one of my favorites, but my friend Sam Arbesman has an ongoing list I believe, and is a big proponent of this idea too.
The difficulty is in identifying generalists who are just playing the Glass Bead Game for their edification and status, vs those who are actually interested in trying and creating something new. I’m actually not very sure anymore that we can even tell them apart to be honest. The question I’ve turned to is less can we tell them apart, but rather - how can we risk-manage our way through the ones that aren’t all that good?
It’s like with trading, it's not about whether all trades are profitable, it’s how well you cut the losses for those which aren’t! Or, to use another analogy, it’s like venture capital, it’s not about whether all your bets are profitable, it’s about ensuring that the few exceptional ones make up for all the rest.
What mental models can protect investors from tail risks when investing in rockstars?
I’m relatively unsure mental models can protect from tail risks, to be honest. Thinking of your portfolio as a portfolio is a great start, rather than a collection of companies. Also, it’s a good idea to do due diligence on whether the company you’re investing in is a fraud…
Beyond that, it's worth asking what the rockstar is bringing to the table. If it’s general swagger like Neumann, then probably not as worth it. If it’s actual competence like Musk, more so. If it’s taste like Jobs, worth it again. We come back to whether there's a narrative about a future you can believe here, that stands separate from the rockstar.
What tools and resources does each level of investor (VC, institutional, employee, outsider) have for assessing company management, and what’s a good process?
One thing I’ve noticed is that private market investing just lets you see so much more information about the management than anything public. Generally speaking, this holds true, so the question is to make sure this doesn’t hurt you much in your investing style.
For instance, in retail markets, it’s better to look at external factors regarding management. For example, sure, Frank Slootman of Snowflake has a track record, but also the actual performance factors of the company have to stand in for any management specialties. It’s worth noting even as a VC: Though you have a lot of interaction with management, it’s not a given that this helps you suss them out or has a direct impact on better decision-making!
Investing in longevity
“The price of following your passion and charging ahead in a given direction, that prize is the Elvis Presley of prizes - to live fast, die young, and leave a good-looking corpse.”
Your piece on what makes companies long-lived and immortal touched on a great idea: Looking at Company Lifetime Value as a metric of the longevity and long-term value of a company.
Has IPO or acquisition culture driven entrepreneurs into an “exit-model” mindset rather than building empires that last forever?
I have this deep fascination with the idea that we’re living in an era that completely undervalues dividend investing. I’d love to own a business that throws off dividends or profit shares to its owners. To me, this is the tried and tested model of a business that is incentivized to help grow sustainably in the long term and provide ongoing returns.
Now, when you’re investing in the markets you’re a participant in it regardless of if you want to be or not. And it’s definitely the case that companies definitely have an exit mentality as an option. But to a large extent, this shows up in a rather loose way of organizing and running the companies - if you’re penalized for profitability why would you ever develop those muscles after all?! If you've been looking at Tech in the last decade this surely stands out!
If dividend investing and profitability are the tried and tested methods, why has there been such a rapid switch in mindset away from them? Is it just plain “greed”, or is it something else?
I think they fall along a continuum. I mean, is Google growth or value? Or Apple? The difference is that some businesses are a bet that the future would look the same as the present, while some are a bet on a different future altogether. Both are different sorts of call options on the future. One’s a boring one though, and therefore also gets short shrift. That said I've come around to the POV that the best investment is one that gives you enough cash outflow to live comfortably, and everything else is then alpha hunting.
On a different note, how do you align long-term incentives with short-term incentives? Your VC firm Unbound’s vision is to back “100-year companies.” How do you demonstrate long-term vision when there are short-term fluctuations?1 Why is longevity investing even good if lifespans are short?
Investing for fees as funds get large is a genuine problem. It's partially ameliorated today by hiring smart people and promising them eventual riches, but there's definitely an aristocracy that gets built up. Part of the interest in longer-term investing is twofold -
The best companies e.g the tech giants are products of like decades of steady growth. In banking, insurance, energy, materials, utilities, healthcare, and so on. Compounding is magical.
It feels like one of the few areas which are anti “the growth now and forever” ethos. Whether it'll work tomorrow I don't know, but whether it'll work eventually seems an easier question.
Sam Bankman-Fried created some commotion when he compared tokenomics with VC: “This is how VCs work as well - They listen to their friends talking about the coolest projects in town and when their investors ask them about it, they say, we’re working on getting into that space.”
Do you think that’s as bad or ridiculous a model as it sounds like? How do you filter out the signal from the noise and how do you do an independent assessment? Or should you just leave perception-based investments alone?
I think it's ironically actually a rather great model. If you trust that there exist pockets of capability where there are networks of people who are innovating in a space, then the best way to bet on that ecosystem is to find a way to hack into that network. Which would, from the outside, look like listening to who’s talking about the coolest project and get into it once they hear a few people refer to the same things. The bad way to do it is to listen to any random Joe, the good way is to listen to someone who’s credibly in or adjacent to the relevant network. That’s the art.
I'd also say the most interesting parts of tokenomics I've seen are to use it to provide utility or to bootstrap a network. But they're both fragile for different reasons. First, because the utility is always hard (it's a seed stage company) and second, because the incentive structure of people in the network becomes muddied once there's trading involved.
Also all investment kind of relies on perception somewhere. Crypto is at one end because it's younger and crazier, but your equity investments also get on the hype Keynesian beauty contest pretty often. Yes, one has an underlying business, but a priori I'm not sure a basket of outcomes like f(0, 100) is less compelling than f(30, 70).
Interesting. I’ve often thought about this: how the stock of a company many times is just stock backed by a story. Why do they have greater legitimacy than crypto? Is this sort of decoupling a good thing, a bad thing, or just inevitable?
Legitimacy is a function of both utility and legibility. If something is highly usable but completely illegible it gets tough to value. As does something completely legible and easy to value.2 A story stock still is higher on present-day utility which gives credence to lower risk, also because the general vetting of companies to go public is high enough. Crypto is less legible and has no institutional grade assessment mechanisms so it's a lot more caveat emptor.
Any “independent assessment” here - in stocks, crypto, anything - has to create a few credible models of what the future looks like (bear case, base case, bull case) for a particular investment you're considering, look at the bet size (how much you're putting in), and the portfolio (total number, size and distribution of bets).
So if you're putting 2% into a crazy boom or bust bet but the rest is sensibly invested, have fun. Barbell strategies rock, as I've written before, in life and finance. Rule #1 is simple in investing, don't be stupid. Come to think of it, also in life!
What counts as an “independent assessment”? News, DCF valuation, looking through financial statements… You must have personally started somewhere, how has this evolved with time?
I started with macroeconomics, which I loved and still do. I made a brief foray into technical analysis that ended disastrously because I didn't understand it, respect it, or believe in it. I then moved to fundamental analysis, basically buying for the future in companies where I could credibly create a longer-term narrative, and this I still do. It fits me.
Regarding DCF etc, any equation where the variables are highly uncertain is pretty pointless in my opinion. Those who do it well, like Damodaran and Michael Mauboussin, use it this way: To identify the moving parts and create plausible futures, with the prices being the output of those futures even if they themselves don't mean all that much.
One other helpful note here is that if you do cases (bull, bear, etc) and you assign probabilities to those outcomes, you can get better at assessing those such that your Brier score gets better. It's like a portfolio management approach to get better outcomes for the overall ROI. Though it should always be emphasized that even if you get really good at predicting the outcome case, probabilities usually aren't the same across market cycles, meaning there are likely to be plenty of times, usually around market turbulence, when many things go to hell together.
That also makes me prefer Buffett’s rule number one, which is to not lose money!
Recommendations and advice
What are you reading now?
A whole bunch of essays and articles in my pocket list, a few books (Talent by Tyler Cowen, David Graeber’s latest The dawn of everything, What We Owe Our Future, Where Good Ideas Come From, and a reread of the Culture Series).
How do you curate your reading list? And if you fall into rabbit-holes during your research, how do you pull yourself out?
I use the Marie Kondo style asking “does it bring me joy?” Reading is fun, and when it stops being fun, I stop. Information’s everywhere, there’s no reason it has to be a slog!
Fun doesn't mean you have to be a greedy algorithm, maximizing and optimizing at every turn, but that you're using your sense of fun as a guide to read and imbibe something. The trick is not to never fall into rabbit holes, but so you have enough forward momentum that even if you fall you end up coming out of them through sheer momentum. Writing helps here a lot because it's direct tangible output and helps you think, enormously!
Are there any reading/educational suggestions for our readers that will make them better investors? (Books, newsletters, podcasts, courses, etc.)
Podcasts, essays, and books, there are others out there (including where you’re reading this), which are excellent. But maybe from the left field let me suggest a few that stayed with me -
The Origin of Wealth by Eric Beinhocker
Glass Bead Game by Herman Hesse
Where’s My Flying Car by J Storrs Hall
The Nature of Technology by Brian Arthur
Do you have any idea or suggestion that our readers can take away to become more well-informed investors, or make investing a little more enjoyable and stress-free?
Know your limitations (Do you love reading 10ks or hate reading economics?)
Figure out your style (macro investing, stock picking, robo-advisor, day-trader) and
Do what you actually find interesting (otherwise you won’t follow through).
And most importantly if you don’t have time or inclination to do it yourself, just make sure you split your play money from your actual long-term investing and put the latter in a market ETF or a lovely robo.
What is one idea you discovered recently that blew your mind or changed the way you think about something?
A creeping realization that small groups of people really can affect or create entire movements that impact the world. The optionality from seemingly pointless activities like writing online is fantastic, and the internet is a brilliant place to make friends.
What this means is that the impetus needed to try something or start something is as simple as not stifling your curiosity about something. Most people will respond if you reach out. Lots of people will engage with your ideas. And with this, it’s crazy in this age of abundance to not start more things!
Which article of yours is the most popular, or most talked about? Does it surprise you?
Probably On Medici and Thiel, and Why do big businesses suck at innovation. They both surprised me, to be honest. Both were very easy to write and snagged an idea that clarified things in the foreground. I think occasionally when you write you stumble onto an idea in the zeitgeist, and that sparks a conversation you weren’t expecting!
Which article or idea of yours is your personal favorite?
Hmm, tough one. I'd probably say Hierarchical Growth Tradeoffs, or A Combinatorial Theory of Progress. First, because it really taught me a lot about the difficulties and benefits of scale, analyzing complexity, and generally systems of all stripes. Plus it has a toy model which was highly satisfying.
The second is because that's probably the article I spent the most time on. It's an idea that I really think is one of the most critical - How innovation actually happens in our society. And it has an extremely gratifying toy model I coded in replit which made me very happy when it worked out.
If you enjoyed this piece, please do me the huge favor of simply liking and sharing it with one other person who you think would enjoy this article! Thank you.
But first, go to Strange Loop Canon and subscribe (it’s free!) for more fascinating posts on innovation, what makes companies great, and thoughts on cutting-edge tech.
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Disclaimer: I am not a financial advisor. Please do your own research before investing.
Some examples of incentives not being aligned: This article by Nick Maggiuli shows that hedge funds maximize fund inflow and fees over long-term returns, tech companies mine attention by polarising over creating value, election races, etc.