Diversification Is Not Innovation & Venture Capital Is Not Private Equity

In 1955, 500 companies featured on the first “Fortune 500” list. Only 12% of those companies survive today. Sixty four years is not an eternity. We carry memories and lessons from the wars of another generation but often forget the changes that defines survival within our own. Moreover, the velocity of change has accelerated with time. A report released by “Innosight” in 2016 confirmed that

“The 33-year average tenure of companies on the S&P 500 in 1965 narrowed to 20 years in 1990 and is forecast to shrink to 14 years by 2026.”

This means that half of the companies which are on the S&P 500 today will be replaced within a decade by a new entrant.

The ability to change and adopt to new trends is not a matter of growth but that of survival and the real estate industry is slowly coming to this realisation. A new movement called “ Proptech” has become the buzz word for the industry. By definition, Proptech is the intersection of the property and technology built to propel the industry forward. But the label has now expanded to include any new changes that are seen in the traditional model of real estate investing. From Co-working spaces to photographing drones, the entire gamut of any changes to the industry is now collected within the larger context of “Proptech”. The acceptance of Proptech into the industry is a welcoming phenomenon but it has created a new dilemma. In order to achieve this acceptance and short term wins, the direction of innovation is being held back due to the bias that the industry has towards innovation.

Diversification is not Innovation

In the 1980’s management was being turned on its head. New degrees and new skill sets were being developed. It saw the birth of new ideas like Six Sigma & Matrix Management. And along with it came the concept of Portfolio Theory. The era was one of managerial bravado. Entering into the nineties, KKRs buyout of Nabisco represented the epitome of the change in the attitude towards the impact of management. This is also the same period when the Harvard Business Review came out with an article by Professor Ralph Briggadike called “ The Risky Business of Diversification”. This report had an impact on the new leaders of yesterday. It used a data driven process to attest for the ideal time that must be given to a business in order for it to succeed.

“New Ventures need on the average, eight years before they reach profitability”. Under the guise of diversification, the concept of corporate venturing was born.

Corporates began to seed new product lines and the idea of “new” was immediately linked to diversification. However, the success of a “venture” was founded on the idea that products or services were being made for existing market while utilizing the same distribution channel. The sunk cost discounted; the marginal impact of diversification was worth the investment in the “new”.

This was also the period when Real Estate as an institutional asset class was maturing. The industry took the view of diversification in order to address two types of risks: Market Risk and Technical Risk. Portfolios over time were diversified by asset class. Innovative financing structures were set up like the creation of securitization. The market eventually drove to changes in lease structures and terms. However, the industry has always shied away from investing in combating technical risk. The birth of Proptech was the first step towards addressing technical risk but from the view of incremental efficiency gains.

The examples of WeWork & Compass are narrated as the success stories of Proptech. But neither is an example of the diversification strategy of incumbents. They are a product of the greatest advantage of a startup which is to start from scratch with the relevance of today without the baggage of legacy. These are not startups that hustled. They conquered and will continue to do so. However, the attitude of incumbents today towards Proptech continues to apply a proven concept to their existing distribution lines. They don’t recognize that the greatest gain from innovation comes from creating distribution lines or markets that have not yet truly existed.

The application of technology is being restricted to arguments of efficiency and value add. Innovation is skipped in order to get instant gratification and the end result is a market full of noise and new dashboards.

Venture Capital is not Private Equity

In 1980 McKinsey was commissioned by AT&T to forecast the cell phone penetration in the US for 2000. Based on the existing metrics and intelligent projects, their prediction claimed a potential market size of 900,000 users . The true number in 2000 was 109 Million users. It is this uncertainty that is the very basis of Venture Capital. In 2013 when Blockbuster closed its last retail store, it was an indication that Netflix had won. When Netflix started delivering DVDs in the mail instead of a quick run to the local Blockbuster, the difference between the “David” and the “Goliath” didn’t seem very large. All they did was set up a website and some postal envelopes. Atleast this is probably what Blockbuster’s board assumed. Actually, I am sure that the board had not heard of Netflix till it was already too late. It was too late when Netflix without its baggage started innovating on content delivery and content itself. It’s not like Blockbuster did not follow suit or set up websites and streaming. But by then, they were already playing catchup. The state of incumbents in Real Estate is the same. They are looking at the innovations around them and grasping at first just catching up. In order to do so, there are many real estate companies investing in “Proptech” funds or setting up their own Venture Capital arms. But how does an industry that has always structured itself with Private Equity investment change everything they know to become venture capitalists. The real answer is that they don’t. Instead of looking for a Netflix, they are constantly looking for solutions they can “invest” in replicating the Blockbuster model of catchup.

There is much capital that is being raised for Proptech with the single aim of “futureproofing” incumbents. The mandate for most of this cash is to provide technology to preferred LPs who can apply and direct the products of companies to work as outsourced solution providers. The real estate industry understands Private Equity and is applying it to their new-found status in Venture. In Private equity, you start with numbers. These numbers represent success, cash flow and a clear tactic. The job of private equity is to optimize. However, Venture Capital does not start with numbers. It is based on people. Its successes are often linked to failures.

The challenge with private equity entering venture capital is that the innovators are being forced to behave like participants in a six sigma process instead of letting loose and fly or fall.

Embracing the Unexpected

In May 2015, Jack Ma addressed students in South Korea and outlined his “advise” for the progress of an individual. He broke life down into decades and assigned purpose to each decade. Before your twenties, life is about learning. Before your thirties is about following a good leader who you can respect and learn from. From Thirty you must find purpose and set the ground work for your life’s work. Your forties are to follow all your training and passion to do what you know well. The fifties is when you work with the younger generation and invest in them. And the sixties are about spending time on yourself.

While we can all relate to this from a personal perspective, we should be applying the same view to the lifecycle of companies. We could compare the incumbents of Real Estate as going through a mid life crisis. They are the equivalent of the 50 year old successful man who is holding on to his methods of success. They are trying to hold on to their relevance, trying to teach younger companies to do things their way but by using new tools. Instead what is needed is encouragement and investment which allows for the next generation to move forward. The strategy of supporting proptech with the bias of diversification & private equity is delaying the inevitable.

Real estate needs true investment in to people. Creative people, risk takers, outliers. People that are building a new future for the industry with no strings attached. It is from here that radical, head spinning change will come.

Andrew Day